Most people look forward to a big tax write-off when purchasing a home. They don’t realize that tax deductions are even more significant when buying an investment property. So, how can you reduce your taxes as a landlord?
To set you up for success, we’re sharing how to reduce taxes on rental income.
Reduce Taxes on Rental Income
1. Deducting Direct Costs
Investors pay a variety of direct costs when it comes to owning and maintaining rental properties. Unlike homeowners, who can only deduct mortgage interest and property taxes, investors can reduce tax on rental income with these expenses. These costs include:
- Mortgage interest
- Property insurance
- Property taxes
- Utilities
- Maintenance repairs
- Advertising costs
- Professional fees
When looking for how to reduce tax as a landlord, direct costs can put you at a huge advantage.
2. Depreciation
A significant way to reduce taxes on rental income is with depreciation. The depreciation calculation is based on the theory that assets lose value over time as they wear out. According to the IRS, furniture, appliances, and other household items “lose all value and become virtually worthless” after five years. Obviously, these items can last longer than that, but the IRS says we can treat them “on paper” as if they don’t.
Let’s say you bought a refrigerator for $1000. You could divide the cost by five years and then write off $200 per year as depreciation on that item. You can also use accelerated depreciation for personal property, which will generate higher deductions in the earlier years of the asset’s depreciable life.
Depreciating real estate is similar. Since land does not “wear out,” the value of the land is then deducted from the price you paid for the real estate. The remaining structure can then be depreciated over 27½ years. For example, if you bought a $100,000 home, you would subtract approximately $20,000 from the land and then depreciate the remaining $80,000 structure. Then you would divide $80,000/27.5 = $2909. This means you get to write off $2909 yearly for 27.5 years.
3. Trade in, trade up
Another way to reduce taxes as a landlord is by using a 1031 exchange. The tax code allows homeowners to exchange one piece of property for another “like-kind” property without paying capital gains tax. You might not think an investor with a long-term outlook would ever need this, but here’s an example of what could happen.
Say you bought a vacant lot 40 years ago for $10,000. It is now worth $500,000. Selling it could cost you more than $100,000 in federal and state income tax! However, if you exchange the lot for another piece of real estate of equal value, say an income-producing property, then you would be able to continue to defer the capital gains tax.
Many investors say, “Defer ‘til you die.” This not only allows you to invest all of the monies gained, but when your heirs inherit the property, the tax basis is usually stepped up to market value. So, if they sell the investment property, they will not pay the capital gains tax either.
Please read our in-depth articles about 1031 exchanges if you want more information. If you are looking for a 1031 exchange facilitator, join RealWealth (for free!) and get access to our exclusive list of trusted industry connections.
4. Active investors win more
Passive investors aren’t actively involved with managing and maintaining their investment properties. Therefore, they can only deduct passive income losses from their rental or other passive income. Even though the list of losses might be higher than the rental income, especially if depreciation is included, it cannot be deducted from other sources of revenue if you are a passive investor.
However, investors who are actively involved in the management of their rental property could unlock unlimited deductions from their real estate investments and use those deductions against any of their earned income.
To qualify for unlimited deductions, you must prove to the IRS that you are a real estate professional. This doesn’t mean you need to be an appraiser, inspector or real estate agent selling houses.
To the IRS, a real estate professional means you spend more than 750 hours a year buying, selling, renting and managing your properties or performing similar services for your clients. To qualify, you cannot have another job that takes more than 750 hours of your time annually.
If an investor does not qualify as a real estate professional but is still actively involved, they can deduct up to $25,000 from any earned income to compensate for passive losses incurred. There is one caveat: the investor must have an adjusted gross income of less than $100,000 per year. Investors with an adjusted gross income of $150,000 annually don’t qualify for this benefit. However, the losses can be used in the future during a year when the investor earns less than $150,000. In addition, any passive income received can be sheltered by your passive loss carryovers.
Grow Your Real Estate Portfolio With RealWealth
Do you want access to an exclusive list of real estate tax professionals and 1031 exchange facilitators? At RealWealth, we give our members the resources and connections they need to reduce taxes as landlords while continuing to build a real estate portfolio. Membership is 100% free and gives you full access to our exclusive list of trusted real estate professionals and property teams who sell professionally managed turnkey properties in the top markets nationwide to our members. If you want to level up your strategy and invest smartly, join RealWealth today!
