Key Takeaways
- Residential rental property earns more than 80% of its revenue from dwelling units and is used as living spaces for tenants.
- These properties can provide monthly cash flow and appreciate over time, making them an attractive investment option.
- Owners may benefit from tax advantages but face liquidity risks and management responsibilities.
- Engaging a property management company can mitigate landlord headaches but reduces profit margins.
- The IRS uses the 27.5-year MACRS schedule for depreciation on residential rental property.
What Is Residential Rental Property?
Residential rental property refers to a type of real estate investment where a property, such as houses, apartments, or condominiums, is leased to individuals or families for living purposes. This property type generates more than 80% of its revenue from residential tenants. Investors often value it for the potential of regular income and tax advantages.
We’ll give you some detailed insights into how residential rental properties work and explain their tax benefits and potential risks. Our aim is to provide you a comprehensive understanding supported by practical examples and IRS guidelines.
Understanding Residential Rental Property Operations
Residential real estate can be single-family homes, condominium units, apartments, townhouses, duplexes, and so on. The term residential rental property distinguishes this class of rental real estate investment from commercial properties where the tenant will generally be a corporate entity rather than a person or family, as well as hotels and motels where a tenant does not live in the property long term.
Residential rental property can be an attractive investment. Unlike stocks, futures, and other financial investments, many people have firsthand experience with both the rental market as tenants and the residential real estate market as homeowners. This familiarity with the process and the investment makes residential rental properties less intimidating than other investments. On top of the familiarity factor, residential rental properties can offer monthly cash flow, long-term appreciation, leverage using borrowed money, and the aforementioned tax advantages on the income the investment produces.
Owning a residential rental property can come with tax advantages that other, more indirect real estate investments like a real estate investment trust (REIT) do not confer to the holder. Of course, direct ownership of residential rental property also comes with the responsibility to act as a landlord or engage a property management company along with the risks involved from vacant units to tenant disputes.
Potential Risks of Residential Rental Property Investments
Of course, there are some corresponding downsides to residential rental property. The key one is that residential rental property is not a very liquid investment. Cash flow and appreciation are great, but if a property stops delivering one or both due to mismanagement or market conditions, actually cutting losses and getting out of it can be difficult. To sell a struggling rental property you need to find a buyer to find value in the investment that you no longer see or simply is not there.
There are also considerable headaches that come with acting as a landlord, although engaging a property management company can help, and that cost eats further into the profit margin of the investment. Finally, there is the risk created by changing tax codes. The tax treatment of residential rental property can change, erasing some of the attractiveness of the investment.
Tax Considerations for Residential Rental Properties
In the United States, the IRS considers residential real estate to be a property that derives more than 80% of its revenue from dwelling units. Residential rental property uses the 27.5-year modified accelerated cost recovery system (MACRS) schedule for depreciation. Income from residential property is treated as passive income, so there are rules around how losses are treated based on the active participation of the owner. The IRS Publication 527 Residential Rental Property provides an overview of the tax rules and is updated when rules or provisions change.