People are renting out their homes for various reasons. Quite often those who lost a job and steady income stream, would like to replace it with cash coming from renters. In many instances, jobs are lost when economy is in deep downturn and chances to sell a home are very slim. Then, renting out become the only viable option to deal with every day expenses. Pretty much everyone aware of the benefits. You get a stable income, almost independent on market conditions. But most people know a little about the losses, associated with rental property. And I am not even talking about the accidental losses, like repairs or maintenance, or unfortunate event of tenant eviction. It is about imminent loss experienced by landlord. In this article, I would like to discuss rental losses and some solutions how to deal with them in more details.

First, there are good news. There are rental property expenses landlord can deduct from the annual income:

• mortgage interest
• property tax
• repair and maintenance
• home office
• insurance
• association fees
• utilities (paid by landlord)
• professional services
• travel expenses, related to the property management
• property depreciation

These are pretty generous deductions. In fact, even according to recent tax reform the entire amount of property tax is deductible, opposite to the principal residence where this deduction is limited to $10K annually. But let us discuss property depreciation in more details. It is based on original total cost of rental property less the value of land. While land can not depreciate, building lose 100% of its value over 27.5 years. The deduction begins, when the property is rented to someone, and ends either after 27.5 years in service or when property is not rented anymore (become either principal residence or vacation house). Annual depreciation is calculated as follows:

• determine the cost basis, i.e. the amount of money initially used to purchase this property
• figure out from the latest tax assessment, what is a break down into the land and building values
• determine the basis for building (amount of money originally spent to purchase a building), based on the assessment value and divide it by 27.5

For example, the property has been initially purchased for $785K. According to the latest tax assessment, the building is responsible for $181K out of $906K in total value. Then, the annual depreciation would be: ($785K x  $181K / $906K) / 27.5 = $5,703.

Typically, rental losses can be deducted from the passive income, such as a rental income itself. But what if there is other income? For those earning less than $100K annually, $25K of passive losses still can be deducted to offset income from other sources. Overall, there are plenty of deductions available for landlord. If we assume that some individual over the age 50 has annual income $48K (which falls into 22% federal tax bracket according to the latest tax reform) would like to rent out a property with mortgage already paid off and property tax $14K, then the following deductions and rental property expenses are available:

• $12K federal standard deduction
• $14K rental property tax
• $5,703 rental property depreciation
• $6500 traditional IRA contribution
• $4450 HSA contribution

Then, the taxable income would be as low as $5K and this is even without taking into account state tax and other smaller scale deductions available. As a result, the tax would be around $500 (or less, after the deduction of state tax, insurance, HOA and repair expenses). This is a great example, how combined deductions and rental expenses can eat up the entire income tax. Meantime, individual would still have $23K in positive cash flow after property tax and pretax contributions.

So far, so good. But is there a negative side of this story? Sure it is. The rental property depreciation effectively reduces the cost basis for the property, which leads to depreciation recapture tax. It is important, when you decide to sell the rental property, you lived in the property for the last 2 out of 5 years and there is a capital gain more than $250K for individual (or $500K for couple) which can be excluded from the income. For a gain over these numbers, long term capital gain tax must be paid. Rental property depreciation makes the amount of gain and associated income tax higher. Moreover, it is considered as a subject to ordinary income tax which is higher than long term capital gain tax. Home value appreciation over the last decade made this situation real in many metro areas, such as NYC, San Francisco Bay, Seattle. For the above example, additional tax for income $28,515 will be applied if property has been rented for 5 years. Essentially, the depreciation tax must be paid back to federal government. Is it possible not to claim rental property depreciation? Yes it is possible, but the pay back would be still required, even when depreciation has not been claimed.

Is there a way to avoid a depreciation recapture tax? Yes: home improvements can offset property depreciation and take building cost basis back, where it was before the rent. Which home improvements can be claimed against cost basis? Pretty much everything. Most popular are:

• bathroom or kitchen remodeling
• windows and doors replacement
• hardwood or laminate floor
• new furnace or heater
• roof replacement
• garage door replacement

Typically, over the long time there will be improvements anyone must have. Each improvement would increase the cost basis and reduces capital gain tax for the sale of the property. The roof replacement alone may offset the decade of property rent. However please keep in mind, these are real expenses. But it does not really matter, if you do it anyway. Home improvements can be done at any time, but before the property is sold. It is also advised to sell the property during a fiscal year, when income from other sources is low in order to reduce the total tax. Again, all these matters for properties with substantial gain in their values in selective metro areas. Otherwise, the owner typically does not pay any tax on the capital gain and home improvement expenses would be entirely after tax money.