The Taxpayer Relief Act of 1997 provides that you can exclude the gain on the sale of a home so long as the home is sold after 6 May 1997 and the taxpayer lived in the home for two of the past five years. The maximum amount of gain that can be excluded is $250,000, if single and $500,000, if married filing a joint return. If a taxpayer lived in the home for less than the full two years during the last five years, he can exclude a pro rata share of the allowable exclusion. For example, if a taxpayer lived in a home for one year during the previous five years, he can exclude one-half of the allowable gain, which is $125,000, if single, or $250,000, if married filing a joint return.
For the investor in residential housing, there are four major provisions to consider: (1) depreciation allowances, (2) the rental loss limitation, (3) the tax rate schedule, and (4) the tax treatment of capital gains.
Financial Operations of Rental Property
In preparing the annual individual tax return, rental income is totaled for the year, and the expenses associated with the rental operations (for example, depreciation, repairs, insurance, mortgage interest, and property taxes) are deducted to determine the taxable income or loss. Depreciation is a particularly important expense. Each year a percentage of the building’s value (but not the land) is taken as an expense to compensate for wear and tear and obsolescence, although this is not an amount that is actually paid “out of pocket.”
Those taxpayers purchasing residential investment property after 1986 are only eligible for straight-line depreciation over a 27.5-year period compared to the more rapid 19-year, 175-percent declining balance method available under prior law. Those currently owning rental property must generally keep using the depreciation schedule they began with.
Rental Loss Limitation
Under the current law, losses from rental property are considered as “passive investment” losses. Losses on passive investments can generally only be used to affect income from passive investments. Accordingly, owners can deduct rental losses only against other rental property income or other passive investment income. Rental losses cannot be deducted against salary, dividends, and interest income. Losses that cannot be deducted currently because of these rules may be carried forward indefinitely to future years and may be used to offset future passive income. Additionally, in the year the property is sold, past, unused losses can be used to offset gain on the sale.
There is an important exception for the small investor, however. Taxpayers with adjusted gross income of $100,000 or less may be eligible to deduct up to $25,000 of passive losses a year against salary and portfolio (investment) income. This maximum of $25,000 of annual losses is reduced or phased out, however, over an income range of $100,000 to $150,000. The available deduction is reduced $1 for each $2 of adjusted gross income above $100,000. To be eligible for this small-investor exception, the investor has to “actively participate” in the management of the property. Property management services can still be used if the owner remains involved in decision making, such as approving tenants, setting rent levels, approving terms of the lease, and approving major expenditures and repairs. At least a 10-percent ownership in the property is also required.
Regardless of when the property was purchased, rental losses that cannot be taken in a given year can be carried forward for use in later years and any remaining loss can be taken in full when the property is sold.
Investors with annual rental losses first use the losses to offset any rental income. Any remaining losses are then applied to offset up to $25,000 of other income for taxpayers who “actively participate” in the management of the property. Any remaining losses are carried forward for use in future years.
Capital gains or “profits” from the sale of a rental property are taxed at different maximum rates depending on how long you held the property and when you sold it. If you sold the property after 1 January 2006, the maximum capital gain rate is 28%, provided that you held the property for longer than 12 months. Further, it is only 5% if you are in the 15% tax bracket.