Owning a rental property, whether a long-term, short-term, or vacation rental, can be an exciting investment opportunity. Not only do investors have the potential to earn additional income, but they can also benefit from several tax deductions and incentives provided by the Internal Revenue Service (IRS). From mortgage interest deductions to operating expense deductions, there are numerous ways for taxpayers to save on their taxes and maximize their returns.
This article is designed to help real estate investors maximize their investments by taking advantage of the five most common tax benefits. From reducing your overall tax burden to potentially increasing your profits, these deductions can provide various benefits that may help make investing in real estate more profitable. So if you’re looking for ways to get the most out of your investments, read on to learn about these top five rental property tax deductions.
1. Operating Expenses
Operating expenses are one of the most common rental real estate deductions that investors can take advantage of. These deductions allow owners to reduce their taxable income by subtracting costs associated with running their investment properties. Some of the most common rental business expenses include:
- Cleaning and maintenance
- Utilities (typically in multifamily and vacation rentals)
- Professional service fees (such as legal and accounting)
- Landscaping/Yard care
- Pest control
- Repair costs
- Property management fees
- Leasing costs/Commission fees
- Furnishing & amenities replacement/repair (landlord’s personal property in furnished rentals)
- Taxes (such as sales or rental tax)
- Travel (oftentimes the standard mileage rate when going to and from the rental property)
- Home office deduction
- Miscellaneous expenses (e.g., local licenses or annual fees for an LLC)
2. Mortgage Interest
The mortgage interest expense allows rental property owners to deduct any interest paid on a loan taken out to purchase, build or improve a rental property from their taxable income. The deduction includes primary and secondary mortgages and home equity loans (HELOCs) used for the investment property’s purchase, construction, or renovation.
As a rental property investor, you can deduct the interest part of your mortgage payment but not the principal payments because those are used to reduce the mortgage loan liability on the property balance sheet. Every year, your lender will issue a Form 1098 to report the amount of interest you have paid on the loan during the year.
3. Insurance Premiums
Landlord insurance is a type of property and liability insurance that provides coverage for rental properties. It can help protect landlords in the event of property damage, litigation, and other potential losses related to owning a rental property.
The premiums paid for this type of insurance are also tax deductible for rental property owners, providing additional savings on top of the security provided by the policy. Insurance for investment property typically includes three types of coverage:
- Property Damage Coverage – For physical property damage, such as fire, vandalism, theft, or natural disasters.
- Liability Coverage – Provides protection against claims made by tenants or third parties.
- Loss of Rental Income Coverage – Protects against lost income if the property becomes uninhabitable due to an insured incident.
4. Property Taxes
Local governments assess property taxes based on the value of your property, typically every year, and these rates differ dramatically from one state to another. Property taxes are usually prorated and included in your monthly mortgage payment if you have a mortgage on your rental. While these taxes provide a valuable tax deduction for landlords, they can also significantly impact cash flow.
Property taxes are generally calculated as a percentage of the assessed value of the property and can range from less than 0.4% to 2.0% or more, according to the Tax Foundation. Therefore, it’s important for investors to understand their local property tax rate before purchasing a rental property in order to budget appropriately.
Tax rates on real estate can also change year-by-year, so it’s important to stay up to date with any changes. Investors looking to purchase a rental property can find out their local jurisdiction’s property tax rate by visiting their county assessor’s office or reviewing their state’s website.
Depreciation is a type of tax-deductible expense that allows owners of investment property to reduce their income tax. This deduction helps make up for the loss in value of a structure over time due to wear and tear caused by use or obsolescence. Unlike other rental expense deductions, such as repairs and maintenance, depreciation is considered a non-cash expense, meaning the deduction does not reduce your cash flow.
For residential rental property, depreciation is generally calculated over 27.5 years (straight-line basis). This means you are entitled to claim a deduction equal to 1/27.5th (3.636%) of the asset’s cost against your taxable rental income each year.
To illustrate, assume a rental property had a total cost basis of $100,000 (excluding the land value). The owner would be entitled to claim an annual depreciation deduction equal to approximately $3,636 ($100,000 divided by 27.5). This amount can be claimed annually against their pre-tax net income and can provide an important source of tax savings for real estate investors.
