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Every Landlord’s Tax Deduction Guide By Attorney Stephen Fishman 4th edition FOURTH EDITION NOVEMBER 2007 Editors DIANA FITZPATRICK JANET PORTMAN Cover Design JALEH DOANE Book Design TERRI HEARSH Production MARGARET LIVINGSTON Proofreading ROBERT WELLS Index JEAN MANN Printing DELTA PRINTING SOLUTIONS, INC. Fishman, Stephen. Every landlord’s tax deduction guide / by Stephen Fishman. 4th ed. p. cm. Includes index. ISBN-13: 978-1-4133-0721-4 (pbk.) ISBN-10: 1-4133-0721-3 (pbk.) 1. Rental housing Taxation Law and legislation United States Popular works. 2. Income tax deductions United States Popular works. 3. Landlords Taxation Law and legislation United States Popular works. I. Title. KF6377.Z9F57 2007 343.7305'23 dc22 2007021458 Copyright © 2005, 2006, and 2007 by Nolo. ALL RIGHTS RESERVED. PRINTED IN THE U.S.A. 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Table of Contents Your Tax Deduction Companion for Landlords 1 Tax Deduction Basics for Landlords How Landlords Are Taxed 6 How Income Tax Deductions Work 8 How Property Ownership Affects Taxes 15 The IRS and the Landlord 24 2 Landlord Tax Classifications The Landlord Tax Categories 32 Business Owner Versus Investor 32 Are You Profit Motivated? 37 Real Estate Dealers 47 3 Deducting Your Operating Expenses Requirements for Deducting Operating Expenses 54 Operating Expenses That Are Not Deductible 60 4 Repairs Repair Versus Improvement 64 The General Plan of Improvement Rule: A Trap for the Unwary 73 How to Deduct Repairs 77 Tips for Maximizing Your Repair Deductions 80 5 Depreciation Basics Depreciation: The Landlord’s Best Tax Break 85 Understanding the Basics 86 How to Depreciate Buildings 93 Depreciating Land Improvements 106 Depreciating Personal Property 107 When You Sell Your Property 124 Tax Reporting and Record Keeping for Depreciation 130 6 Maximizing Your Depreciation Deductions Determining the Value of Your Land and Buildings 134 Segmented Depreciation 144 7 Interest Interest Landlords Can (and Can’t) Deduct 152 Mortgage Interest 153 Other Interest Expenses 156 Points and Prepaid Interest 157 Interest on Construction Loans 158 Loans With Low or No Interest 159 Loans on Rental Property Used for Nonrental Purposes 160 Keeping Track of Borrowed Money 161 8 Start-Up Expenses What Are Start-Up Expenses? 164 Determining Your Business Start Date 166 Avoiding the Start-Up Rule’s Bite 169 How to Deduct Start-Up Expenses 170 If Your Business Doesn’t Last 15 Years 175 If Your Business Never Begins 175 9 The Home Office Deduction Qualifying for the Home Office Deduction 178 Calculating the Home Office Deduction 185 IRS Reporting Requirements 196 Audit-Proofing Your Home Office Deduction 196 Deducting an Outside Office 198 10 Car and Local Transportation Expenses Deductible Local Transportation Expenses 202 The Standard Mileage Rate 206 The Actual Expense Method 209 Other Local Transportation Expenses 220 Reporting Transportation Expenses on Your Tax Return 220 11 Travel Expenses What Are Travel Expenses? 224 Deductible Travel Expenses 228 How Much You Can Deduct 230 Maximizing Your Travel Deductions 240 12 Hiring Help Deducting Payments to Workers 245 Employees Versus Independent Contractors 247 Tax Rules When Hiring Independent Contractors 253 Tax Rules for Employees 260 Hiring Your Family 264 Hiring a Resident Manager 271 13 Casualty and Theft Losses What Is a Casualty? 276 Calculating a Casualty Loss Deduction 278 Disaster Area Losses 283 Casualty Gains 284 Tax Reporting and Record Keeping for Casualty Losses 285 14 Additional Deductions Dues and Subscriptions 289 Education Expenses 289 Gifts 291 Insurance for Your Rental Activity 292 Legal and Professional Services 293 Meals and Entertainment 295 Taxes 297 Unpaid Rent 298 15 Vacation Homes The Vacation Home Tax Morass 302 Regular Rental Property 303 Tax-Free Vacation Home 303 Vacation Home Used as Rental Property 305 Vacation Home Used as Residence 308 Calculating Personal and Rental Use 312 Converting Your Home to a Rental Property 316 16 Deducting Rental Losses What Are Rental Losses? 