Why Tax Planning for Real Estate Has Become More Important
As the real estate market slowly recovers and many are feeling the effects of the 2013 tax rate increases, tax planning for real estate has become more important than ever. Higher-income taxpayers may have already seen a reduction in some of their home-related deductions as a result of the 2013 reinstatement of the itemized deduction phase-outs along with higher income tax rates plus the new 3.8% net investment income tax on real estate income and gains.
Here is a summary of the tax rate changes and phase-outs that went into effect for 2013 and continue to affect many middle to high income individual taxpayers.
- Tax rates (ordinary). While the existing tax brackets of 10%, 15%, 25%, 28%, 33% and 35% were left in place, the new 39.6% bracket starts when taxable income hits $457,601 for joint filers ($406,751 for single). Income of less than $457,601 is still taxed at these various brackets.
- Tax rates (capital). The existing 15% tax rate applied to qualified dividends and long-term capital gains remains for taxable income below $457,601 for joint filers ($406,751 for single), but increases to 20% for those above $457,601.
- Net investment income tax (NIIT). A 3.80% tax is assessed on net investment income if one’s adjusted gross income (AGI) exceeds $250,000 for joint filers ($200,000 for single). See below for more discussion on this tax.
- Payroll (Medicare) tax. A 0.9% tax is assessed on earned income such as wages that exceed $250,000 for joint filers ($200,000 for single). This tax is imposed on the employee but not the employer.
- Itemized deduction and personal exemption phase-outs:This “phase-out” takes away deductions from those whose AGI exceeds $305,050 for joint filers ($254,200 for single). Effectively, by allowing fewer deductions, taxable income that is subject to tax is higher. There is a cap that prevents no more than 80% of itemized deductions from phasing-out.
New net investment income tax (NIIT)
Effective January 1, 2013, a new 3.8% tax is assessed on net investment income for those with AGI above $250,000 for joint filers ($200,000 for single). The NIIT tax is an extra tax that is assessed in addition to your regular income tax. Investment income includes interest, dividends, capital gains, royalties, rental income, and “passive” business activities. The tax is assessed only to the extent of the income that exceeds $250,000.
Rental of residential real estate
Rental activities generally fall into the category of “passive” activities. This means that rental losses you incur can be deducted currently only against passive income and not against nonpassive income, such as wages or investment income.
However, if you “actively participate” in the residential rental activity, you may be able to deduct a loss of up to $25,000 in a tax year against nonpassive income. You actively participate in the rental activity if you make key management decisions such as approving new tenants, deciding on rental terms, approving capital expenditures. You also can show active participation by arranging for others to provide services. You need not have regular, continuous, and substantial involvement with the property. To satisfy the active participation test, you (together with your spouse) must own at least 10% of the rental property. Ownership as a limited partner doesn't count.
If you meet the above tests, you can claim up to $25,000 in losses against nonpassive income. If your adjusted gross income (AGI) is above $100,000, the $25,000 allowance amount is reduced by one-half of the excess over $100,000. So, if your AGI is $150,000 or more ($75,000 or more for eligible married taxpayers who file separately), the allowance is reduced to zero.
Example.Tina, who's single, has adjusted gross income of $120,000. One-half of the $20,000 excess ($120,000 - $100,000) equals $10,000. So, Tina's maximum loss allowance is reduced from $25,000 to $15,000.
Losses that aren't allowed because of the amount limitations don't just disappear. They are carried forward and can be deducted against nonpassive income in future years if you continue to actively participate in the rental real estate activity that generated the losses, subject to the $25,000 limit.
If you stop actively participating, the carried-forward losses are treated as passive activity losses that may only be used to offset passive activity income. To the extent your passive losses aren't used up, you can deduct them in the tax year in which you dispose of your entire interest in the passive activity in a fully taxable transaction.
Home office deduction
If use of a home office is for your employer’s benefit and it’s the only use of the space, you generally can deduct a portion of your mortgage interest, property taxes, insurance, utilities and certain other expenses. Further, you can take a deduction for the depreciation allocable to the portion of your home used for the office. You can also deduct direct expenses, such as a business-only phone line and office supplies.
A new simplified home office deduction became available beginning in 2013. The optional deduction is $5 per square foot for up to 300 square feet of home office space for a maximum annual deduction of $1,500. If you choose this option, you can’t deduct depreciation for this portion of your home. But, you can take itemized deductions for otherwise allowable mortgage interest and property taxes without allocating them between personal and business use.
Kim Paskal CPA is a tax shareholder at BeachFleischman PC and specializes in real estate taxation. She has been in public accounting since 1994.
The information provided should not be used in any actual transaction without the advice and guidance of a professional Tax Adviser who is familiar with all the relevant facts.
Although the information contained here is presented in good faith and believed to be correct, it is General in nature and is not intended as tax advice. Furthermore, the information contained herein may not be applicable to or suitable for the individuals' specific circumstances or needs and may require consideration of other matters.
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