Due to the inherent challenges of frequent, military-mandated moves, military real estate investors often ask about the unique rental property income tax considerations they must address.
In this article, we’ll cover the following topics pertaining to filing rental property income taxes as a military investor:
- Rental Real Estate Income Overview
- Tax Filing Challenges for Military Investors
- Challenge 1: Transitioning Your Primary Residence to a Rental Property
- Challenge 2: Filing Taxes in Multiple States
- Final Thoughts
Rental Real Estate Income Overview
Prior to understanding the tax implications of rental property income, military investors first need to understand what actually qualifies as rental property income.
According to the IRS, rental income constitutes any payment received for the use or occupation of your property, and you must report all of these rents in your gross income. For a military landlord, this means that all of the following forms of rental income must be reported when you file your taxes:
- Base monthly rent
- Rent paid in advance
- Landlord expenses reimbursed by the tenant (e.g. HOA fees, utilities, etc)
- Lease cancellation fees
- Property or services received in lieu of rent (measured at fair market value)
- Security deposits converted to final month’s rent payment
NOTE: Security deposits that will be returned to tenants at the end of a lease term do not need to be reported as income.
However, while the above may seem like a ton of taxable income, military landlords do not pay taxes on the sum of this rental income. Instead, landlords are allowed to deduct from this total the ordinary and necessary expenses associated with their rental property. While not an all-inclusive list, the following represent the most common deductions military landlords will use to reduce their taxable rental income:
- Mortgage interest
- Property taxes
- Operating expenses (utilities, landscaping, management fees, HOA fees, etc)
- Repairs (either deducted or capitalized, depending on character)
NOTE: While the Tax Cuts and Jobs Act placed a ceiling on mortgage interest and property tax deductions for primary residences, no such limit exists for rental properties.
After adding up all of their rents received, military landlords then need to subtract all of these tax-deductible expenses to arrive at their total, taxable rental income.
Tax Filing Challenges for Military Investors
Now that we’ve explained rental property income, the next items to cover are the specific tax filing challenges faced by military investors. Specifically, these challenges arise due to the unique nature of the military profession – and the regularly mandated moves associated with it.
While most real estate investors have the luxury of investing in their own local areas, many military investors pursue a build-a-portfolio-as-you-go approach. In other words, while stationed in one area, a service member may use the VA home loan to purchase a primary residence. But, upon transferring to another state, rather than selling that initial residence, many military members instead transition it into a rental property, buying a new primary residence at the next duty station.
While this approach allows for a steady accumulation of rental properties, it also poses some tax filing challenges for reporting rental property income, two of which we’ll address in the following sections.
Challenge 1: Transitioning Your Primary Residence to a Rental Property
If you buy an investment property and immediately rent it out, the tax treatment is straightforward, that is, it’s always treated as a rental property. However, if a military family receives orders to move in June and begins renting out what had been their primary residence in July, how should they file taxes?
In this situation, military landlords need to apply the yearly expenses on a pro rata basis, that is, they can deduct as rental expenses an amount proportional to the amount of time the property was a rental. This means that, as this example property was placed in service in July (half the year), landlords can deduct 50% of annual property taxes, insurance, depreciation, and mortgage interest as rental expenses.
For monthly expenses like utilities and HOA fees, landlords can only deduct the amounts for months during the rental period. Using the above example, this means that electricity bills from January to June – while the family lived in the home as a primary residence – are non-deductible. However, once the property is placed in rental service in July, the subsequent electricity bills qualify as tax-deductible operating expenses for the rental property.
Challenge 2: Filing Taxes in Multiple States
In addition to their federal income tax bill, military landlords also need to pay taxes on rental property income at the state level. This begs the question, if a military member has rental properties in California and Virginia but currently lives and works in North Carolina, where should he or she actually pay state taxes on that rental income? California? Virginia? North Carolina? All or some?
This is a problem faced by many military landlords, but, due to differences in state tax authorities, a universal solution does not exist. However, broadly speaking, military landlords with rental properties in states other than where they currently live will need to file nonresident state income tax returns in the states where their rental properties are located (assuming they meet minimum filing requirements, which vary state-by-state). Additionally, most investors will need to also include this income on their home state tax returns, though most states provide a credit for any rental income also taxed by another state.
NOTE: In addition to working with local tax professionals, online tax preparation software can assist military investors with filing their state returns. Once you’ve entered all income for your federal tax return, these software programs can automatically populate the state returns – based on rental property addresses – where you’ll need to file.
By ensuring accurate reporting of rental income on federal and state returns, military investors A) avoid tax-related penalties and fees, and B) document their history as landlords, a critical step in qualifying for subsequent investment property loans.
Rental property income taxes can be an overwhelming topic for military investors. However, as the above article illustrates, these service members just need to account for a couple unique considerations in filing their tax returns.
Maurice “Chipp” Naylon spent nine years as an infantry officer in the Marine Corps. He is currently a licensed CPA specializing in real estate development and accounting.