Type of Property the IRS Considers Residential Rental Property
Residential rental property is pretty much what it sounds like – a residential home that you buy in order to rent it out to tenants. It's a fairly major investment, requiring hard cash or an investment property loan upfront, but it can be a lucrative one offering plenty of tax deductions for landlords. The rules are clear about what is, and what is not, a residential rental property. However, you need to tread carefully if you're planning on using the home yourself for part of the year.
What Is Residential Rental Property?
If an investor buys a home and rents it out to tenants, then he's dealing in residential rental property. There are two elements to the residential rental property definition:
- The property must be a residential dwelling unit; that is, someone's home. The property itself can be a single-family home, townhouse, apartment, condominium unit, duplex, mobile home or even a boat. As long as it has living accommodations, such as a toilet, cooking facilities and somewhere to sleep, then it is classified as residential property.
- The investor must rent the property, or intend to rent the property, to tenants under a lease or rental agreement. Generally, the tenants must be third-party tenants. People who rent property to their friends and family can still receive the rental income, but they will lose virtually all their tax deductions.
Residential vs. Nonresidential Property
When in comes to rental property, the term "residential" distinguishes the investment from another type of investment known as commercial rental property. Offices, warehouses, restaurants, retail stores, parking lots, malls, medical centers and industrial units are all examples of commercial property. If a tenant occupies a unit for the purpose of running a business from it, then it's going to be a commercial rental property, not residential.
Furthermore, even though individuals and families that occupy hotels and motels are not running businesses from their rooms, these properties are still classified as commercial. That's because the hotel is in the business of making rooms available for paying customers on a transient basis. It isn't giving someone exclusive use of the rooms during the year.
The IRS 80-Percent Rule
In the language of the IRS, a property is residential rental property if it derives more than 80 percent of its revenue from dwelling units. For most properties, the 80-percent rule is an unnecessary test. If you rent a single-family home or an apartment to a family, for example, then 100 percent of the revenue will derive from the dwelling.
The test kicks in if you have a mixed-use building that is partly residential and partly commercial, like a 30-door complex with a couple of retail units on the first floor. Here, the property will be classified as residential if 80 percent of the monthly rental income comes from your residential tenants. Otherwise, it will be classified as commercial property.
There are some further rules for partially rented property in which the owner rents one part of the property and lives in the other – for instance, the owner lives in one duplex and rents the other out to tenants. According to the IRS, the part of the property the owner lives in is classified as the owner's primary residence and the other part is classified as residential rental property.
What's the Significance?
The significance here is that owning a residential rental property gives the investor additional tax advantages that other types of investments, including a primary residence, may not confer. The main benefit is you're running a business, and that means you can deduct your day-to-day operating expenses.
Virtually, you can deduct all the legitimate expenses of renting the home from the rental income. This includes repairs, maintenance, cleaning, property manager's fees, taxes, advertising, legal fees, insurance, utilities and travel expenses to and from the unit. You can also deduct mortgage interest on the loan used to acquire the rental property as well as the expenses you paid to obtain the mortgage such as points and closing costs. Mortgage interest typically represents the landlord's biggest deductible expense.
You cannot deduct the cost of capital improvements. These are items that better the property such as replacing the entire roof, adding a deck or constructing an addition. If the work goes beyond a simple repair, then it almost certainly is an improvement. That's not to say you cannot recover the cost of improvements. The difference is that you must deduct it through a specific depreciation schedule.
Depreciation of Residential Rental Property
The second major tax advantage of owning residential rental property is you can recover the cost of the home as a capital expense by depreciating the property; that is, by deducting some of the cost each year on your tax return. This concession is unique to rental real estate. You cannot depreciate a primary home. Landlords can also depreciate the tangible items inside the rental property that last for more than one year – refrigerators, stoves and furniture, for example.
There are two things you need to determine the annual depreciation allowance:
1. The property's cost basis. Generally, this is the purchase price you paid for the property together with closing costs such as abstract fees, recording fees, legal fees, transfer taxes, title insurance and so on. If you improve the property, for instance, by remodeling or extending the home (not everyday maintenance expenses), you can add the cost of the construction to your tax basis.
