Deducting Rental Losses
Subject: Rental property
Dear Kerry Kerstetter,
One of your clients is our friend and realtor. We are thinking about investing in rental property for tax purposes and later to use as a retirement source once the properties are paid for.
She told me that you have helped her so much regarding taxes. She suggested I should contact you to ask the following question.
If you are in the 35% tax bracket- do you get a better tax break by having the rental property under our names or by setting up a corporation to manage the rentals. We just want to be sure there will be a tax benefit by obtaining rental property and we have been given different advise and are not sure which is correct. She said you would know the answer to this question.
Thank you for your time.
You are going to need to work with your own personal professional tax advisor on this matter because there is no easy cut and dried answer.
For example, it depends on what occupations you and your husband have. If either one of you qualifies as a Real Estate Professional (REP), you will be able to deduct your net rental losses against your other kinds of income, with no limit.
However, if neither of you qualifies as an REP, your net rental losses will be treated as nondeductible passive activity losses and will have to be deferred until future years when you have some passive activity profits, such as from the sales of rental properties.
I can tell this by the fact that you claim to be in the 35% Federal tax bracket, which means your Taxable Income is well over $300,000. The passive activity restriction phases out any rental loss deduction if your Adjusted Gross Income exceeds $150,000.
Using a C Corp sometimes makes sense because it is allowed to deduct rental losses up to the amount of other income. However, there is a downside to owning real estate in C corps because they don't have the same special low long term capital gains tax rates that individuals can use.
A strategy that may be able to give you the best of both worlds is to own the property individually and lease it to your C corp, which can then operate it as a rental.
Your C corp would need to have net income from other operations in order to be able to claim the rental losses. If you don't already have a C corp, even without the rental property issue, one could be used to shift some of your 1040 income so that you aren't in such a high tax bracket. I have a lot of info on using corps on my website.
Your own personal professional tax advisor should be able to help you come up with the best strategy for your particular situation.
Thank you so much for your response. If you should ever take new clients please keep us in mind. This information was very helpful and I will look at your website.
Depreciating converted property
Subject: Depreciation QuestionHi Guru, Have been reading you for a long time but never have seen a question like this. From 1999 to 2006, I ran a B&B and depreciated the business portion of my property as a commercial business. On Jan 1, 2007, I converted this property to a single family rental. Do I use the residential depreciation schedule this year? Also, would I continue to use the old basis or create a new basis when the property was converted. The property has appreciated almost double in value from 1999 to 2006.Thanks for your advice and hopefully this might be helpful to some other loyal readersThanks
If you have been reading my stuff for any length of time, you should know that you need to be working directly with a professional tax advisor to ensure that you do things properly.
This is a perfect example of a very common way in which people accidentally commit tax fraud; by setting up assets converted from personal to business use at a much higher cost basis than is appropriate. The tax law is very specific in the fact that converted assets are to be set up at the lower of their original cost or their current fair market value as of the date of conversion. Under no circumstances could you increase the depreciable value above what your actual cost was. To do so would essentially be giving you tax deductions on values to which you are not entitled.
That is the case for assets converted from purely personal usage to a new business usage. In your case, you were already using the property in a business, so you have no justification whatsoever for modifying the cost basis for depreciation purposes in its new use. You need to keep track of the original cost, along with the deprecation you had already claimed.
If you were depreciating the structure over the 39 years required for nonresidential real estate, you can change the appropriate life to the 27.5 years used for residential rental property as of the date of the new use. Again, you should have an experienced professional tax preparer do those calculations for you.
I hope this isn't too confusing and properly stresses how dangerous it is for you to continue to try to negotiate the treacherous tax waters on your own.
Thanks!! I appreciate your swift reply
Mineral Lease Income
Subject: Lease IncomeKerry,If you had a mineral lease to receive payments as "rents", would you take payment as personal income and avoid the 15% SE tax, or structure a sole proprietorship/farm or LLC and receive it as income and take deductions? "Rents" are projected @ between 1K-6K/month for 8-12 years.I realize that there are potentially more deductions than the 15% SE, however I'm near retirement and don't want to do a business full-time.Also, to minimize liability, should I consider a family partnership/trust and sell or transfer the lease to it?Thanks for any insight you may give.
This is the kind of thing that you really need to be addressing with your own personal professional tax advisor.
I'm not sure where you got the impression that the mineral lease payments would be subject to SE tax because that is not normally the case. SE tax would only be appropriate if you will be physically working to extract the minerals, such as with some gold miners I had as clients. However, if you are merely the property owner and are being paid for the use of the property, that income would be reported as Rent and/or Royalties on Schedule E, which is not subject to SE tax.
Whether there is a need to set up a separate entity for this or anything else in which you are involved is a subject nobody can competently comment on without detailed discussion and analysis of your unique circumstances.
Good luck. I hope this helps.