Real Estate Investors: Debunking 5 Myths About Rental Property Taxation

One of the most profitable ways to generate passive income is by purchasing properties and renting them out. This can be especially lucrative in areas that are getting an influx of millennials, who are much more open to renting than previous generations.

However, what you may not know is there are enduring and costly misunderstandings about rental property taxation. Here are five myths in particular that, once debunked, will hopefully be as clear and unmistakable to you as one of those  giant office lobby signs with blinking LED displays:

Myth: You either use your passive losses from real estate, or you lose them.

Truth: If you have a passive loss from your real estate investments and cannot offset them because you are generating high income from other sources, then you will not lose them. Instead, if you qualify as a real estate professional (and you do not need to be licensed or complete a course to qualify), then you can suspend your passive losses and apply them in the future.

Myth: You can always deduct the costs of renovating rental units.

Truth: The reason this myth has such staying power, is because it is partially true — or if you prefer, partially false. The true part is that you can indeed deduct the costs of renovating rental units. However, contrary to what many people believe (or are led to believe), the deduction can only be made when rental units are placed into service — which basically means when the units are advertised to prospective tenants. This usually includes cleaning services for your unit as well. When your place is sparkling clean, it definitely attracts potential renters.

Myth:  Flipping a property is considered a long-term capital gain.

Truth: There are even some CPAs out there who aren’t sure about this one, but the IRS is clear on the matter: any investor who buys a property, develops it, and sells it incurs a short-term capital gain. Alternatively, any investor who buys a property, holds for at least a year, and sells it incurs a long-term capital gain — and reaps the added tax savings. The moral to this story? If you didn’t hold onto a property for at least a year, then the profit you make after flipping it is a short-term capital gain. While this may be very disappointing to learn, it’s better that you discover that now vs. from the IRS during an audit.

Myth: A security deposit never needs to be included as rental income.

Truth: If you plan on returning a tenant’s security deposit at the end of their lease (which is usually the case), then you don’t have to include it as rental income when you file your taxes. However, if you keep any portion of the security deposit, then it becomes rental income and must be reported as such.

Myth: You should never allow a tenant to give you property or services instead of money, because you cannot deduct it as a rental expense.

Truth: Provided that you included the fair market value of the property or services as part of your rental income, then you can usually deduct the same amount as a rental expense.