Investing in rental properties is a great way to generate additional income and increase your equity. But it also allows you to take advantage of several tax benefits specific to landlords, meaning that your investment can have great returns.
Below, we’ll walk you through the various credits, deductions and incentives available for owners of rental properties, so that you can maximize your benefits.
Overview of Rental Property Ownership
If you own rental property, it’s vital to report all the income you receive. This includes rent, tenant-paid expenses deducted from their rent, or if your tenant exchanges services for rent. You’ll also need to report security deposits that aren’t returned if your tenant breaks any lease terms – like damage to the property.
This income is reported on Form 1040, Schedule E. Also, it’s not considered earned income, unless you’re a real estate professional.
This is important because real estate is considered a passive activity. But if you’re a real estate professional, any income from your rental property is actually considered active income. It’s all a result of material participation. The IRS has a number of tests to determine participation.
Yet there are many other tax advantages that can significantly impact your property’s profitability. For example, if you own a pass-through business entity, such as partnerships and S corporations, you may qualify for pass-through income deduction and deduct up to 20% of your net business income from your income taxes. However, this is subject to certain restrictions.
And that’s just the beginning.
Depreciation Deduction
A major tax benefit of owning rental property is the depreciation of expenses. This is the process of deducting the value of the building (and not the land on which it is located) and any improvements against your taxes. Essentially, the IRS allows you to depreciate your rental property over its useful life, or 27.5 years, to recover the costs of wear and tear. This is done according to the Modified Accelerated Cost Recovery System (MACRS). It is applicable to the cost of the property, and items that increase the cost basis (or what you paid for the property), like roofing or carpeting. Appliances can also be depreciated, but over a period of five years.
To do so, you need to meet a few requirements. You must own the property, use it in your business or in an income-producing activity, and expect it to last for longer than a year. You also can’t have used the property and then disposed of it during the same year.
So how is it done? Say you want to depreciate the cost of a new roof. You’ll add the amount to whatever you paid for the property, to get an adjusted cost basis.
This amount is then divided over 27.5 years, and deducted from your taxable income.
Mortgage Interest
Mortgage interest on your rental property is fully deductible. And if you have an investment property, you can also deduct the mortgage interest as a business expense. However, expenses incurred to obtain your mortgage are not deductible. Instead, they’re added to the cost basis of your rental property.
As such, we suggest speaking with a CPA or tax professional if you’re considering making use of this deduction.
Deducting your mortgage interest reduces your taxable income to save you money on your taxes. However, there are a few things to consider. Firstly, the property in question must be held for income, and be available for rent. You must keep detailed rental income and expense records, to itemize the costs on your return.
Note that the IRS doesn’t let you deduct interest on a mortgage that was refinanced for more than the previous mortgage balance, unless you’re using it for home improvement costs. Instead, this difference can be depreciated. Also, you may face a penalty for paying off your mortgage early, but you can deduct the penalty as interest.
Property Maintenance and Repair
There are also tax deductions available for the maintenance and repair of your rental property. As mentioned above, repairs are usually deductible in the year you give out the cash for them to be completed.
It’s important to report repair costs correctly. Many people mistakenly deduct capital improvements as repair costs, and this could be a potential red flag for the IRS, which may lead to audits.
According to the IRS, maintenance and repairs keep your property in good working condition without increasing its value or prolonging its useful life. This includes painting, appliance and HVAC repairs, plumbing repairs, yard maintenance, and pest control.
On the other hand, improvements make your property better than it was before, restore it to operating condition, or adapt it to a new use.
Improvements aren’t deductible; rather, they get capitalized and become part of your basis. And that could mean a larger depreciation write-off. This includes things like additions, security systems, or insulation.
Operating Expenses
The operating expenses of your rental property are also deductible. These are expenses incurred for maintaining and managing your property, like advertising costs, lease commissions, property taxes, liability insurance, utilities, and professional fees.
If you hire a property manager, you’re still able to deduct a few operating expenses. These include continuing education (such as belonging to a real estate investment club, or taking real estate courses). Travel expenses such as airfare and lodging can also be deducted, as long as they meet IRS requirements.
As with the other deductions discussed in this blog, these can lower your taxable income. But remember to keep detailed records for these expenses, so that you claim them correctly, and at the right time.
Section 1031 Exchange
Deductions aren’t the only way a rental property can help with your taxes. Another aspect to consider is a Section 1031 exchange. This applies when you sell your rental property.
As mentioned above, if you sell the property for more than you paid for it, you’ll be liable for capital gains taxes. But these exchanges are a way of deferring that. Essentially, you swap a property for another that’s of equal or greater value.
The great thing about these exchanges is you can use them indefinitely. However, if you cash out your profits from these exchanges, you’ll need to pay taxes on them.
The rules and restrictions relating to a Section 1031 exchange can be complex. In a nutshell, you need to have a replacement property of equal or greater value, have it identified within 45 days, and purchase it within 180 days?
There are also additional tax breaks if you conduct the exchange for a property in an opportunity zone. These are areas designated by the US Department of Treasury as low-income or disadvantageous tracts of land. Essentially, unrealized capital gains are placed into a Qualified Opportunity Fund, and it goes towards improving these areas.
That way, you defer capital gains taxes until 2026 or until you sell your stake. These funds also allow you to grow your capital gains by 10% over five years, and by 15% for over seven years. If you keep the funds invested for over a decade, you can avoid paying capital gains entirely.
To ensure you make the best use of these exchanges, speak to your CPA.
Tax Credits for Energy-Efficient Improvements
Energy-efficient improvements to your rental property don’t just make it more attractive for renters, and ensure long-term savings. You might also be eligible for the Energy Efficient Home Improvement Credit.
To qualify, you must meet certain requirements. These include that the property is located in the US, and owned by a US taxpayer. For rental properties in particular, qualifying expenses include natural gas or propane air conditioners and water heaters, electric or natural gas heat pumps, biomass stoves or boilers, and solar panel installation.
To be certain that your property qualifies, you can get a free energy audit. Here, an inspector will come to your property to inform you about rebate programs for which you might qualify.
Another option is the Residential Clean Energy Property Credit. Here, you have access to a credit of $1,200 per year, for solar and small wind energy expenditures, geothermal heat pumps, and fuel cell expenses.
Record-Keeping and Documentation
As discussed above, if you plan to make use of any of these tax breaks, accurate record-keeping is essential. Good records will help you prepare your financial statements, identify the sources of income and expenses, and track any deductible expenses. They’ll also help you to prepare your tax returns.
And in the event that you’re selected for an audit, organized records will help you provide evidence for any IRS queries.
Consulting tax professionals
An expert can help you organize your records for tax purposes. But more importantly, they can help you optimize your tax strategy for your rental property, with personal guidance on how to maximize any available deductions and credits.
At Fusion CPA, our team of real estate accountants and tax professionals has years of experience helping clients streamline their accounting and taxes, to ensure they have access to long-term savings.
To see how we can help you maximize the tax benefits of rental property, schedule a Discovery Call with one of our CPAs.
The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.