You probably know that there are a number of tax benefits of owning rental property. But what are these rental property tax benefits? You’ll find out in this article.
The fact is that real estate investors can write off big chunks of their monthly tax bill. This is one of the reasons why the average landlord’s income is 44.8% higher than the median U.S. household income.
Many landlords fail to take advantage of these tax benefits of owning rental property and thus lose a significant amount of their income each year to taxes. In this article, we will go over the various ways owning real estate can save you money during tax season. You’ll also learn the rental property write-off limits so you’ll know what to aim for.
10 Rental Property Tax Benefits & Deductions
There are several tax benefits and deductions available to rental investors and property owners. They include the following:
#1 - Deductible Operating Expenses
Operating expenses are the recurring costs of running a business. They are the costs associated with the operation and general maintenance of a rental property.
You can deduct expenses related to managing and maintaining a rental property. According to the Internal Revenue Service, these expenses are considered ordinary and necessary for conserving and maintaining the property. These expenses are broker fees, utilities, advertising costs, maintenance expenses, property management fees, lawn care, service fees, and taxes.
#2 - Depreciation Deduction
Depreciation is the reduction in the value of property due to wear and tear, over time. According to the IRS, Depreciation is an annual income tax deduction that allows you to recover the cost basis of a property over time.
This depreciation expense is not deducted at once but over a period of time. This period amounts to 39 years for commercial real estate and 27.5 years for residential rental properties.
Since land doesn’t depreciate, the depreciation expense only includes the cost of the house and improvements in the home that can be affected by wear and tear. This includes roofing, fencing, home additions, HVAC systems, and other similar items. For example, if you purchase a property for $500,000 and the lot is valued at $80,000, the cost basis of the property adjusted for depreciation is $420,000. Assuming you added a garage at an expense of $30,000 and installed a brand-new roof for $15,000. Your property’s cost basis would be adjusted for those improvements and would total $465,000. That would yield an annual depreciation expense of about $16,900 (over 27.5 years).
IRS rules for rental property state that a replacement roof’s cost depreciates for the same amount of time as the property, while appliances depreciate over five years. Depreciation commences on a property as soon as it is either placed in service or ready to be rented out.
#3 - Mortgage Interest Deduction
This is most likely the largest deduction homeowners can receive on their property. According to the Tax Cuts and Jobs Act (TCJA) of 2017, homeowners can now receive a tax reduction on the mortgage interest paid on home loans up to $750,000 (previously $1 million).
The interest on home equity loans is deductible as long as the borrowed funds are used to buy or improve your home. Landlords can also deduct the interest on credit cards for goods or services used in running their business, as this is qualified as “business credit.” For this reason, investors should have a separate business credit card.
When a property owner refinances a property for more than it is currently worth, they can deduct the interest. This is if the revised terms are intended for the improvement or maintenance of the property.
#4 - Deductible Travel Fees
Travel expenses are another deduction real estate investors are entitled to. You can deduct most travel expenses, including vehicle expenses, airfare, lodging, and meals. However, they must meet the guidelines laid out in IRS Publication 463:
- According to the IRS, travel expenses are costs incurred while you’re away from your tax home. Your tax home is defined as your regular office where you work, most of the time.
- The trip must be for business reasons. It may have a secondary personal purpose but it should mainly be for business.
- Meals that aren’t considered lavish are deductible travel expenses.
- In order to qualify for the deduction, a business expense must be deemed ordinary and necessary (O & NE)
For meals, you can deduct a standard meal allowance instead of the actual cost of the daily meals. This allowance tends to vary from state to state. You can check the IRS website for the standard rates.
Also, you may be able to deduct vehicle expenses used in operating and maintaining your car when traveling to the property. For instance, driving to the rental property to collect rent or repair an appliance is considered a deductible travel expense.
There are two ways you can deduct travel expenses. You can deduct the actual expenses if you recorded them or the standard mileage rate plus parking fees and tolls. For 2022, the standard mileage rate is 58.5 cents per mile.
You are allowed to use the standard mileage rate if you drive less than five cars for your business operations. You apply it in the first year of using a car for your real estate business.
#5 - 20% Pass-Through Income Deduction
Investors who own pass-through businesses and have positive taxable income are qualified to have up to a 20% pass-through deduction (qualified business deduction) on their tax returns.
Pass-through, in this sense, means that the profits and losses incurred in the operation of the business, are distributed to the individual owners of the businesses who then pay taxes at individual tax rates. Pass-through businesses include sole proprietorships, partnerships, LLCs, and S Corporations.
For instance, an investor who owns several condos in a business he runs by himself. If he turns in $100,000 every year, he will be able to write off 20%, i.e. $20,000, of that income on his tax return as a pass-through deduction.
With the Tax Cuts and Jobs Act (TCJA) that took effect in 2018, owners of pass-through businesses who qualify can receive up to a 20% deduction of their total business income from their income taxes. Investors must own a pass-through business and must have qualified business income (QBI) to qualify for the deduction.
QBI represents the net profit earned by a pass-through business. However, QBI excludes capital gains, dividends, and interest.