However, it is important to remember that these deductions are only available while the asset remains in service and may need to be recaptured when it is disposed of. Depreciation recapture is a method of taxation designed to recapture the deductions taken over the life of an asset. When an asset is sold, the owner may be required to pay taxes on any depreciation expense taken while they owned it. This can create a large capital gains tax bill that must be paid at the end of the year the property was sold.
To avoid this, investors can conduct a 1031 tax-deferred exchange, which allows them to defer paying tax on the recaptured depreciation, and the gain that arises from the sale of an investment property. By utilizing this strategy, real estate investors can defer taxes on the sale of one property and use those funds to purchase multiple properties or higher-value investments that will further enhance their financial goals.
How To Report Rental Property Tax Deductions
One of the biggest benefits of owning investment property is that the write-off deductions from your rental income could reduce your total taxable income to zero. For instance, depreciation expense on a home can be used to offset any profits earned by the property. If these deductions are more than the amount of income, you may end up with no taxable income at all, even if your rental property has a positive cash flow.
Schedule E is used to report income and expenses from rental properties to the IRS. This tax return form is filed annually as an attachment to Form 1040 and provides the necessary information for calculating rental income or loss for tax purposes.
When completing your Schedule E, you’ll need to include all of your rental property-related income as well as any deductions taken during the course of a given year, including repairs and maintenance costs, mortgage payments, taxes paid on the property, insurance premiums, travel expenses incurred while managing the property and more.
It’s also important to note any capital improvements or additions to your rental property, such as adding a new roof, that might qualify as capital expenditures which should be added to your cost basis and deducted over time as property depreciation expense instead of one lump sum amount.
By knowing what deductions can be taken when filing taxes on a rental property, you can ensure that you’re reporting all profits accurately and paying only the required taxes owed. Also, note that generating income through passive activities such as rental properties is typically not classified as self-employment, leaving investors exempt from FICA and payroll taxes.
7 Tips for Tracking Income and Expenses
Accurately tracking income and expenses for rental property investments is essential for any real estate investor. Without proper tracking, investors face the risk of costly mistakes that can significantly impact their bottom line. In addition, keeping track of income and expenses in the short term helps ensure that any tax bills are accurate and minimized, while long-term tracking allows investors to plan accordingly for future investments.
Here are some best practices for a real estate investor to follow when it comes to tracking rental property income and expenses:
- Utilize Property Management Software – Using property management software like QuickBooks or Landlord Studio can help streamline the tracking of income and expenses associated with each rental property.
- Be Proactive About Tracking Income & Expenses – Keeping up with regular updates throughout the year will allow investors to know exactly how much they’re earning from each investment, as well as how much they’re spending on maintenance and repairs so that no surprises arise when it comes time to file taxes or plan for future investments.
- Establish Separate Bank Accounts – Real estate investors should create separate bank accounts for each rental property to track income and expenses, ensure accurate cash flow reporting between properties, and maximize tax deductions. This will improve the financial visibility of each unit and prevent commingling funds, where money from multiple sources is mixed together in one account.
- Automate Record Keeping With Your Bank Accounts – Connecting bank accounts directly to your property management software allows for easy tracking, categorizing, and reporting of transactions so that you can always be sure of where your money is going and coming from.
- Track Financial Metrics – When you’re tracking your income and expenses, it’s also essential to be mindful of data such as total revenue, adjusted gross income, net operating income, vacancy rate, and capital expenses to make any necessary adjustments quickly if needed.
- Create Detailed Reports – This includes rent roll reports which outline monthly income streams, expense records that track maintenance costs, cash flow statements to analyze liquidity and profitability trends, balance sheets that provide an overall snapshot of the asset’s finances, and profit and loss (P&L) statements for a full overview of revenue and expenses.
- Hire a CPA – Working with a Certified Public Accountant (CPA) or other tax professionals who specialize in real estate investment is recommended to ensure accurate reporting of all income and expenses associated with rental properties. This service may include tax preparation at the end of each tax year.
Owning a rental property can be an excellent investment, providing investors with numerous tax deductions. By taking advantage of all available deductions related to owning a rental property, real estate investors can maximize their profits while keeping their taxes to a minimum.
Searching for the ideal real estate investment can be challenging, let alone ensuring every expense is claimed and accounted for. Luckily, Arrived offers a range of options that help reduce risk and simplify the process of locating, managing, and investing in properties. Explore our selection of investment homes today to discover how your initial investment could grow in years to come.