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Rental Properties: Tax haven or nightmare?

Added on 2/17/2007

Until 1987, rental properties were considered a tax haven as well as a good investment.  Inflation continually drove up the selling price of the real estate as well as the rents that could be charged each year.  In addition, depreciation was deducted from ordinary income, which for high-income taxpayers could be as high as 50%, but when the property was sold the tax paid on depreciation taken in prior years was taxed at a much lower rate (50% of the taxpayer’s rate in most years).

Then came the Reagan Tax Reform act of 1986, which went into effect in 1987.  The maximum tax bracket was lowered to 28% and the tax haven for rental properties was greatly reduced.  Currently, if your AGI is below $100,000 you may only deduct up to $25,000 of rental losses.  Any amount above this is carried forward and used against income from rentals in future years.  If there is never a gain, then the accumulated losses are taken in the year the rental property is sold.  If your AGI is above $100,000 and under $150,000, it is less.  Above $150,000, all losses are carried forward to future years.

 When a property is sold, depreciation that was taken in prior years is now taxed, but at your ordinary tax rate, not to exceed 25%.  It is possible that when the property is sold the tax paid on the “recaptured” depreciation will be higher than the tax benefit realized at the time depreciation was deducted.

 To make matters worse, beginning about 1989, inflation in rents and rental property values dropped substantially.  It was now possible that the original purchase price, plus interest paid on the mortgage and operating expenses would be greater than the selling price of the property, leading to a financial loss.

 Money can still be made in rental properties provided that good financial sense is used in selecting and buying a rental property.  Generally never buy a rental property for more than 100 times the monthly rentals, provided that the tenant pays all utilities in addition to the rent.  Example:  Monthly rents are $800; do not pay more than $80,000 for the rental property.  This is a very old financial rule that predates the US income tax law.

 There are many other factors that will determine how financially successful a rental property will be including, but not limited to the quality of the tenants and the willingness of the landlord to be “hard nosed” when collecting rents.