April 10, 2018
By Cassie James, PMI Communications Manager
Tax season can be stressful for solo entrepreneurs and landlords. The last thing any investor wants is for an unexpected tax bill to cut profits on their real estate investment. If you own residential property, you are aware that there are a number of unavoidable costs and expenses that go along with the territory. If you want to maximize the return on your investment, it is essential to understand what expenses you can deduct related to your property so that you don’t end up overpaying during tax season. In fact, the opportunities that come with an understanding of tax policies is a big part of why real estate is such a popular investment. The Internal Revenue Service taxes the rent you collect from your residential rental property as business income. As a business income, the expenses of owning a rental property are considered business expenses, and much of the cost of maintaining and managing your rental property can be subtracted from that income, reducing the tax you pay.
DEPRECIATION OF RENTAL PROPERTY
Depreciating real estate is one of the most impactful ways to immediately reduce income taxes from your rental. The IRS allows owners to depreciate residential rental property over a period of 27.5 years, which enables you to write off everything except the land which is non-depreciable. Here is a simplified example of how to calculate depreciation allowance.
A $300,000 rental house that has an allocated value of $75,000 of land and $225,000 of building improvements. Then divide $225,000 by 27.5 years to find an annual depreciation allowance of $8181.82.
There is one catch to taking this deduction; the catch is that the government doesn’t forget that it gave you this break and you have to pay those taxes when you sell the property. In the year you take the deduction, the depreciation allowance is considered an expense and lowers taxable income for that year. If you sell your depreciated rental property for more than its depreciated value, the IRS will impose a depreciation 25% recapture tax on the total depreciation that you claimed while you owned it. Whether or not this is financially beneficial depends on your specific situation. For example, if you are in a tax bracket above 25%, the recapture tax is less than you would have paid. If your tax bracket is less than that you may end up paying more, but it could be worth the cost to have the money to use at the time you took the depreciation.
Many real estate investors avoid paying the recapture tax by taking advantage of a 1031 exchange, with which investors can defer depreciation and recapture tax liability and capital gains, making it possible to re-invest with more cash. Be aware; the IRS has very specific requirements for using a 1031 exchange.
INSURANCE PREMIUMS
Rental property insurance premiums are tax deductible. The amount of premium you deduct must be for no more than one year of coverage. If you pay for multiple years at once, you can only deduct the part that covers one year.
MORTGAGE INTEREST & POINTS
Interest is one of the most reliable yearly deductibles most landlords have. Interest payments on bank loans and other financing are tax deductible as long as those loans are used to purchase and improve the rental properties. The exact amount you claim should be mailed to you from the lender on a Form 1098 or similar statement.
Because the IRS considers the rental property to be a business, credit card interest for items and services used for your rental is deductible too. To claim this on your taxes, the credit card used must be exclusive to business-related charges. If you use the card for personal expenses, you can not claim the interest on that card as a business expense.
PROFESSIONAL & LEGAL
Many property owners have found it beneficial to hire a professional property manager for worry-free landlording that doesn’t necessarily reduce profits because of the issues a property manager can resolve and prevent. If you pay for professional property management services for your property, these fees are deductible expenses. If you paid an attorney or title company for legal services regarding your rental property, these expenses are deductible as well.
TRANSPORTATION & TRAVEL*
If you drive your vehicle to and from your rental property to collect rents, maintenance inspections, or other management activities, the mileage may be tax deductible. If you’re an out of state (or just out of town) property owner who travels to collect rent, managing, or maintaining their rental property, you can allocate travel expenses and deduct to portion attributed to your rental property. Something to remember is that if the purpose of the travel is to make improvements to the property, the travel expenses are not deductible because the cost of improvements is recovered when depreciating the property.*Keep all records for transportation and travel so that you can submit them with your tax returns as required by the IRS.
BUSINESS AND PRE-RENTAL EXPENSES
As soon as your property is available for rent, and not being used as a primary residence, the costs you incur towards renting your property are deductible. Here are some common examples of these types of expenses.
- Advertising and listing the rental property
- Tenant screening
- Software needed to manage the property
- Cleaning
- Equipment rental costs
- Repairs
- Maintenance
- Tax preparation
IMPROVEMENTS ARE DEPRECIATED NOT DEDUCTIBLE
While the expenses just discussed generally may be deducted, owners must capitalize improvement or betterment expenses. According to the IRS, “an expense is an improvement if it results in the betterment of your property, restores your property, or adapts your property to a new or different use. The following are a list of types of improvement expenses that can not be deducted.
- Fixing a pre-existing condition
- Enlarging or expanding the property
- Increasing capacity, strength, or quality of the property.
Expenditures to improve or add to your property are depreciated over time. Improvements are things you must buy or replace completely, not simply maintain. Buying a new porch would be considered an improvement while painting the existing porch would not. The IRS determines the estimated life value of these additions, so you can schedule the depreciation you deduct according to how long their value lasts. If the porch is estimated to last ten years, you could divide its cost by ten and then deduct that much for the next ten years you operate the property. The expenses you accrue improving your property can generally be depreciated as if the improvement were separate property.
TAKE ADVANTAGE OF TAX LAW TO MAXIMIZE INCOME
As a landlord who wants to get the most out of your investment, you’ll want to make sure to keep detailed records of your expenses throughout the year. Save your receipts, digital and physical, and hang on to any contracts you’ve made. Having this information close at hand will make it easier to remember what expenses you incurred so that you can be sure to claim each one. Understanding the implications of depreciating the property will allow you to make an informed decision to create the best outcome for your situation. If you hire a tax professional with this portion of your taxes, remember to claim that expense as a deduction in the following tax year.
For a more detailed explanation about income tax on residential rental property and vacation rental property, please see IRS Publication 527.
