Maximizing Tax Benefits: A Guide to Rental Property Tax Planning [Updated February 2024] - Merriman Wealth Management (2024)

Updated February 2024 by Geoff Curran, Jeff Barnett, & Scott Christensen

Nearly everyone wants to be thoughtful about how much they pay in taxes and make smart decisions with their investments. With wins under your family’s belt like buying your first home, launching your careers, moving up to a forever home, and turning your starter place into a rental in your growing investment portfolio, it’s time to answer some of those tax questions about your rental property. We want to help you build on your success!

One trending piece of advice we’ve seen is to keep your first house as a rental when you move, so you can start claiming depreciation as a tax deduction and minimize your taxable income each year. You could take that a step further and buy rentals to stack up enough depreciation and net losses to minimize your tax even more, but it doesn’t necessarily work that way. Buying rentals was also a very popular way to access cheap leverage when mortgage interest rates were very low. Now that rates have climbed, keeping your first home as a rental with its low-cost loan is appealing.

Trending advice aside, we also enjoy our fair share of armchair financial tips, but the tax discussion is not that simple. Let’s take a look at some of the moving pieces for determining taxes when you own and sell your rental.

One of the benefits of having a rental is the ability to claim depreciation on the property, which allows you to offset rental income that would otherwise be taxed as ordinary income. If you have a net loss from your rental after claiming depreciation, those losses could then reduce your other income to an extent. It sounds appealing to purchase rentals to claim depreciation and reduce your taxable income, but the IRS is aware of this trick.

Losses from rental properties are considered passive, and unless you’re a real estate professional, you probably won’t be able to utilize them too much beyond offsetting other sources of passive income. The challenge is that you are not allowed to offset wages and other non-passive income with passive losses if you’re a high earner. You can only deduct up to $25,000 of passive losses against other income if your adjusted gross income (AGI) is below $100,000 ($12,500 limit up to $50,000 if married filing separately), and the $25,000 deduction fully phases out above $150,000 AGI ($75,000 if married filing separately). For people above those incomes, your excess losses are suspended until you can utilize them in a future year against other passive income or on the sale of the property.

People often underestimate the expenses of owning and maintaining rental properties or don’t understand how they affect taxes. When you pay an ongoing maintenance cost on the property or make a repair, like with a lawn service or a broken pipe, that may be an expense that reduces your net income from the property. However, when you make a capital improvement or restoration, that cost may be depreciable during your ownership of the property rather than an expense you can deduct upfront. How the IRS defines repairs versus improvements is complex and varies on the part of the house and the scope of work completed. There are also safe harbors for real estate investments that apply in some cases, like the Safe Harbor for Small Taxpayers, the De Minimis Safe Habor, and the Routine Maintenance Safe Harbor (IRS, 2023). The clear takeaway is that it’s essential to work with a knowledgeable accountant when navigating these issues with rental properties and plan ahead for major expenses like a new roof, windows, and siding, just like you would with your primary residence.

Now that you have claimed all that depreciation against your property as a tax deduction each year, let’s review what happens when you sell. The depreciation you take reduces your basis in the property, potentially resulting in more capital gains when you ultimately sell. If you sell the property for a gain, the amount up to the depreciation you took is taxed at ordinary income rates up to a maximum rate of 25% instead of lower long-term capital gains tax rates that apply to the rest of your gain. That might feel a little harsh, but since you were able to deduct depreciation at ordinary income tax rates, you now simply must tax your gain at similar rates on the portion originally deducted as depreciation. Lower long-term capital gain tax rates apply to the rest.

While claiming depreciation to reduce income each year provides a current tax benefit, you’ll eventually pay up to 25% tax back if your investment grows. The tax savings each year is appealing, but if you’re reducing your taxable income at rates below 25%, you may eventually pay the price when you sell at a gain. A large gain with significant depreciation may be mostly taxed at 25%, even if you were only claiming a deduction at lower rates throughout the ownership of the property. We can talk strategies to avoid a sale and kick the can down the road, like with a 1031 exchange, but it’s important to keep in mind that depreciation isn’t a free lunch.

Note: Please be aware that your capital gain on the sale of a property may also be subject to Net Investment Income Tax (NIIT). NIIT is an additional 3.8% tax that applies to certain net investment income when your modified adjusted gross income is high (NIIT thresholds: filing single MAGI >$200,000; married filing jointly MAGI >$250,000). NIIT may apply to your realized gain, whether any portion of that gain is also subject to Section 1250 depreciation recapture or long-term capital gain tax rates.

Please be aware that if you sell your home for a loss, whether it’s a rental or your primary residence, you aren’t subject to depreciation recapture or other gains taxes. However, due to depreciation decreasing your cost basis in the property each year until it reaches zero, it’s more common that sales of former rental homes result in gains.

Note: You can’t claim a loss for tax purposes if the property sold is your primary residence. Read We Sold Our Home for a Loss – Now What? for more information.