319 Overview of the Passive Loss Rules 320 The $25,000 Offset 323 The Real Estate Professional Exemption 329 Rental Activities Not Subject to PAL Real Property Rental Rules 346 Vacation Homes 347 Deducting Suspended Passive Losses 349 Tax Reporting for Passive Rental Losses 351 Strategies for Dealing With the Passive Loss Rules 352 At-Risk Rules 354 How to Deduct Rental Losses 356 17 Record Keeping and Accounting Record Keeping Made Simple 362 Accounting Methods 389 Tax Years 393 18 All About Schedule E Who Must File Schedule E? 396 Filling Out Schedule E 398 Schedule E Example 403 19 Claiming Tax Deductions for Prior Years Reasons for Amending Your Tax Return 410 Time Limits for Filing Amended Returns 411 How to Amend Your Return 413 How the IRS Processes Refund Claims 414 20 Help Beyond This Book Secondary Sources of Tax Information 418 The Tax Law 423 Consulting a Tax Professional 430 Index Introduction Your Tax Deduction Companion for Landlords 2 EVERY LANDLORD’S TAX DEDUCTION GUIDE T his is a book about income tax deductions for landlords—that is, people who own residential rental property. If you are one of the millions of Americans who owns a small number of residential rental units (one to ten), this book is for you. And even landlords who own dozens of residential rental properties will find lots of useful information in this book that can help them save money. No landlord would pay more than necessary for utilities or other operating expenses for a rental property. But, every year millions of landlords pay more taxes on their rental income than they have to. Why? Because they fail to take advantage of all the tax deductions available to owners of residential rental property. Rental real estate provides more tax benefits than almost any other investment. Often, these benefits make the difference between losing money and earning a profit on a rental property. But tax deductions are worthless if you don’t take advantage of them. That’s where this book comes in. It gives you all the information you need to maximize your deductions—and avoid common deduction mistakes. You can (and should) use this book all year long, to make April 15th as painless as possible. To take advantage of the benefits tax deductions offer, you’ll have to figure out which deductions you are entitled to take—and keep proper records documenting your expenses. You will also learn how to make the most of the deductions available to you as a landlord. For example, did you know that: • Landlordscangreatlyincreasethedepreciationdeductionstheyreceivetherst few years they own rental property by using segmented depreciation (Chapter 6). • Carefulplanningcanpermityoutodeductinasingleyearthecostof improvements to rental property that you would otherwise have to deduct over 27.5 years (Chapter 5). • Youcanrentoutavacationhometaxfreeinsomecases(Chapter15). • AlthoughtheIRSdoesn’tpublicizeit,landlordscanqualifyforthehomeofce deduction (Chapter 9). • Mostsmalllandlordscandeductupto$25,000inrentalpropertylosseseach year (Chapter 16). • Aspecialtaxrulepermitssomelandlordstodeduct100%oftheirrentalproperty losses every year, no matter how great those losses are (Chapter 16). • Peoplewhorentpropertytotheirfamilyorfriendscouldlosevirtuallyallof their tax deductions (Chapter 15). [...]... 5 for more on this topic.) 12 Every landlord’s tax deduction Guide Tax Credits for Landlords Tax credits are not the same as tax deductions—they are even better A tax credit is subtracted from your tax liability after you calculate your taxes For example, a $1,000 tax credit will reduce your taxes for the year by $1,000 There are many different types of federal income tax credits, but only two can... Audit 28 6 Every landlord’s tax deduction Guide T he tax code is full of deductions for landlords Before you can start taking a dvantage of these deductions, however, you need a basic understanding of how landlords pay taxes and how tax deductions work This chapter gives you all the information you need to get started, including: • how the IRS taxes landlords • how tax deductions work • how... Tax Deduction Basics for Landlords How Landlords Are Taxed 6 Income Taxes on Rental Income 6 Income Taxes on Profits When You Sell Your Property 6 Social Security and Medicare Taxes 7 Property Taxes 8 How Income Tax Deductions Work 8 What Can You Deduct? 