Chairman Mao once paraded landlords before crowds to their deaths and many today would confiscate landlord’s control over property without recompense. When tax clients ask why the rich pay few taxes, I puzzle depreciation expenses, passive income and Trump’s Section 199 qualified business income deduction.
Large companies manage apartments and shopping centers, but there are many small SLV landlords, frequently elderly, who rent ADU rooms just to buy basic food and care. SLV landlords like me do provide useful service: housing those who can’t afford homes. How does the IRS tax Schedule E rentals?
What is a rental? The IRS maintains complicated rules about “personal use” of properties so people won’t deduct expenses, other than mortgage interest and taxes, from primary residences or personal ski lodges. Hotels and Airbnb rentals are active businesses, not passive rentals for IRS purposes because substantial services are provided.
IRC Section 199A, which may expire in 2025, allows some landlords 20% deductions on rental income. This deduction is controversial because “[n]either the statutory text of section 199A nor the legislative history provides a definition of trade or business for purposes of section 199A.” (IRS REG 107892-18)
The Tax Advisor (Dec. 1, 2023) says “The rental of real estate will be a trade or business if a taxpayer engages in regular and continuous activity with respect to the property rented, even if only one property is rented.”
Most schedule E entries are straightforward. “Rents received” records money paid, but this need not include rental deposits. Few people deduct rental advertising or commissions today. Auto expenses are usually deducted as standard mileage for those who travel extensively to properties. Management fees are more common for passive investors who hire property managers.
Property taxes and insurance costs are ubiquitous and legal/professional fees can cover evictions or tax preparation related to the property. Deduct repairs or maintenance (e.g. cleaning, gardening, toilet plunging) when restoring the condition of property, but capitalize remodeling expenses (complicated rules here) by making them depreciable. Landlords cannot deduct their complete mortgage, but can deduct interest from Form 1098—the only rental form regularly sent to the IRS by others.
Landlords must purchase or build to gain “basis” in property. Landlords have paid for realty in advance but can only deduct over 27.5 years for residences, 39 years for businesses and nothing for land. Yet the full purchase price is basis even if landlords borrowed 80% of the money to buy properties.
Assume a Silicon Valley engineer bought a median Scotts Valley house for $1.2 million with a $240,000 down payment and rented it—with land as half the value—they could deduct nearly $22,000 per year against passive income for depreciation. The starving homeowner who rents out a room might find they bought a 1970 home for $100K—minus $50K for land—and they can only deduct depreciation on the quarter of the house rented out. That would be roughly $1,800.
Rentals are passive activities if others manage, but “non-passive” if the landlord “materially participates.” Rental income is taxed like ordinary income, but deductions against ordinary income are limited to $25,000 for those who earn under $100,000 annually, and even that deduction phases out with higher income. So passive loss carryovers are held uselessly until rentals get sold.
At sale, the small game of cashflow—rental income versus expenses—plays into the large game of counting capital gains from compounded property appreciation, which has been over 60% in the last 10 years. Of course, capital gains are taxed federally at lower rates than ordinary income, so landlords win with sales and death may give heirs stepped up basis.
Landlords are delighted that section 199 lowers taxes, while depreciation sometimes allows landlords positive cash flow with zero taxable income. But landlord tax is less unfair than it seems because losses are delayed, cash goes out first for basis with no deduction and risks are substantial: if rents and real estate prices tumble, cash flow is negative and selling the rental won’t pay off the bank. Government encourages these risky investments because they house real people.
Robert Arne, EA, CFP, MS, of Carpe Diem Financial Life Planning, is a Certified Financial Planner who gives holistic financial advice as his client’s fee-only fiduciary. He serves mostly Santa Cruz Mountain dwellers. These articles must not be read as personal financial, mortgage, tax or investment advice; consult appropriate professionals. Learn more at www.carpediem.financial.