Another strategy for paying less tax is to move back into your rental and use the property as a primary residence before selling. Living in your rental full-time for at least two years prior to selling can help you take advantage of the gain exclusion of $500,000 ($250,000 if single), which can wipe out all or most of your gain on the property. Sounds easy, right?

Moving back into your rental to claim the primary residence gain exclusion does not allow you to exclude your depreciation recapture, so you might still owe a hefty tax bill after moving back, depending on how much depreciation was deducted (IRS, 2023). Even with gains beyond any depreciation, you might not be allowed to claim all your primary residence capital gains exclusion. You also have to account for the time you used your home as a rental when determining your exclusion amount.

Your eligible exclusion amount considers the time you lived in the home versus maintaining it as an investment property as a ratio. This gets tricky since we have to dig into recent changes in the tax code. Since 2009, the IRS has required your ownership period to be categorized between qualifying and non-qualifying use. Qualifying use is when the home serves as your primary residence and is eligible for the IRC Section 121 gain exclusion for the sale of a principal residence. Non-qualifying use is when the property is rented out or serves as a secondary home to you, such as a vacation property.

This test applies to ownership periods starting in 2009, and it determines how much of your gain is eligible for the tax-free exclusion and how much is subject to capital gains taxes. Ownership periods prior to 2009 are always considered qualifying use for the purposes of this test.

You may have to prorate your capital gains exclusion based on the number of years of qualifying use of the property. That means if you move back in for two years after renting for seven years, your prorated exclusion limit will equal 2/9 of the gains. If 2/9 is less than the full $500k exemption ($250k for single filers), then you are limited to excluding the lower amount.

Prorating the exclusion only applies where the taxpayer used the residence for non-qualified purposes and then converted the property to a principal residence. The opposite is not true. If the residence was used as a principal residence first and then converted to non-qualified use, the taxpayer may potentially qualify for a full exclusion. The IRS doesn’t want people abusing the five-year rule with rentals they move back into just before the sale. This creates two examples to consider.

1. If you live in your home for two years and then rent it out for two years before selling it, you qualify for the full exclusion amount due to meeting the use test by having lived in the home for two out of the last five years before the sale and meeting the ownership test.
2. If you rent out your property for two years and then move back in for two years before selling it, you must prorate your exclusion because the exception to periods of non-qualifying use only applies to portions of the five-year use test period that occur after the last date that the property is used as a principal residence [26 U.S.C. § 121(b)(5)(C)(ii)(I)].

Note: If there’s a gain (whether it’s eligible for the gain exclusion or not), depreciation recapture is recognized first, prior to determining how much is tax-free and how much is subject to capital gains taxes.

If you’re facing a large tax bill because of the non-qualifying use portion of your property, you can defer paying taxes by completing a 1031 exchange into another investment property. This permits you to defer recognition of any taxable gain that would trigger depreciation recapture and capital gains taxes. More importantly, it allows you to separate tax-free and taxable portions of the property sale. A 1031 Qualified Intermediary is needed to help facilitate the exchange.

Note: Property you convert to a primary residence that was part of a previous 1031 exchange must be held for at least five years to be eligible for any gain exclusion.

Now that we have investigated potential capital gains tax exclusions and issues like depreciation recapture that is recognized first on your rental, we’ll break down how to determine your adjusted cost basis for calculating gains on the sale of your property.

Your adjusted basis is typically the home’s original purchase price plus improvements made minus depreciation on the property. An exception is if you converted your home into a rental when the property’s market value was below your adjusted basis per the formula. In that case, your basis decreases to the fair market value of the property at the time it became a rental. This eliminates people’s ability to beat the system by renting out their home for a short period just to be able to take the capital loss since they can’t take a loss on the sale of a primary residence.

In the examples below, a family purchases a home on January 1, 2013, for $300,000 and makes $75,000 worth of improvements through remodeling the kitchen and bathrooms. Their adjusted basis before converting the home into a rental is $375,000. This home is their primary residence for two years.

SCENARIO 1

The couple then rents out the home starting on January 1, 2015, for four years prior to selling it for $525,000. During the four-year rental period, they take approximately $40,000 of depreciation. When they sell the property on January 1, 2019, its adjusted basis is $335,000 ($375,000 – $40,000 depreciation taken). The gain on the sale is $190,000.

Even though 33% of their ownership period was for qualifying use, they fail the gain exclusion test by one year because the home was not their primary residence for two of the last five years. Therefore, the entire gain is subject to tax.

The first $40,000 of the gain is subject to depreciation recapture at up to a 25% tax rate. The remaining $150,000 of gain is subject to long-term capital gains taxes (plus the 3.8% net investment income surtax if their AGI exceeds the applicable threshold).

Note: The couple could instead complete a 1031 exchange into another investment property to defer recognition of any taxable gains.

SCENARIO 2

This is the same as Scenario 1, except after the four-year rental period, the couple moves back in full-time for two years prior to selling the home on January 1, 2021. We’ll use the same dollar amounts as above.

