My husband and I recently purchased our first rental property. Over the past few months, we’ve repaired and renovated the 1930s-era home and started to look for tenants.
And it turns out our timing couldn't be better: The Tax Cuts and Jobs Act of 2017 made several changes for rental property owners that portend a more profitable enterprise than it used to be.
“For rental property owners, [the act] will generally benefit you,” says Thomas Castelli, a New York City–based certified public accountant and tax strategist with the Real Estate CPA, a firm focusing on real estate tax.
How exactly the federal tax changes apply to individual property owners can vary, so Castelli recommends seeking out a tax professional well-versed in real estate to help sort things out. But here’s a general overview of some of the new tax rules that will most likely affect rental real estate owners—including me.
The rental house we purchased before the remodelErica Sweeney
The newly renovated rental house, with a new roof, fresh paint, and an opened-up front porchErica Sweeney
Landlords can deduct a big 'bonus' the first year.
Blame it on wear and tear, or just the passage of time, but in the eyes of the IRS, rental property depreciates over time. For landlords, that's a tax break—typically one that's spread out over several years.
The good news? During the first year of owning a rental property, landlords can take a "bonus" depreciation deduction. In the past, that deduction maxed out at 50% of the property's value. But under the new tax act, that deduction doubled to a max of 100%, which could amount to the entire sum you paid for the place. In other words, it's a huge chunk of change!
This bonus deduction would be netted against revenue, which, in many cases, would make rental income show a loss, Castelli says.
“So you won't be paying tax on your rental income," he says. “I'd say that's probably the biggest and most important change or most beneficial change to rental real estate investors.”
Keep in mind, though, that your property has to qualify. The property must place it in service (meaning available for rent) after Sep. 27, 2017, and before Jan. 1, 2023. Two, all or part of the property must have a "class life" of less than 20 years. Since most properties typically have a class life of 27.5 years, it would need to be reclassified as a five-, seven-, and 15-year property to take advantage of the bonus depreciation (a CPA can help with this).
Here's how it all plays out in dollars and cents: “Let's say you have a property worth $100,000, and you can get 20% of that reclassified as a five-, seven- and 15-year property," Castelli says. "That's a $20,000 deduction.”
Up to 20% of rental revenue can be tax-free.
While rental income is taxed, the tax act could offer landlords a nice tax shelter of sorts where up to 20% of that rental income is tax-free.
“What that means is for every $100 of taxable rental income, it's possible that you only pay tax on $80 worth of it,” says Amanda Han, a certified public accountant and assistant managing director at Keystone CPA, in Fullerton, CA.
It works: Section 199A of the IRS code provides some taxpayers with a deduction for qualified business income. In the past, there was much confusion about whether this applied to landlords. Still, the IRS issued a clarification, providing a safe harbor for a “rental real estate enterprise” to be treated as a business.
“That is helpful for a lot of landlords and is available as long as it’s rental income,” Han says.
Landlords can deduct more home improvements immediately.
In the past, landlords could immediately deduct repairs to a rental property, but home improvements were depreciated over time. This has often confused landlords.
“What is a repair versus what's an improvement?” Han says. “There were always questions about that because repairs we deduct immediately; improvements we have to depreciate."
Yet, the tax act simplified those rules. Under section 179, the IRS increased the immediate deduction threshold for home improvements to $2,500 per item. In other words, money spent on improvements under $2,500 can be deducted immediately, rather than going through the complicated depreciation process.
One negative? Some landlord losses are now capped.
One new aspect that could sting rental owners relates to losses on the property. A loss occurs when a property's expenses total more than rental income. Previously, owners of rental real estate could take unlimited losses from their rental real estate. Castelli says the tax act now limits those losses to $250,000 for a single person and $500,000 for married couples.
The upside? Since these limits are quite high, Castelli says this change will not affect most individual rental property owners.
How to make the tax act work for you
The tax act has been better than expected for rental property owners, Han says. “It's a great opportunity for real estate investors.”
Good record-keeping is essential for rental owners. Han recommends that property owners keep sales closing disclosures, purchase closing disclosures, refinancing documents, and receipts for anything to do with the home for at least three years.