Are you an accidental landlord? Here's how to tackle your taxes
Even if you didn't plan to become a landlord, that won't change the tax obligations you have for the property. There are nuances of being a landlord and we'll explain how it impacts your tax return.
Accidents happen
Have you become an accidental landlord? It happens more often than you might think. Whether you can't sell your home or simply aren't ready to part with it yet, renting out your home is a potentially lucrative way to cover your expenses. However, there are a few different tax implications to be aware of if you become a landlord.
You might need to change homeowners insurance policies
Typically, homeowners take out home insurance policies, known as HO3 policies. These cover the property that you live in, your personal property, and certain property structures, among other items.
Regardless of whether you choose to remain within the residence or not, when you become a landlord, you usually need to switch to a rental dwelling or landlord insurance policy — commonly referred to as a DP3 policy. Luckily, the insurance on a rental property is usually tax-deductible as a landlord.
You need to keep track of income and expenses
As a homeowner, your mortgage company usually reports the information you need for your tax return, such as mortgage interest paid as well as property taxes and insurance paid if you have an impound account. Things can change as a landlord. Your mortgage company will still report the same information to you as they did before, but you also likely have numerous other deductions you can take advantage of once you start renting out your home.
- You'll have to keep track of any income you receive (typically, those rent checks) as well as your expenses. One easy way to do this is making a folder.
- Put all canceled rent checks and receipts for expenses in it throughout the year.
- You can also use the folder to gather any statements or other documentation you receive related to the property.
Here are some of the most common deductions for landlords and what records you should keep.
Deductions for landlords
As a landlord, you can usually deduct all eligible expenses incurred in the course of running your rental property, some of which are explained below. Thankfully, the limitations on what you can deduct aren't nearly as strict as a landlord as they were when you lived in the property.
Expenses to manage and maintain the property
Any money you spend to manage or maintain the rental property is generally tax-deductible, such as costs related to:
- advertising
- auto
- travel
- cleaning
- maintenance
- commissions
- insurance
- legal fees
- other professional fees
- mortgage interest
- repairs
- supplies
- taxes
- utilities
- depreciation
Whenever you spend money on your rental property or managing it, keep the receipts and write down how the expenditures were related to your rental property. At the end of the year, comb through your expenses and sort them into the above categories so you can deduct them when you file your tax return.
Travel expenses
You can also take a deduction for traveling to and from the rental property in the ordinary course of business. You'll have to keep track of your mileage or your actual expenses to take this deduction, depending on which way you calculate your auto and travel expenses.
To expense your mileage, you should keep a log of each trip that includes the:
- date
- destination
- starting odometer readout
- ending odometer readout
- total mileage driven
- purpose for the trip
At the end of the year, total up your business miles driven and multiply it by the standard mileage rate, provided by the IRS, to get your mileage expense deduction.
If you use the actual expenses method, keep track of your automobile expenses for the vehicle and keep your receipts. You'll need to know the miles driven for business and total miles driven during the year, too. Common expenses include:
- gas
- oil
- maintenance
- insurance
- depreciation
- garage rent
To get the allowable expenses, calculate your percentage of mileage driven for business purposes during the year. Then, multiply that percentage by the total of your actual expenses to get the amount that is tax-deductible.
Depreciation
Depreciation is a deduction that allows recovery of the cost of the property over time. It basically allows you to expense the cost of the house itself over its useful life. Most homes can be depreciated over 27.5 years, but you can't depreciate the land portion of your home's value.
Here's an example to explain how it works:
The value of your home without the land is $275,000. In this case, you'd get a depreciation deduction of $10,000 per year ($275,000 divided by 27.5) to use as an expense for your rental property. This would lower your rental property profit for your taxes but doesn't impact the cash you get from your rental property. Depreciation could save you a significant amount of money on your taxes.
Selling your rental property
When it comes time to sell your rental property, there are additional considerations you'll need to think about. You'll need to plan in advance if you want to take advantage of the capital gain exclusion for selling your home if it was once your primary residence and you meet the requirements – see below. You should also prepare to pay any depreciation recapture you may owe.
You may lose the capital gain exclusion
When you sell your home, you may have to pay capital gains tax. This is a special tax rate on capital assets, such as a home, that is usually lower than your ordinary income tax rate. The capital gains tax is charged on the difference between the sales price and your adjusted cost basis of the home.
With a special capital gains exclusion that exists in the tax code, you may be able to exclude:
- up to $250,000 of the capital gains filing Single, Head of Household, or Married Filing Separately
- $500,000 of the capital gains as a couple filing Married Filing Jointly
In general, you must have owned and lived in the house as your primary residence for two of the last five years to get this exclusion. If you qualify for this exclusion, it could save you quite a bit of money, especially if your home has appreciated significantly.
- You won't immediately lose access to this exclusion when you become a landlord.
- That said, the years can pass by quickly, and you will lose it if you're not watching the calendar closely and you no longer meet the two-of-five-year requirement noted above. Plan carefully if you want to take advantage of this exclusion before it disappears.
As a landlord, you can deduct depreciation expenses. When you sell your rental property, due to the depreciation recapture rules, you may have to pay a higher tax rate based on unrecaptured Section 1250 gains due to those depreciation deductions — the maximum rate for which is 25%.
- This is higher than the usual long-term capital gains tax rates and can be a big surprise to landlords that aren't expecting it.
- Any capital gains above the amount of depreciation are typically taxed at regular capital gains tax rates as long as the sale qualifies.
As an accidental landlord, you may not realize the opportunities you have to lower the amount of taxes you pay.
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