10 How Your Tax Status Affects Your Deductions 13 The Value of a Tax. .. for more on determining your tax status.) The Value of a Tax Deduction Most taxpayers, even sophisticated businesspeople, don’t fully appreciate just how they save with tax deductions Only part of any deduction will end up back in your pocket as money saved Because a deduction represents income on which you don’t have to pay tax, the value of any deduction is the amount of tax you would have had to pay... marginal 14 Every landlord’s tax deduction Guide tax bracket For example, if your marginal tax bracket is 25%, you will save 25¢ in federal income taxes for every dollar you are able to claim as a deductible b usiness expense (25% x $1 = 25¢) This calculation is only approximate because an additional deduction may move you from one tax bracket to another and thus lower your marginal tax rate For... a deduction of $1,000 won’t save you $1,000—it will save you whatever you would otherwise have had to pay as tax on that $1,000 of income To determine how much income tax a deduction will save you, you must first figure out your income tax bracket The United States has a progressive income tax system for individual taxpayers with six different tax rates (called tax brackets), ranging from 10% of taxable... actually earned from the property) to determine your “taxable income.” You pay income tax only on your taxable income, if any Expenses you can deduct from your income are called tax deductions or tax write-offs These deductions are what this book is about Although some tax deduction calculations can get a bit complicated, the basic math is simple: The entire tax regimen for rental real estate can be reduced... state income tax rates at www.taxadmin.org/FTA/rate/ind_inc.html When you add up your savings in federal and state income taxes, you can see the true value of a tax deduction For example, if you’re in the 25% federal income tax bracket, a deduction can be worth 25% (in federal income taxes) plus 6% (in state income taxes) That adds up to a whopping 31% savings (If you itemize your personal deductions,... subject to taxation Profits from the sale of rental property owned for more than one year are taxed at capital gains rates These rates are generally Chapter 1: Tax Deduction Basics for Landlords 7 lower than income tax rates—usually 20% lower, except for taxpayers in the lowest tax brackets (See Chapter 5 for an example of the tax effects of a rental property sale.) However, you may be able to defer tax. .. Chapter 1: Tax Deduction Basics for Landlords 13 How Your Tax Status Affects Your Deductions Owning rental property can be a business for tax purposes, an investment, or, in some cases, a not-for-profit activity Landlords whose rental activities qualify as a business are entitled to all the tax deductions discussed in this book However, those whose rentals are an investment lose certain useful deductions, . topic.) 12 EVERY LANDLORD’S TAX DEDUCTION GUIDE Tax Credits for Landlords Tax credits are not the same as tax deductions—they are even better. A tax credit is subtracted from your tax liability. Book Secondary Sources of Tax Information 418 The Tax Law 423 Consulting a Tax Professional 430 Index Introduction Your Tax Deduction Companion for Landlords 2 EVERY LANDLORD’S TAX DEDUCTION GUIDE T his. 7 Property Taxes 8 How Income Tax Deductions Work 8 What Can You Deduct? 10 How Your Tax Status Affects Your Deductions 13 The Value of a Tax Deduction 13 How Property Ownership Affects Taxes 15 Individual
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