Income from rental properties requires careful tax planning

The rent is too darn high.
That’s great news for clients who own a second home and want to receive rental income from it, as long as they’re ready to put in the necessary elbow grease to maintain the property and are willing to deal with the extra tax planning required.
Research from housing marketplace Zillow showed that rents leaped at the start of the year. The median rent for the U.S. hit $1,350 in January, reflecting a 3.3% increase year-over-year. The highest rents were in California, with San Jose’s median rent at $3,190 and San Francisco’s at $3,055 — and both reflect double-digit increases from the same period a year ago.
Demand for rentals is rising at a time when individuals are finding it difficult to scrape together the dollars needed for a home purchase.
Considering those rising rents and the fact that fixed-income investments are still being pulverized by low interest rates, clients with a second home might be tempted to rent it out to supplement their income.
“If you can keep the home and manage it yourself, you’ll get more income than you would from an alternative investment with the same amount of money,” said Philip G. Lubinski, founding partner with First Financial Strategies.
“But for someone who hasn’t had rental property for most of their life and now they think this is a good idea, it may be a disastrous situation,” he warned. “They don’t know how to be an effective landlord and how to do all the work that’s involved in generating rental income.”
FIT TO BE A LANDLORD?
Before delving into the potential tax and income benefits of having a rental property, clients need to weigh whether they’re really cut out to screen tenants, make repairs and handle the dirty work of managing renters.
Clients who are approaching retirement and still have the energy to manage a property tend to fare well, but often the maintenance work became burdensome as those clients age, Mr. Lubinski observed.
And there’s always the risk that a client will have a nightmare tenant. In one scenario, Mr. Lubinski had a client who owned a duplex in Denver and decided he would sell it. The tenants moved, but unbeknownst to the client, the tenants had been cooking meth in the home. An inspection at the request of a potential buyer revealed structural damage from the tenant’s meth lab, resulting in $40,000 of repairs.
“You don’t know the damage that a tenant will do,” Mr. Lubinski said.
In another scenario, George Papadopoulos, a fee-only adviser in Novi, Mich., had a client who was renting out a cottage in the Wolverine State and incurred a stream of losses.
The client couldn’t deduct the losses on the rental property until the time came to sell it, which he did in 2014. “We had a nice large loss that we were able to deduct in 2014, which brought his taxable income way down,” Mr. Papadopoulos said. “To plan around that, since we knew the losses were coming, we accelerated a bit of the client’s income [which is commission-based] from his employer.”
Being a landlord isn’t for the faint-hearted, and it’s not for people who hope to make a quick and easy buck, Mr. Papadopoulos warned, himself a landlord. “I’m not a guy who fixes things, and if something breaks in my house, I find someone else to fix it,” he said. “I still see people out there who are interested in buying homes and renting them out, and that’s their retirement fund. I just shake my head.”
TAX PLANNING FOR RENTAL INCOME
Say your client is ready to roll up her sleeves and rent out a second home she already owns, perhaps a beach house. The property will generate income that will require special tax planning around it.
The first thing to consider is the Internal Revenue Services’ 14-day test to determine whether the owner is using the rental property as a home. A client uses a dwelling as a home if she uses it for personal purposes for more than the greater of 14 days or 10% of the total days it’s rented to others at a fair rental price.
If the second home is primarily used as a home but rented to someone else for less than 15 days out of the year, then the dwelling’s primary function isn’t considered a rental and it doesn’t have to be reported. This means the client doesn’t have to report rental income and expenses.
On the other hand, if the client doesn’t use the beach house at all, then all of the home-related expenses are deductible and income from the rent is taxable, according to Tim Steffen, director of financial planning at Robert W. Baird Co. You will attach that rental income or loss to your client’s 1040 using Schedule E.
Finally, if the client uses the beach house as a home and rents it out more than 15 days of the year, then she needs to report the rental income. She also needs to divide the expenses related to rental use and personal use, as rental expenses are deductible but personal expenses aren’t.
“Anything in the rental [expense] category can be used to offset the rental income that’s received,” Mr. Steffen said. “From a record keeping point of view, the big things to do is to track rental and personal use days, and track all of the expenses.”
WATCH OUT FOR THE NIIT
Rental income is considered passive income, so it could be subject to the 3.8% net investment income tax if your client’s modified adjusted gross income is over the $200,000 mark for single filers or the $250,000 threshold for married-filing-jointly.
Taxpayers can also use passive activity losses to deduct other passive income, but they must be aware that those deductions begin to phase out if the taxpayer surpasses the MAGI threshold of $100,000.
“It’s probably too late for 2014, but for 2015, if you’re bumping against that $100,000 threshold and you have a loss in rental property, be careful about doing Roth conversions or recognizing large gains that will push you over the threshold for the deduction,” Mr. Steffen warned.