Forex

Do you own real estate that you rent out? Besides the potential for an ongoing income and capital appreciation, such investments offer deductions that can reduce the income tax on your profits. But first, what kind of real estate investor are you: a passive investor or real estate professional? In this article we'll show you how your classification could make a big difference in the number of tax breaks you get.

If you spend the majority of your time in the real estate business as a real estate professional, your rental losses are not passive. This means that your losses are fully deductible against all income, passive and non-passive. Otherwise, your losses are passive and only deductible up to $25,000 against your rentals' income (deduction phases out if your modified adjusted gross income (MAGI) is between $100,000 and $150,000). However, losses of more than $25,000 can be carried over to the following year.

The IRS defines a real estate professional as someone who spends more than one-half of his or her working time in the rental business. This includes property development, construction, acquisition and management. You must also spend more than 750 hours per year working on your real estate rental properties.

Common Income Sources
Rental Income
Money you receive for rent is generally considered taxable in the year you receive it, not when it was due or earned; therefore, you must include advance payments as income.

For example, suppose you rent out a house for $1,000 per month and you require that new tenants pay first and last months' rent when they sign a lease. In this case, you'll have to declare the $2,000 you received as income, even though a $1,000 of that $2,000 covers a period that might be several years in the future.
Tenant-Paid Expenses
Expenses your tenant pays for you are considered income. This would include, for instance, an emergency repair on a refrigerator a tenant has to have done while you are out of town. You can then deduct the repair payment as a rental expense.

Trade for Services
Your tenant might offer to trade his services in exchange for rent. However, you must include a fair market value of the services as income. As an example, if your tenant offers to paint the rental house in exchange for one month's rent (valued at $1,000), you must include the $1,000 as income, even though you didn't actually receive the money. However, you will be able to deduct the $1,000 as an expense.

Security deposits
Security deposits are not taxable when you receive them if the intent is to return this money to the tenant at the end of the lease. But what if your tenant does not live up to the lease terms?

For example, suppose that you collect a $500 security deposit and then your tenant moves out and leaves holes in the walls that cost $400 to repair. You can deduct that amount from the security deposit during the year that you return it. At that time, though, you must include the $400 that you used to repair the wall as income. You will also be able to show the $400 as a deductible expense.

Repairs Vs. Improvements
Rental property owners may assume that anything they do on their property is a deducible expense. Not so, according to the IRS.

A repair keeps your rental property in good condition and is a deductible expense in the year that you pay for it. Repairs include painting, fixing a broken toilet and replacing a faulty light switch. Improvements on the other hand, add value to your property and are not deductible when you pay for them. You must recover the cost of improvements by depreciating the expense over your property's life expectancy. Improvements can include a new roof, patio or garage.

Therefore, from a tax standpoint, you should make repairs as the problems arise instead of waiting until they multiply and require renovations