Since the couple meets the requirements to use the tax-free gain exclusion, we need to break down the gain based on qualifying use and non-qualifying use:

• Qualifying use – The home was their primary residence for four years out of the eight-year holding period, so 50% of the gain is eligible for the tax-free exclusion.
• Non-qualifying use – The home was not their primary residence for four years out of the eight-year holding period, so 50% of the gain is subject to capital gains taxes.

Note: Depreciation is recaptured first, and then the remaining gain is split between qualifying and non-qualifying use.

Of the $190,000 gain, the first $40,000 is subject to depreciation recapture up to 25%. Since the gain exceeds the depreciation recapture amount, the remaining $150,000 ($190,000 – $40,000) must be allocated between qualifying and non-qualifying use. The $75,000 ($150,000 × 50%) related to the qualifying use part of the gain is tax-free as part of the Section 121 gain exclusion. The remaining $75,000 pertaining to non-qualifying use is subject to capital gains taxes.

SCENARIO 3

This is similar to Scenarios 1 and 2, except the couple buys the home on January 1, 2003, and then rents the house for 10 years starting January 1, 2005. They move back in full-time on January 1, 2015. They sell the property two years later, on January 1, 2017, with a depreciation of $70,000 over the rental period.

As a result, the property’s adjusted basis is $305,000 ($375,000 – $70,000 depreciation taken). The gain on the sale is $220,000 ($525,000 – $305,000).

Since the couple meets the requirements to use the tax-free gain exclusion, we need to break down the gain based on qualifying use and non-qualifying use:

• Qualifying use – The home was their primary residence for four years out of the 14-year holding period. Also, four years of the 10-year rental period are considered qualifying use because they occurred before 2009 when all ownership is considered qualifying use for the purpose of this test. Therefore, eight years or 57% of the gain is attributable to qualifying use and is eligible for the tax-free gain exclusion.
• Non-qualifying use – Six years of the rental period is considered non-qualifying use, so 43% of the gain is taxable.

Of the $220,000 gain, the first $70,000 is subject to depreciation recapture at up to 25%. Of the remaining $150,000 gain (appreciation above the original basis), $85,500 ($150,000 × 57%) is considered qualifying use and is eligible for the home sale exclusion and is tax-free. 64,500 ($150,000 × 43%) is considered non-qualifying use and is subject to capital gains taxes.

SCENARIO 4

This is similar to Scenario 2, except the home sells for $395,000 instead of $525,000. With an adjusted basis of $355,000, this means the property sold for a $40,000 gain.

The ownership period was 50% qualifying and 50% non-qualifying, and the couple is eligible for the gain exclusion for the qualifying portion, but depreciation recapture is recognized first. Since the gain is $40,000 and the depreciation recapture of $40,000 up to 25% is paid first, there is no gain left over that’s tax-free or taxable at capital gains rates. It’s important to realize that, whether qualifying or non-qualifying, depreciation recapture tax is paid first when there’s a gain.

It’s important to keep good records of all improvements you make to the home. Every dollar can help reduce taxes you may owe on the gain one day. For more information, read Why It’s Important to Keep Track of Improvements to Your House.

Moving back into your rental to qualify for the principal residence capital gains exclusion might not help reduce your tax bill much if you have substantially depreciated your property or owned the real estate for mostly non-qualifying use. Other options, like deferring taxes with a 1031 exchange, could also be more helpful for managing your tax payment than selling your rental outright. Understanding the best approach for your personal situation might not be simple, but we love digging into these questions here at Merriman. Contact the Merriman team if you would like help strategizing the upkeep or sale of your rental and managing your wealth with an eye for the big picture.

References

Exclusion of gain from sale of principal residence, 26 U.S.C. § 121 (2017). Retrieved from https://www.govinfo.gov/content/pkg/USCODE-2017-title26/html/USCODE-2017-title26-subtitleA-chap1-subchapB-partIII-sec121.htm

Internal Revenue Service. (2023, June 15). Property (Basis, Sale of Home, etc.). Retrieved from https://www.irs.gov/faqs/capital-gains-losses-and-sale-of-home/property-basis-sale-of-home-etc/property-basis-sale-of-home-etc-5

Internal Revenue Service. (2023, January 4). Publication 925 (2022), Passive Activity and At-Risk Rules. Retrieved from https://www.irs.gov/publications/p925

Internal Revenue Service. (2023, September 28). Tangible Property Regulations – Frequently Asked Questions. Retrieved from https://www.irs.gov/businesses/small-businesses-self-employed/tangible-property-final-regulations

Disclosure: All opinions expressed in this article are for general informational purposes and constitute the judgment of the author(s) as of the date of the report. These opinions are subject to change without notice and are not intended to provide specific advice or recommendations for any individual or on any specific security. The material has been gathered from sources believed to be reliable; however, Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal, or accounting advice, and nothing contained in these materials should be taken as such.