When it comes to owning rental properties, taxes drive a lot of decisions. And while I’ve always kept in mind that when it comes to taxes and real estate investment, you shouldn’t let the tail wag the dog, it’s sometimes very difficult to follow the plan.
Let’s start off by stating the obvious: The tax system is stacked heavily in the landlord’s favor. Tenants get virtually no tax benefit from renting, while landlords benefit more than virtually any other taxpayer, because they have feet planted in two tax-favored worlds — business and real estate. As a result, over many years of renting, I have paid little if any additional income taxes for my Dupont Circle apartment.
As one reader of my first column astutely observed, making a taxable gain is the last thing a landlord wants to do, and the series of deductions available to landlords frankly makes attaining a taxable income from your property pretty hard to accomplish. For instance, every dime spent ostensibly on the apartment is deductible, from larger ticket items such as property taxes and management fees, down to the smallest such as the paper clip attaching the check to the lease. I even had one friend, who also is a landlord, tell me that I could fly to Washington, dine with friends and tour the Phillips Collection, and, as long as I visited my apartment or stopped in to see my property manager, I could deduct the cost of the trip as a rental expense. (I would not recommend following this “advice.”)
The gift that keeps on giving is the mortgage interest deduction. Like homeowners, landlords can deduct the part of their mortgage payment that reflects the amount of interest paid on their apartments. In addition, if you cash-out refinance the mortgage, the increased interest payments and even part of the loan origination fees and points can be deducted as long as the money taken out was reinvested back in the property. This, of course, distorts the landlord’s incentives; and just as economists predict, landlords overcompensate by borrowing to the hilt to maximize the interest deduction.
Some have talked about eliminating the mortgage interest deduction as a way to simplify the tax system, reduce the deficit and raise revenue. Whether this effort succeeds in Congress or not, landlords are unlikely to be nicked by this tax reform. Landlords receive the interest deduction because it is a business expense, not because it is a home mortgage.
This is not the only advantage landlords have over regular homeowners. Landlords get to deduct items such as insurance, maintenance and utilities from income, which homeowners do not. And the most scandalous and least understood deduction that landlords get is the deduction for depreciation. This deduction assumes that your business asset — the apartment — is like a piece of business equipment with a finite life and, therefore, you are allowed to write off that “loss” over time. This can amount to several thousands of dollars per year in deductible losses. In other words, my appreciating, income-producing asset which has increased in value several times over since I bought it, is treated by the tax code as though it is wasting away and slowly turning to dust.
The obvious retort is that I should just not take the deduction and pay my equitable share of taxes. But they don’t make it easy to be altruistic. The tax program that I use to file my taxes was so hostile to my not claiming depreciation as a deduction, it continually overrode my decision and left me no choice but to manually delete that line item from my tax return. This, in turn, messed up all the calculations; and my return failed the final error check that the program performs prior to filing. I submitted my taxes with the “error” anyway; I figured that if I am audited by the IRS, they could hardly fault me for giving more than what was due to the Treasury.
The Treasury’s largesse to landlords does have its limits. After all the deductions the IRS gives you, the losses remain paper, “passive losses” and those that exceed the rent you received cannot be used to offset ordinary income, such as your salary. (At lower incomes, the loss can be deducted from ordinary income and thereby entitle you to a tax refund, but this phases out for higher incomes unless you qualify as a real estate professional.) So landlords like me are left with a lot of paper losses that can only be used in future years if I make a profit or if I have other passive gains to offset (e.g., income from other real estate investment).
The paper gains and losses are all supposed to wash out in the end, when you sell the property. But even then, the taxman can be cheated--by dying. A person who dies owning a highly appreciated property gets to pass on the property to an heir on a “stepped up basis,” i.e., with the current market value. That means that capital gains on the property’s appreciation evaporated for tax purposes. For the landlord, death may be a certainty, but taxes? Not so much.
A Colorado-based lawyer, Douglas Hsiao has rented out his Dupont Circle condo for 18 years. In his occasional column, he details his experiences as a long-distance landlord.