Investing in real estate rental properties is different than investing in stocks and bonds. There are pros and cons to each and the jury is out which is the better investment choice. As a realtor, I’ve had many clients find themselves becoming landlords but a surprising number did not take advantage of the many tax deductions for real estate properties. One couple I knew rented out their starter home and had no idea that they could offset their income and reduce their tax bill. Whether you rent out a single apartment or have a portfolio of rental units, you should learn about one of the key reasons to invest in rental properties: tax deductions for real estate.
To learn more about what a tax deduction is and the difference between a standard deduction and itemized deductions, check out this article.
Real estate is a great way to build wealth. Depending on where you buy, you can create a steady source of income while building equity as the property appreciates over time. There’s also many tax benefits that you can take advantage and save money.
What are the Key Tax Deductions for Real Estate
Tax deductions for landlords who rent real estate property are different than tax deductions for homeowners of primary residences without tenants.
When you rent real estate to a tenant, you might be able to take advantage of the following tax benefits. Uncle Sam looks at landlords similar to small business owners and the tax system is designed to encourage real estate investment.
Deduct rental property expenses
Rents that you are paid are income but common expenses can be deducted from your taxes such as:
- Property taxes (Note: Unlike primary homeownership, there is no $10,000 a year State and Local Tax (SALT) limit; Property taxes on rental properties is only deductible the year they are paid)
- Property insurance
- Mortgage interest
- Property management fees
- Utilities
- Snow removal
- Landscaping
- Pest control
- Repairs
- Home Owner Association (HOA) dues
Expenses that have to do with the business of operating your rental unit can also be deducted including:
- Advertising (social media, newspaper, Zillow, etc)
- Office space
- Business equipment (paper, printer, business cards, computer, etc)
- Professional fees (lawyers and accountants)
- Education or training courses
- Travel – This can include the cost of travel for repairs or tenant turnover but not improvements.
Sometimes landlords may use personal property in their rental units. Personal property can be deducted for property costing up to $2,000 or 100% bonus depreciation from 2018 through 2022. Personal property may include appliances, furniture and/or gardening equipment.
You can also deduct expenses related to employees and independent contractors. If someone performs a service, you can deduct wages or payments as business expense. For example, an employee can be a property manager or an independent contractor might be a repair person, plumber, or electrician.
For all business expenses that you plan to deduct, you need accurate records and receipts to prove your claims in the event the IRS audits you. Each year, I make a folder on my computer and physical filing cabinet and save all receipts associated with each rental property. Create a system and stick to it.
Some important documents that you should keep:
- Annual mortgage interest statements from your lender (Form 1098)
- Property Tax bills
- Receipts from any improvements made to the property
- Repair and maintenance receipts
- Insurance bills
- Credit Card and Bank statements
- Tenant leases
Depreciation can also offset rental income
Real Estate depreciation is a concept often overlooked by new landlords but can be a significant tax savings. Depreciation is an accounting term referring to the reduction in an asset’s value over it’s useful life. Even though a real estate property may be appreciating in value, you can deduct the cost of buying and improving a rental property over its useful life. You can deduct depreciation as an expense as long as you own the rental property, the property is used in your business or as an income producing activity and the property has a determinable useful life. The expected life for residential properties is 27.5 years and the expected life for commercial properties is 39 years.
Buildings are able to be depreciated but you cannot depreciate land. When doing the calculation, you must subtract the value of the land from the value of the building. If you get a tax assessment notice, you’ll see that the government provides a breakdown of the assessment into Land and Improvements and the Total of the two to determine your tax assessment.
As an example, if you bought a house for $100,000. Your most recent tax assessment might value the property for $80,000. $72,000 attributed to the house and $8,000 attributed to the land. Using this assessment, you can allocate 90% ($72,000/$80,000) of the purchase price to the house and 10% ($8,000/$80,000) of the purchase price to the land.
Apply this basis to your rental property. 90%*$100,000 = $90,000 can be depreciated.
$90,000 / 27.5 years (useful life) = $3,272 can be depreciated each year for 27.5 years.
As you can imagine, the depreciation expense can quite large depending on the purchase price of your rental property. This can offset your rental income and sometimes, you might not pay any taxes.
If you sell your rental property, depreciation recapture is a tax that allows the IRS to collect taxes on any profitable sale of an asset that the taxpayer used to previously offset taxable income. For real estate, depreciation recapture on gains is capped at 25%. You can avoid depreciation recapture by not selling your rental property or buying another investment property using a 1031 exchange. We’ll explain what a 1031 exchange is below.
Pass-through Deduction
When you own rental property as a sole proprietor, via a partnership or through an LLC or S corporation, the rental income is considered qualified business income (QBI). If this is the case, you can deduct 20% of qualified business income (QBI) on personal taxes. Note that this is a provision of the Tax Cut and Jobs Act of 2017 and set to expire in 2025.
Capital gains
Capital gains are treated differently depending on the length of time that you hold an investment. Capital gains are classified as either short term or long term.
Short term
Short term is considered a time period less than a year. Short term capital gains are taxed at your regular income rate
Long Term
Long term is considered a time period longer than one year. Long term gains are taxed at a lower rate and depending on your income level, you may not pay any capital gains taxes at all.
How to defer taxes on rental property
1031 exchange
Section 1031 of the US Internal Revenue Code or simply referred to as a “1031 Exchange”, allows you to avoid paying capital gains taxes when you sell a rental property and reinvest the proceeds from the sell within a certain time frame into one or more properties of like kind and equal or greater value.
Currently, there is no limit to number of times you can do an exchange but you must follow specific conditions or else you’ll find yourself having to pay capital gains tax to the IRS.
Stay informed about potential changes – In 2021, Congress discussed making changes to the 1031 exchange but nothing was put into law.
Opportunity zones
Opportunity Zones were designed to change the tax code to encourage private investment in lower income and distressed communities and incentivize long term investments in these areas. Opportunity Zones were enacted as part of the Tax Cuts and Jobs Act of 2017 as a way to spur economic growth and create jobs. By investing in qualified areas designated by the state, you can potentially defer taxes but there are many rules you must follow to qualify.
Items that you can’t deduct
So far, we’ve discussed tax deductions and deferring taxes related to real estate but not everything related to a rental property can be written off. Here’s some items that you can’t deduct:
Improvements and travel associated with property improvements
If you are adding value to your property, you can’t cannot deduct the costs. This includes additions, renovations, and upgrades.
Commuting
Unless you have a home office, driving to your rental property is considered a commuting expense.
Vacancy
If your property is vacant, you cannot deduct the rent you would have received. You don’t owe taxes on rent you didn’t receive. You might be able to carry over these losses and offset future rental income or potential rental property gains if you were to sell.
Points related to your mortgage
Points are pre-paid interest on a mortgage and can be deducted over the life of the loan. You can’t just deduct them in the year you paid them.
Claiming Rental Property Tax Deductions
Rental property tax deductions should be completed on a Schedule E. The Schedule E allows you to report “supplemental income and loss” related to your rental estate property. Note that this is reported as “supplemental income and loss” and not “earned income”. Generally, supplemental income is considered passive income.
If you claim depreciation for your rental property, use Form 4562.
Talk to a CPA or tax professional who can provide you with expertise guidance and advice.
Summary
Real estate and rental property can offer sizeable deductions and tax benefits but many landlords do not take advantage of tax deductions for real estate and rental properties. This oversight can be costly and lead to paying taxes and lowering profit margins on your real estate venture. It’s important to know what expenses you can deduct on your rental property and keep good records and documentation.
