I do my own taxes and each year I tend to come across something new.
Last year before I left Rackspace, I would have quarterly meetings with Phil White (the resident CFP) about financial “stuff”. These were great meetings because Phil and I would talk about concepts that a CFP doesn’t usually talk about with clients.
For example, where most clients need to be taught the basics of personal finance, Phil and I would talk about complex financial tools, stock market strategies, tax planning, and real estate investing.
See, one of the things that always bugged me about rental property was that I never understood how people actually made money on them. It didn’t pass the logic test that it would be a “Good Idea” to take on a large amount of debt in exchange for a piddly (by comparison) monthly income; the risk was too high.
I also didn’t understand how income generated from the rental actually made you any money. It always seemed to me like that would increase your taxable base.
It was these questions that I would ask Phil because I genuinely didn’t know, and I wasn’t finding the answers on the internet.
Well, the answer to the question is really a large mix of expenses that you are allowed to deduct. These expenses can be a LOT of stuff; stuff that you’d be paying in the normal operation of a house. Things like property taxes, mortgage insurance, house (landlord) insurance, expenses related to fixng broken stuff, etc.
Still, this never quite seemed to quite turn the tables in your favor money wise.
Well, there’s another huge deduction that I was overlooking.
It was only this year that it occurred to me that I had forgotten to depreciate the rental property itself. Whoops.
I had read about this, but
- It totally slipped my mind
- I didn’t know where to do it in TurboTax
Both of those problems have since been addressed.
The area of Turbotax is in the rental itself. For instance, I have a rental called the address of my house. Inside of that I have an asset that I depreciate (the refridgerator I had to purchase to replace a dead one).
In addition to that one asset though, I also need to add another asset that is the house itself. Duh.
The one thing to keep in mind is the cost basis that you report. You report the remainder of what you owe on the mortgage as of the date that you started renting it. In addition to that, you list the value of the land so that Turbotax can do its’ calculations correctly. This value is listed on your property tax documents.
With that additional deduction in place, you tend to see a whole lot of what you owe suddenly fall off the table. This is actually a rather convenient thing because if you haven’t adjusted your witholdings on you W-2 recently, you’re probably in need of doing that now (which will increase your take-home pay).
The whole concept of owning a rental though brings with it another oddity that I wasn’t expecting; the standard deduction.
You see, when you own a house, you generally pay a butt-load of money each year in the form of interest. Usually this amount is something far north of the standard $6200 bucks the standard deduction gives you, so you tend to itemize your deductions. Great success.
With a rental property, the tables turn. All that stuff you used to get in the form of itemized deductions now turn into credits, as reported by TurboTax (forgive me for incorrect terms if there are any, this is what the software calls them).
So why is this weird? Well, because you no longer tend to have enough deductions to qualify for using itemized deductions. All the expenses related to your rental property fall under the “Credits” header instead of the “Deductions” header.
So here you are getting the standard deduction even though you paid thousands of dollars in mortgage interest, property taxes and repairs and such for your home.
Slowly but surely the concept of how people make money with real-estate is becoming more clear to me. I would LOVE to sit down and learn from someone who does this to a larger extent than I do because I would be asking questions until I was blue-in-the face.
Note also that now that TurboTax “knows” about these assets on the property, it will automatically track the depreciation going forward; no effort on your part. Just click through the form every year and the next year’s amount of various depreciation will be taken off.
Another kinda neat trick with the whole depreciation thing is that even if you’re not renting it, as long as it’s not your primary residence, you can keep skimming that depreciation off of it. And it’s not like you don’t have a lot to skim. Houses are depreciated over 27.5 YEARS. So suppose you didn’t have a tenant for a whole year. Well, with depreciation, you’d realize a huge lose in that year (upwards of thousands of dollars) and this would offset some of the income that you brought in from your day job.
Perhaps even to a sizeable amount where you end up getting a fat refund from the feds…such an odd tax world we live in…
Anyways, just thought I’d raise these topics for my own future knowledge, and others, because I have yet to find a good (said readable) PF blog that specifically targets rental property information.
All the best!