2. The recovery period. Residential rental property is depreciated over a recovery period of 27.5 years. Nonresidential rental property depreciation, by contrast, takes place over 39 years, so you get a full write off much more quickly as a residential real estate investor. Things like furniture have a shorter recovery period in the region of five to seven years.
Calculating Depreciation on Residential Rental Property
The standard method for depreciating residential rental real estate is called the Modified Accelerated Cost Recovery System (MACRS). Generally under MACRS, you will depreciate the property using the straight-line method. All you do here is deduct an equal amount of the property's tax basis each year for 27.5 years, that is, around 1/27th of the value every year. For instance, a rental with a cost basis of $200,000 would depreciate at $7,272 per year ($200,000/27.5 years).
To make it easy, the IRS publishes a depreciation table in Publication 946. However, it is definitely worth hiring a tax professional to review your tax situation because the depreciation rate varies among different types of assets, and some investors may qualify to use a different (and potentially more favorable) method of depreciation.
You can continue to claim depreciation on residential rental property even if it is temporarily idle and not producing income. For instance, if you spend a few weeks repairing the property between one tenant leaving and another tenant arriving, you can still claim a depreciation deduction during the vacancy period.
Residential Rental Property vs. Second Homes
The residential rental property classification will always cover a home that's rented out full time to tenants with no personal use by the landlord. This type of property is acquired specifically to generate income and/or capital appreciation, not as a home for the landlord and her family.
If you own a second home that you sometimes rent and sometimes use yourself, then different rules apply. Basically, if you personally use the property for more than 14 days in the tax year, or 10 percent of the time it's offered for rent (whichever is greater), then the home is considered a vacation home and not a rental property. Using the home yourself includes letting your family members and friends also use the vacation home, either free of charge or at a discounted rent.
If you occupy the vacation home for less than 15 days a year, or not at all, then the IRS considers it to be a residential rental property. You don't have to generate rental income from the property on a consistent basis to receive this classification – the test is how often you use it.
Comparing the Tax Rules for Vacation Homes
The tax benefits for a vacation home depend on how many days the home is rented out versus how many days you spend in the home. Generally though, the tax benefits are much more favorable if the home is classified as residential rental property. To break this down, remember:
- If you never rent the vacation home out, you can deduct real estate taxes and mortgage interest just as you would with a primary home. You can't deduct other expenses like repair bills and utilities.
- If you rent the vacation home for less than 14 days a year, you can pocket the rental income tax free and still deduct property taxes and mortgage interest on Schedule A. However, you can't deduct any expenses associated with the rental, like advertising the vacation home.
- If you rent the property out for 15 days or more, the home is considered a residential rental property. You must report the rental income to the IRS, but in return can deduct all your rental expenses associated with rental activity as we have seen.
To figure out how much you can deduct, compare the number of rental days to the number of days the property was used in total. For instance, if the home was used for 200 days in total and 120 of them were rental days, 60 percent of the expenses (120/200) can be deducted against the rental income.
Passive Activity Losses
Investing in residential rental property is a passive activity, which means it's subject to the passive activity loss rules. These rules are complicated but generally, they limit a landlord's ability to offset other types of income with losses from the residential real estate investment.
The good news is that as well as deducting rental activity expenses, you may be able to deduct up to $25,000 each year in passive losses as long as you manage the property yourself. You don't have to mow the lawn or fix the toilet yourself, but you do have to make management decisions like vetting potential tenants and establishing the terms of the lease.
This exception phases out as your modified Adjusted Gross Income rises, with the $25,000 deduction decreasing by $0.50 for every dollar over $100,000 AGI. The exception disappears completely when your modified AGI reaches $150,000. For more information, see IRS Instructions for Form 8582: Passive Activity Loss Limitations.
- Internal Revenue Service: Publication 527, Residential Rental Property
- Internal Revenue Service: Publication 946, How to Depreciate Property
- Turbo Tax: Real Estate Tax and Rental Property
- Internal Revenue Service: Tax Topic 425: Passive Activities-Losses and Credits
- Internal Revenue Service: Instructions for Form 8582
Jayne Thompson earned an LLB in Law and Business Administration from the University of Birmingham and an LLM in International Law from the University of East London. She practiced in various “big law” firms before launching a career as a commercial writer. Her work has appeared on numerous financial blogs including Wealth Soup and Synchrony. Find her at www.whiterosecopywriting.com.