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COVID-19 Crisis May Impact Tax Strategies for Rental Property Losses

The ongoing COVID-19 crisis has brought about significant economic repercussions, resulting in potential tax losses for rental real estate properties in 2020 and beyond. In this article, we will explore the important federal income tax...

The ongoing COVID-19 crisis has brought about significant economic repercussions, resulting in potential tax losses for rental real estate properties in 2020 and beyond. In this article, we will explore the important federal income tax rules related to these losses, providing you with valuable insights and guidance to navigate this challenging situation.

Rental Properties with Positive Taxable Income

Despite the COVID-19 crisis, some rental properties are still generating positive taxable income in 2020. When rental income exceeds deductible expenses, owners must report these profits as passive taxable income. However, if you have accumulated suspended passive losses from previous years, you can now utilize them to offset your passive income.

An added benefit is that taxable income from rental real estate is not subject to self-employment (SE) tax, unlike most other unincorporated profit-making ventures. However, higher-income individuals who own rental properties may be subject to the 3.8% net investment income tax (NIIT) on their passive income. It is advisable to consult with your tax advisor for specific details and guidance on your situation.

Deductible Expenses for Rental Property Owners

As a rental property owner, you can deduct various expenses from your taxable income. These expenses include mortgage interest, real estate taxes, utilities, insurance, repairs and maintenance, as well as the care and maintenance of outdoor areas. These deductions can significantly reduce your overall tax liability.

One of the key tax advantages for rental property owners is the depreciation deduction. While the value of the property may appreciate over time, the cost of the rental building itself (excluding the land) can be depreciated over a specific period. For residential buildings, the depreciation timeframe is 27.5 years, while for commercial buildings, it is 39 years. Depreciation write-offs can lead to substantial tax savings, especially if you own multiple properties.

For instance, let's consider Ann, who owns an apartment building with a cost of $750,000, excluding the land. Her annual depreciation deduction amounts to $27,273 ($750,000 divided by 27.5 years). Ann can use this deduction each year to offset up to $27,273 of positive cash flow from income taxes.

QBI Deductions for Rental Properties

Many rental properties are owned through "pass-through" entities, such as sole proprietorships, partnerships, limited liability companies (LLCs), or S corporations. Under the Tax Cuts and Jobs Act (TCJA), a new personal deduction based on qualified business income (QBI) from pass-through entities was introduced for tax years 2018 through 2025. This deduction can potentially be up to 20% of QBI, subject to certain restrictions for higher-income individuals.

In 2019, the IRS issued a safe-harbor provision allowing QBI deductions based on net income generated by eligible rental property activities owned through pass-through entities. However, it is important to note that specific rules must be followed to qualify for this provision. It is advisable to consult with your tax advisor to determine if you meet the requirements for the safe-harbor provision.

QIP Correction for Commercial Property Owners

The Coronavirus Aid, Relief, and Economic Security (CARES) Act includes a retroactive correction to the Tax Cuts and Jobs Act (TCJA) regarding qualified improvement property (QIP) for commercial real estate. QIP refers to interior improvements made to nonresidential buildings that occur after the building was placed in service. Thanks to the CARES Act correction, eligible QIP can now qualify for 100% first-year bonus depreciation or be depreciated over 15 years using the straight-line method.

Importantly, this correction retroactively applies to QIP placed in service in 2018 and 2019. Previously, QIP placed in service during those years had to be depreciated over 39 years. This change allows commercial property owners to benefit from accelerated depreciation, providing increased tax savings opportunities.

Commercial Property Caption: Commercial property owners can take advantage of accelerated depreciation for qualified improvement property (QIP) placed in service.

Expanded Section 179 Deductions

The TCJA increases the maximum Section 179 deduction to $1 million for eligible property placed in service in tax years beginning after 2017. This deduction privilege allows you to write off the entire cost of eligible property in the year it is placed in service. For tax years beginning in 2020, the maximum Section 179 deduction is $1.04 million, with annual inflation adjustments.

The definition of eligible property has been expanded to include expenditures for nonresidential building roofs, HVAC equipment, fire protection and alarm systems, and security systems. Additionally, depreciable tangible personal property used predominantly to furnish lodging, such as furniture and appliances, also qualifies as eligible property.

Navigating the PAL Rules

Rental properties often incur losses, especially during periods of economic downturn or when seeking tenants for new properties. These losses are generally classified as passive losses, subject to the passive activity loss (PAL) rules. Under these rules, you can deduct passive losses only to the extent that you have passive income from other sources or gains from selling other rental properties. Any excess passive losses are suspended until you generate more passive income or sell the property that produced the losses.

The PAL rules can delay the tax benefits associated with rental property losses for several years. However, there are exceptions that allow you to deduct rental property losses sooner rather than later. It is recommended to consult with your tax professional to explore these exceptions and determine if you can qualify for early deductions.

Excess Business Loss Disallowance Rule

Another hurdle to navigate when deducting rental property losses is the excess business loss disallowance rule established by the TCJA. For tax years 2018 through 2025, you cannot deduct an "excess business loss" in the current year if it exceeds $250,000 ($500,000 for married joint-filing couples). However, any excess business loss can be carried over to the following tax year and deducted under the rules for net operating loss (NOL) carryforwards. It is important to note that this rule applies after applying the PAL rules.

The CARES Act suspends the excess business loss disallowance rule for losses that arise in tax years 2018 through 2020. This temporary relief provides additional opportunities to currently deduct rental property losses, minimizing the financial burden caused by the COVID-19 crisis.

Net Operating Loss (NOL) Deductions

If your rental property losses satisfy the PAL rules and the excess business loss hurdles, they can be used to offset taxable income from other sources. If your losses exceed your other income, you may have a net operating loss (NOL) for the year. The CARES Act introduced a five-year carryback privilege for NOLs arising in tax years 2018 through 2020. This means you can carry the NOL back to earlier years, deduct it, and potentially recover federal income tax paid in those carryback years. This can be especially beneficial since tax rates were generally higher before the TCJA came into effect.

Seek Professional Guidance

The economic fallout from the COVID-19 crisis increases the chances of rental property losses in 2020. However, various tax relief provisions can help mitigate the impact. If you have any questions or require further information, it is advisable to consult with a tax advisor who can provide you with specific guidance tailored to your situation. At [Your Company Name], we offer comprehensive business tax planning services, including personal tax services. Contact us today to learn more.

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