If you’re new to the world of real estate investing, we have great news heading into tax season. There are a lot of benefits to owning even one rental property. From deductions to capital gains tax deferment, we’re going to cover everything you need to know as you begin tax planning. Here are 8 tax benefits that could help you keep more money in your pocket when it’s time to file.
1. Mortgage Interest Deduction
Of all the deductions you may be able to claim, this is a big one. Mortgage interest is considered a business expense when you have a rental property. You can report any mortgage interest paid on Schedule E of Form 1040 (or on a partnership or corporate tax form). Rental property owners aren’t subject to a limit on the amount of debt.
2. Defer Capital Gains Tax
Tax benefits allow you to defer paying capital gains tax, which is a major advantage for someone who owns a rental property.
When a rental property is sold, an investor will usually pay a long-term capital gains tax of up to 20% on any profit from the sale. However, a 1031 exchange allows you to defer paying capital gains if you put the money to work by investing in another rental property.
In general, the replacement property must be of equal or greater value to the one being sold and must be identified within 45 days and purchased within 180 days. A tax professional can help you identify whether this situation applies to you.
Instead of taking one big deduction when you buy a property, depreciation allows you to deduct the costs over the property’s “useful life.”
Here are the requirements set forth by the IRS:
- You are the owner of the property
- You use the property for business or to produce income
- It has a determinable useful life (this means it can eventually wear out or lose value due to natural causes)
- You expect the property to last for at least a year
- The property was not placed in service and then taken out of use for business in the same year
The catch? Land can’t be deducted, which means you can only deduct the value of the building itself.
4. Operating Expenses
Maintaining a rental property takes time and effort, especially if you’re doing it from out of state. If you decide to hire a property management company to assist with these duties, the expenses are generally deductible.
Are you going it alone and acting as the landlord? Tenant screening costs and background or credit checks are also tax-deductible. Other expenses that are necessary to maintain the property will also fall under this category, as well as landlord-paid utilities or HOA dues.
Other tax-deductible operating expenses may include:
- Appliance repairs and maintenance
- Carpet cleaning
- Pest control
Keep in mind, you may also be able to deduct the portion of your home that is used as a home office. If it’s designated exclusively for your business and used on a regular basis, the IRS allows you to claim a simplified standard deduction of $5 per square foot with a maximum of up to 300 square feet.
5. Property Taxes
This tax on real estate is dependent on where the property is and how much it’s worth. A property tax assessment will be completed by a government assessor to determine the amount.
Fortunately, rental property owners have access to this deduction, but most people don’t know that. Homeowners can deduct up to a total of $10,000 ($5,000 if married filing separately) for property taxes, but the limit doesn’t apply to business activities.
Property taxes may be fully deductible depending on how you operate your real estate business.
Before you get too excited, it’s important to know that not every repair or improvement is deductible.
A repair involves fixing or replacing something that keeps your property in working condition — and it’s only deductible in the year you pay for it. This may include fixing a broken toilet or replacing a light switch that isn’t working.
Unfortunately, improvements that add value to your property are not usually deductible. Examples of this include bathroom renovations or add-ons. That said, the cost of improvements like these is depreciable over the useful life of the property.
7. Legal Fees
Unfortunately, some situations between landlords and tenants can become contentious. In cases of eviction or other legal issues, going to mediation or court is often the only option. But unlike your tenants, attorney and court fees are a tax-deductible expense for your business.
8. Travel Expenses
Living in California while buying up property in Arizona? Many people choose to invest in markets outside their home state. Fortunately, you can deduct your travel expenses, including airfare, lodging, and meals.
The trip must be for business reasons and all expenses must be deemed “ordinary and necessary.” IRS Publication 463 provides a lengthy number of details on what will pass the test.
Which Expenses Aren’t Tax-Deductible?
Now that we’ve discussed some of the big deductible expenses, it’s important to clear up misconceptions.
Here are rental property expenses that aren’t eligible for deductions:
- Political contributions
- Fines or penalties
- Commuting to and from work in an office
- Lost rent due to tenant vacancy
- Moving expenses (unless you are a member of the military)
Tip: Hire a Tax Expert
Much like a long-distance move or big home renovation, filing taxes can be complicated when you have a rental property. For this reason, it’s important to work with a professional who can guide you through the process to ensure everything is done right.
If you can find an accountant that has experience in real estate, even better! This will benefit you in the short term because you may save on how much you owe the IRS. Plus, the long-term benefit is avoiding audits and other errors that can be incredibly stressful to rectify.