Tax planning for rental property owners in Northern Virginia

What counts as rental income

The IRS defines rental income as any payment you receive for the use or occupation of property. Rent is the obvious part. Advance rent is income in the year you receive it, whatever period it covers. A payment a tenant makes to break a lease is income. An expense a tenant pays on your behalf is income to you and then a deduction. A refundable security deposit is not income when you receive it, as long as you are obligated to return it. Any part you keep becomes income once you have the right to retain it. All of it lands on Schedule E, property by property.

What you can deduct, and the repair-or-improvement line

The ordinary costs of running the property are deductible: advertising, cleaning and maintenance, commissions, insurance, legal and professional fees, management fees, mortgage interest, points, repairs, property taxes, utilities, and the cost of travel to look after it. Depreciation is a deduction too, and for most owners the largest one.

The line that matters most is the one between a repair and an improvement. A repair keeps the property in its ordinary condition and is deducted in the year you pay for it. An improvement is a betterment, a restoration, or an adaptation to a new use, and it is capitalized and depreciated over years. Replacing a broken window pane is a repair. Replacing the roof is an improvement. The distinction changes how much you deduct this year, and it is decided by what the work did, not by what the invoice says.

Depreciation: the deduction that runs for 27.5 years

You recover the cost of a residential rental building by deducting a part of it every year over 27.5 years, on a straight line, starting in the month you place it in service. Land is never depreciated, so the purchase price has to be split between building and land, and that split sets your deduction for the next three decades. Improvements you add later start their own depreciation schedules. Form 4562, the depreciation form, reports it, and the schedule has to be kept from year to year because every dollar of depreciation you take reduces your basis and comes back into the picture when you sell.

A cost segregation study looks at the components inside the building that have shorter lives than the structure and lets them be depreciated faster. It is a real tool for a larger property or a portfolio, and it is one we bring up when the numbers make it worth the study's cost.

When a rental loss is allowed

Rental activity is passive under the tax code, whatever your hours. A passive loss can offset passive income, and whatever is left over is disallowed for the year and carried forward. Two exceptions let a loss offset your other income, and short-term rentals are a third case, covered below.

The first is the special allowance. If you own at least 10% of the rental and actively participate, which means making the management decisions rather than doing nothing, up to $25,000 of loss a year can offset your wages and other income. The allowance shrinks by half of the amount your modified adjusted gross income, a figure close to the total income on your return, exceeds $100,000, and it is gone at $150,000. Form 8582, the passive loss form, does the arithmetic.

The second is the real estate professional rule: more than half of your working hours in real property trades or businesses in which you materially participate, and more than 750 hours in the year. Meeting both tests only lifts the automatic rule that treats rentals as passive. You still have to materially participate in each rental for its loss to count as nonpassive. It is a documentation test as much as a tax test, and the hours need a log.

Losses that were disallowed do not disappear. They are generally deductible in full in the year you dispose of your entire interest in the property, to an unrelated party, in a fully taxable transaction. A like-kind exchange generally does not release them, because the gain or loss is not recognized.

Short-term rentals and the home you also use

A property rented for stays that average seven days or less is not treated as a rental activity under the passive rules. It is treated as a business, which changes which tests apply and can make the loss usable against other income if you materially participate, most simply by putting in more than 500 hours.

A home you use yourself and rent for fewer than 15 days in the year sits outside all of this: the rent is not income and the expenses are not rental deductions. Rent it 15 days or more and the expenses are allocated between personal and rental use by the days.

Selling, or exchanging instead

When you sell a rental, the gain is the sale price minus your adjusted basis, and the basis has been reduced by every year of depreciation. So part of the gain is the depreciation coming back, and it is taxed on its own terms. The suspended passive losses, as above, are released by a fully taxable sale of your entire interest to an unrelated party.

A like-kind exchange under section 1031 of the tax code, usually just called a 1031 exchange, defers that tax. You exchange real property held for investment for other real property held for investment, and no gain is recognized except to the extent you receive cash or other property, called boot. Since 2018 only real property qualifies. The deadlines are strict: identify the replacement property in writing within 45 days of transferring the old one, and receive it within 180 days or by the due date of your return, whichever is earlier. A third party the rules require, called a qualified intermediary, holds the proceeds in between, and an exchange with a related party carries a two-year holding rule. Form 8824 reports it. An exchange also leaves any suspended passive losses where they are, because the gain is not recognized. The planning starts before the listing, because a closed sale cannot be turned into an exchange afterwards.

Virginia, and owners who live elsewhere

Income from the rental or sale of Virginia real estate is Virginia-source income. A Virginia resident reports it with everything else. An owner who lives in another state files a Virginia nonresident return, Form 763, for the rental income and, in the year of a sale, the gain. Owners in Maryland and the District of Columbia are not exempted from this by the reciprocity agreement, which covers wages rather than rental income. If the property is in one state and you live in another, both states are usually involved, with a credit in one for tax paid to the other.