#6 - No FICA Taxes
Federal Insurance Contributions Act (FICA) taxes, also called payroll taxes, is a United States payroll tax deducted from both employees’ and employers’ salaries to fund the Social Security and Medicare programs. Self-employed taxpayers are usually required to pay both the employer and the employee portion of the FICA tax – about 15.3% in total (for 2021). Social Security taxes are paid on up to $147,000 of your total income, and you pay Medicare taxes on all of your combined earnings.
However, rental income is not subject to FICA tax, since it is not legally classified as earned income. For example, if Jane runs a freelance business and earns $120,000 annually, she would be required to pay a payroll tax of 15.3% or $18,360. But, if that income was received from a rental business, she would not be liable for a payroll tax.
#7 - Deductible Legal Fees
In the event of evictions or legal disputes, you can also deduct legal fees such as payments to real estate attorneys and court fees. These fees are considered operating expenses and can be deducted as long as they are related to your real estate business.
These can either be classified as facilitative costs (that is amounts paid to facilitate the acquisition of a real property or a business) or investigatory costs (paid in the process of performing due diligence on the property). These costs can also include appraisal fees, title fees, and the cost of obtaining regulatory approval as long as they are directly related to your real estate business operations.
#8 - Home Office Deduction
If you run your business from home, you might qualify for a deduction due to what the IRS calls “business use of your home.” Also, according to the IRS, the term “home” may be a house, boat, apartment, condo, or similar property as long as it provides basic living accommodations.
There are three requirements you need to meet before you can be considered for a home office deduction:
- Regular Use. You must have a designated area in your home to conduct business.
- Trade or Business Use. Your activities in this area should be related to an established trade or business.
- Principal Place of Business. Your home must be your primary workplace to conduct activities related to your business.
If you’re eligible for this deduction, you should be able to deduct most of your home expenses, including rent, repairs, utilities, telephone charges, mortgage interest, and real estate taxes. You can choose to use either the Simplified Method or actual expenses. You are allowed this deduction, regardless of whether you own the workplace or you rented it.
#9 - Defer Capital Gains Tax
Real estate inventors are permitted to defer paying capital gains tax and depreciation recapture on the sale of a rental property by performing a Section 1031 exchange.
Ordinarily, on the sale of a property, the amount of profit you made on your property due to depreciation is taxed as depreciation recapture. Depreciation recapture is taxed at a maximum rate of 25%.
Also, you are required to pay a long-term capital gains tax (usually 15-20%) on your profit from the sale. If you hold the property for less than a year, you are instead charged at the ordinary income tax rate (up to 37%).
For this reason, investors often opt for a 1031 exchange to defer taxes for a later time. A 1031 exchange involves a swap of an investment property for another to defer capital taxes. The process of a 1031 exchange can be complicated and you should hire a professional to walk you through it. You can learn more about 1031 exchanges here.
The properties must be of “like-kind”, i.e of a similar nature and intended for the same purpose.
There is no limit on how often you can conduct 1031 exchanges. So, it is possible to defer capital gains and depreciation taxes indefinitely.
However, taxes will have to be paid at some point, except in the case of inheritance where a stepped up tax basis is used.
#10 - Medical Home Improvement Deductions
Homeowners are also allowed to deduct home improvements made for health reasons. Home improvements that are made to provide medical care for house residents are considered medical expenses and are deductible. These improvements may include fire alarms and warning systems modifications, entrance, and exit ramps, installation of railings in bathrooms, and stairway modifications.
To qualify for this deduction, you need to be able to prove that a resident requires those improvements. You’ll have to itemize and ensure that you deduct only medical expenses that are more than 7.5% of your adjusted gross income (for 2022). Also, you’re required to subtract the increase in the value of your home from your deduction.
As an example, let’s say you install porch lifts in your home to provide accessibility and spend $5000 in total. If it increases your home’s value by $2000, you can only deduct $3000.
Claiming this deduction can be a tad tricky, so it might be helpful to work with someone who’s licensed and experienced.
Note that homeowner’s insurance and private mortgage insurance are not tax-deductible at the moment.
How Much Can You Write Off On a Rental Property?
Homeowners have always been allowed to deduct the property taxes they pay on their homes each year. The 2018 TCJA capped the maximum amount anyone can write off on itemized deductions at $10,000 for state and local income, sales, and property taxes. Married couples that are filing separately have a limit of $5000 each. If you wish to claim tax deductions for rental property, you must be the owner of the property.
Investors may want to use standard deduction instead of itemized deductions. For 2021, the standard deduction is $12,550 for single taxpayers, $18,800 for heads of households, and $25,100 for married couples filing jointly. For 2022, it is $12,950 for singles, $19,400 for heads of households, and $25,900 for married couples. If you choose the standard deduction, you can not use itemized deductions for the rest of that year. You should compare both deductions to see which lowers your tax bill the most. The rental property tax deduction calculator includes a section for standard vs itemized deductions so you can determine which is more beneficial to you.
By now, you should know the rental property tax benefits you qualify for and how you can deduct them to improve your bottom line. Landlords who fail to take advantage of these tax deductions end up paying more than they need to and earning less than they should. However, it helps to work with a registered tax consultant, so you can get the information and assistance you need.
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