Caught in the housing downturn and unable to sell your house or condo at a decent price in 2006, you may have decided to rent out the property. Now, at tax time, you are left with a jumble of rules you never encountered in the past. Here's what to do:
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The rent you have been paid by your tenant is going to be income. But don't assume you will pay taxes on all, or even any of it.
Before you record rental income on your 1040 form, you should try to whittle away the income you received from the renter. The goal will be to turn your rental income into a smaller number, or better yet, a loss. If you can turn it into a loss, it could reduce the taxes you otherwise would owe on earnings from your job.
You will do this by adding up all the expenses you incurred during 2006 to attract and serve a tenant. Then you subtract those expenses from the rent your tenant paid, and that will be your income from the property. To do the calculation, use Schedule E.
Say you had to go to a condo in the middle of the night to fix a leaky toilet. Anything you spent on the repair is an expense -- the cost of driving to the condo, or driving to the hardware store to get a part. If you paid for parking, that's an expense, too, said John Scherer, a Madison, Wis., financial planner. You can take 44.5 cents per mile.
Did you advertise for a tenant or use a lawyer to draw up the lease? Did you bring in a cleaning service? Do you have a cell phone to conduct the business? Even paper for a flyer tacked onto a grocery store bulletin board will count as an expense, Scherer said.
You will need a record of the expenses. Scherer suggests dumping receipts in an envelope and sealing it at the end of each month.
"It all adds up," he said.
Under tax laws, you can take as much as $25,000 in a loss if your adjusted gross income is $100,000 or less. Up to $150,000, you can use some loss, but not as much as $25,000.
The most helpful expenses could be large items like property taxes, insurance, condominium assessments and mortgage interest payments.
If you lived in the house part of the year, and rented it out for another portion of the year, you will divide up the taxes and mortgage payments into appropriate proportions.
Sometimes taxpayers don't like to give up the opportunity to use the full mortgage deduction for themselves rather than deducting it from rental income, said Lisa Featherngill, a Richmond, Va., certified public accountant. If you faced a transition between living in a residence and getting it ready to rent, you might have a few weeks leeway to allocate the deductions. Featherngill suggests calculating the numbers two ways to see what's best.
In other words, experiment with taking the deduction as a homeowner or a landlord. You would use Schedule A for the period when you were a homeowner and Schedule E for when you were a landlord.
-- Depreciation is your friend
Besides all the expenses that might come to mind, you also are going to be able to depreciate some of the value of the home or condo.
In other words, every year for 27½ years, you are going to be able to remove some of the value of the property, and use it to reduce the income you had from your tenant that year.
That, of course, will lower your tax bill.
The concept is that your property is wearing out. It might not seem that way. After all, you might be able to sell it in the future for a lot more than it is worth today. But from a tax standpoint, Uncle Sam lets you account for wear and tear. Each year as your property deteriorates in value -- theoretically -- you toss away a portion of the value. And that helps you on your taxes.
Keep in mind that buildings and equipment wear out, but land does not. So when you start figuring out what you can depreciate, you will have to determine what portion of the property value is attributed to land, and what portion to the building.
So if the property cost you $300,000, and the tax assessor or an appraiser says $25,000 of the value is the land, you could depreciate $275,000 said Noel Hastalis, a certified public accountant with Virchow Krause & Co. in Chicago.
Simply put, that would mean each year for 27½ years you could take $10,000 a year in depreciation expenses. If you were only renting the property out for part of the year, you would not take a full year of depreciation.
If the landlord of a condo received $1,500 a month in rent, or $18,000 a year, but had $10,000 in depreciation expenses, and expenses totaling $26,400 from taxes, a condo assessment, mortgage interest and repairs, the person could have a loss of $18,400. That could then be applied to reduce the income they had from their salary alone.
Depreciation is complicated, though. So, as a new landlord, you might want to hire a certified public accountant experienced with real estate. That would be another expense that you could deduct.
To make matters more complicated, certain improvements in the property also can be depreciated. If you add a refrigerator or stove, for example, you depreciate the appliances over seven years. Presumably, after seven years the machine will wear out and you will need to buy a new one. If the stove wears out sooner, you can write off the appliance sooner than seven years.
Some people, faced with the complications of the depreciation schedule, decide to ignore it. That's a mistake, Hastalis said.
The government assumes you take depreciation whether you claim it or not. If you don't claim it, you may pay higher taxes each year you skip it. Then when you sell the property, you could face higher capital gains than you were anticipating.
Contact Gail MarksJarvis at email@example.com or leave a message at 312-222-4264.