Have you ever wondered what rental property expenses are tax-deductible or how much they can save you at tax time?
One of the biggest benefits of real estate investing is offsetting your rental income with tax deductions. For many real estate investors, these tax deductions can exceed rental income and lower their tax bill from other income sources. This makes real estate investing particularly beneficial for high-income earners or anyone looking to reduce their tax bill.
Disclaimer: There is a lot of complexity in the US federal tax code. You should consult with a certified accountant or tax professional in determining your tax liability.
We will take a look at the top 5 rental property tax deductions that have a big impact on your tax bill. We will also look at how these deductions can reduce, eliminate, or exceed the income from your rental property.
But first, let’s take a look at what a tax deduction is.
What Is a Tax Deduction?
Investopedia defines a tax deduction as a deduction that lowers a person or organization’s tax liability by lowering their taxable income.
In real estate investing, this means tax deductions counteract your rental income. Because some of the deductions aren’t directly related to the expenses of rental property, many people end up with a negative tax liability from their real estate investments.
Types of Tax Deductions
In real estate investing, there are 2 primary categories of tax deductions. The IRS defines what falls into each of these categories.
Ordinary Expenses are directly deducted from your income. Ordinary expenses related to the operation of your business can be deducted from your income in the year they are incurred.
Typically these are services or products that are used up like utilities, property management fees, insurance, office supplies, etc. Ordinary expenses also include repairs you make to your rental property.
Capital Expenses are deducted from your taxes over the useful life of the product or property. These aren’t fully deducted from your taxes in the year they are incurred.
There are 2 types of capital expenses in real estate investing. The first is the property itself. The second is any improvements to your property. The IRS requires you to depreciate these expenses and provides a table with examples of improvements.
The Top 5 Rental Property Tax Deductions
Now let’s take a look at the 5 top deductions and how each of these affects your taxable income from your rental property.
It is important to remember there are nuances to each of these deductions. You should always consult with a certified accountant or tax professional.
1. Mortgage Interest
Mortgage interest is the interest you pay as part of your mortgage payment. Your lender charges you a percentage of your outstanding loan balance each month. This starts as a substantial portion of your mortgage payment and becomes less as you pay down your loan.
This is great when you are first starting as it provides a large tax deduction in the first few years you own your rental property. This helps bring your net income down and significantly reduce (or eliminate) your tax liability.
Your lender will show you exactly how much you paid in mortgage interest. This is included as a separate line item in your monthly mortgage statements. Your lender is also obligated by the IRS to send you a Form 1098 which details the amount you paid in mortgage interest in the previous year.
With a $275,000 loan and a 3.275% interest rate, you can expect to pay (and deduct) just over $14,000 in mortgage interest in the first year of ownership. Bankrate has a great calculator to help you estimate the different components of your mortgage payment.
2. Operating Expenses
Any expenses you incur while operating your rental property are tax-deductible. This includes many different expenses like:
- Property Management Fees
- Insurance
- Advertising
- Utilities you pay
- Paint
- Cleaning
- Yard Maintenance
The list includes many more expenses. In general, any money you pay to attract or manage your tenants or maintain your property falls into this category.
You must track all of these expenses carefully and keep receipts in case the IRS wants proof of these expenses.
3. Property Taxes
Every person who owns property pays property tax to their state, county, or city. States rely heavily on property taxes to fund critical infrastructure like police and fire departments, schools, roads, etc. Property tax varies widely by location and typically increases every year. Depending on your state, you can expect this to be 0.28% to 2.49% of the value of your property.
Your state or county will send you a bill for your property taxes once a year. If you have an escrow account with your loan, the administrator of that account may be making this payment on your behalf. In that case, your mortgage statement will include a line item showing you how much property tax you have paid.
4. Depreciation
Depreciation is a bit more complicated than the previous deductions. It is deducted from your income over several years. The IRS decides what must be depreciated and provides a schedule for every depreciable expense.
The largest expense you must depreciate rather than deduct is the rental property building itself. The IRS allows you to depreciate the buildings, but not the land so you’ll need to differentiate the value of these.
You depreciate the cost of your rental property over 27.5 years. If your rental property is worth $275,000 when you purchase it, you get to claim a $10,000 deduction each year. Note that the first and last years only depreciate a portion of this based on when your property was put into service as a rental. We put together a helpful guide on calculating depreciation if you want to learn more.
This deduction, along with mortgage interest deduction can be more than the income you receive from your rental property. This is not uncommon, especially in the first few years of ownership when the mortgage interest is highest. Check out our visual guide to depreciation to see how this works.
5. Repairs and Improvements
You will spend money maintaining your rental property. Repairs and improvements are very similar but handled differently by the IRS. It is important to consult a certified accountant or tax professional to properly categorize these expenses.
Expenses that are to maintain the state of the property are considered repairs. These include paint, fixing broken faucets, appliances of similar value, etc. These are typically deducted as ordinary expenses because they don’t add any value to your rental property.
In contrast, improvements are intended to add value to your property. Additions, new decks, new garage, new rooms, remodels, etc, add value since you would sell your property for more with these than without. The IRS requires you to depreciate these expenses.
The gray area between these two categories comes in when you replace something in your rental property. If the refrigerator breaks and you replace it, that’s likely considered a repair. If you replace all of the kitchen appliances, that would qualify as an improvement.
Can I Claim a Tax Loss On My Rental Property?
It is common for rental property owners to claim passive losses on their rental property. The IRS sets a limit of $25,000 passive loss if your modified adjusted gross income is $100,000 or less. This limit phases out until your income reaches $150,000. An income of more than $150,000 cannot claim a passive loss.
What happens to the portion I can’t claim?
The IRS allows you to carry over any passive losses that you can’t claim in a given year. This means that, even with high passive losses, or at high-income levels, you can gain the full benefits of these deductions. As you own your property for longer periods, the rental income typically goes up and the mortgage interest goes down. Once your yearly income exceeds your yearly expenses, you can start to claim your carry-over losses.
Summary
There are a lot of different types of tax deductions for rental properties. Because owning and managing a rental property is a business, the litmus test to deduction expenses is whether the expense was incurred in the operation of the business.
The tax benefits of rental properties are one of their alluring qualities. With a rental property, you can make a positive cash flow while claiming a passive loss on your taxes. You can even offset some of your income from other sources or your job with these passive losses.
While this may sound too good to be true, it is very common in real estate investing.
Regardless of the deductions that apply to your rental property, you will want to keep good records and consult tax professionals to ensure you don’t fall on the wrong side of the IRS.
Do you offset income from other sources with your rental property tax deductions?