Taxpayers with rental properties in the District may have questions including tax reporting, what expenses can be deducted and licensing. Many taxpayers who move out of the District and opt to rent their property in lieu of selling have questions on tax consequences. Additionally, taxpayers should be aware of their obligations as a landlord.
Prelisting Rental Considerations:
Taxpayers considering renting out their property should first obtain the necessary licensing, whether it be the basic business license or short-term rental license for daily and weekly stays. It may also be necessary to cancel your property homestead deduction, to reflect the correct property tax. Next you should weigh whether to hire a property manager to oversee your rental activity which will qualify tenants, collect rents, pay bills and coordinate repairs. You should adjust your insurance coverage to make sure you are adequately covered for liability. Finally, you should registration with the Office of Tax and Revenue (OTR) as your activity will be subject to the unincorporated franchise tax and clean hands (no taxes owed) will be required for license renewal.
Tax Reporting:
Landlords will report activity on Form 1040 Schedule E, Supplement Income and Loss listing all rents collected, expenses and depreciation claimed. If renting through a listing service, you may receive IRS Form 1099 showing the rents paid. Expenses include cleaning, maintenance, repairs, advertising, commissions, insurance, supplies, utilities, HOA fees and legal fees. If you live in part of the property, you allocate your mortgage and taxes expense between Schedule A and Schedule E. Many taxpayers neglect to include deprecation for residential real estate is 27.5 years for the life of the building, excluding land. Depreciation as a non-cash write-off may create a loss for taxes even though your rental may be cash flow positive. Too good to be true, right?
Your rental activity will likely generate tax losses that may or may not be currently deductible depending on your income level. If your adjusted gross income is below $150,000 you will be able to offset this loss against your wages. However, if your income is above the threshold, the loss will be suspended and carried forwards until you sell the property.
In the District, rental active is reported on Form D30 Unincorporated Franchise Tax. Currently, this return must be uploaded to the tax portal or paper filed as tax preparation software may not support electronic filing. Even if your rental activity has a loss, there is a minimum franchise tax due of $250. You will need to register with DC OTR in advance of filing form D30 otherwise the tax form will be rejected.
Gain on Sale of Rental:
Many taxpayers are familiar with the potential tax-free gain on sale of residential property so long as they have occupied and owned the property as their primary residence for two years. However, taxpayers who are renting their property likely have questions about potential taxes on sale. It is advisable to get an estimate of taxes due before closing. First, you must estimate your adjusted basis in the property, that is what you paid for the property plus any capital improvements (keep those records) less depreciation claimed on Schedule E. Capital improvements include large renovations with a useful life, as opposed to smaller repairs that are expensed. Next estimate your net sales proceeds (contract price less closing costs, which usually includes a realtor commission). Previously suspended rental losses are now allowed to offset gain. Gain can be estimated by subtracting your adjusted basis from your net sales price. This gain will be taxed at the capital gains tax rates (which varies based on your income) usually 15% and District franchise taxes of 8%. In addition to capital gains tax and franchise tax, you may have to recapture all that depreciation expense that was claimed at 25% rate. Ouch that’s a lot taxes!
Taxpayers may be able to reduce or defer taxes with smart planning. If you have previously lived in this property for two years, you can rent it out for three years and escape capital gains. This is a great option for taxpayers who want to test renting first before selling. However, you will still have to recapture all the depreciation claimed to offset rental income. For taxpayers who have rented for more than 3 years, moving back in will help reduce gain if they live there for an additional two years. Under D.C. law, residents have grounds to evict tenants if changing a rental to a principal residence. Additionally, some taxpayers may also seek to defer taxes through a 1031 exchange whereby they identify a replacement property to acquire.
Conclusion and Takeaways:
If you are currently or considering renting your property, you should carefully evaluate your obligations as landlord. Renting may pose an opportunity rather than selling into a weak real estate market. With careful planning you can make sure your rental activity operates smoothly, stays compliant with regulations and even save on future taxes.
