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Rental Property Tax Deductions for Real Estate Investors
From lease up to move out, and everything in between, owning rental properties can be a lot of work. However, one of the many benefits aside from additional income of owning rental property, are the rental property tax deductions of owning these assets. Many rental home expenses are tax deductible and often offer larger deductions and tax benefits than most investments. These deductions can sometimes make the difference in making a profit or losing money on your rentals.
If you own a rental property, the IRS allows you to deduct expenses you incur for the upkeep and maintenance of the property, managing the property, and other miscellaneous expenses associated with the property rental.
Tax Deductions for Rental Properties
The Sticky Subject of Investment Interest
Professional real estate investors can deduct investment interest – but not in the same way you might deduct credit card interest, interest paid on a conventional small business loan, or even the way primary homeowners deduct mortgage interest.
“Investment interest expense must be capitalized, because it’s one of the costs incurred – just like building materials – in order to end up with a product to sell,” says Roger D. Upton, CPA, a partner with MS Consultants, LLC, a firm specializing in real estate income tax law and cost segregation. “Once the product – that is, your property – is ready to sell, the interest is deductible.”
Take Advantage of Depreciation
As a professional, you can also take advantage of depreciation deductions on a rental or fix-and-flip property. You may be able to deduct the depreciation of the property plus any capital improvements over 27.5 years for residential properties, resulting in significant tax savings over time for as long as you own the property, according to Zillow.com.
Don’t confuse this with depreciating your expenses, which is typically not desirable. “A real estate professional can deduct repairs in the current year as an expense,” notes Upton, pointing out that it’s important to understand the difference between repairs and capital improvements or speak to a tax professional who can help you sort it out.
Tax Savings for Investors through Passive Activity
If you’re sitting on a property you intended to fix and flip and, as a result, are facing a large tax liability, you might consider getting the building in service as quickly as possible so you can deduct expenses sooner.
If you take steps to rent it out, even with the ultimate goal of selling it, you can claim depreciation deductions and enjoy other benefits under passive activity rules. “Investors who hold on to a property may be able to take advantage of much more favorable capital gains on properties when they sell,” says Upton.
While part-time investors can only deduct business losses up to the amount of their income, Upton says, “professional real estate investors – specifically, those who rent their properties – fall under a completely different set of tax rules.”
As a real estate pro, you can deduct losses even if they exceed your income. “Once you show that rental real estate is your livelihood, your losses are deductible regardless of income,” Upton says.
Even if you’ve been at this awhile, it’s important to speak with a tax specialist to make sure you can file as a real estate professional and take advantage the deductions. “The rules for qualifying are stringent,” Upton warns, “and the IRS monitors this area very closely.”
Tax Deductions For Real Estate Investors
If your real estate investments showed a profit last year, you may dread tax time. Take heart: Many real estate investors don’t take advantage of all the tax deductions available. Knowing what you can legally claim can help you reduce your tax liability and leave you with more money in the bank to buy your next hot property.
Deducting Professional Services
A successful real estate investor doesn’t work alone; instead, he or she relies on the expertise of a number of professionals to keep the business running smoothly. The costs of using many of these professional services are tax deductible. “Two of the most commonly overlooked tax deductions include legal counsel and tax preparation,” says Tristan Lloyd, a tax attorney at T.J. Lloyd Law Firm a boutique law firm licensed in Washington and Colorado.
Deducting Costs to Rent a Property
Landlords prefer to not have any property sitting vacant, but renting a property in some regions can take time and money. Those costs, including advertising and travel, can count as tax deductions.
“Investors can deduct travel expenses, including the standard mileage deduction, for trips taken to the property for business purposes,” says Andrew Poulos, tax accountant and founder of Georgia-based tax firm Poulos Accounting. “If an investor pays fees to a realtor or property manager in order to secure a tenant, those costs are also tax deductible.”
Likewise, any costs to screen tenants, such as credit checks, can be deducted from rental income in that year, Lloyd points out.
Deducting Insurance and Utility Costs
Homeowners’ insurance and flood insurance costs can add up, especially if you own multiple properties. Lucky for real estate investors like you, these expenses are deductible. If you decide to rent the property with utilities included in the price of rent, you can deduct these costs since they are coming out of your pocket. Additionally, “you can deduct the cost of utilities paid while a property might be vacant,” says Poulos. That takes some of the sting out of vacant properties and can help reduce your tax bill.
Deducting Closing Costs
Whether you invest in rental properties or buy homes to fix and flip, closing costs most likely comprise a large portion of your operating expenses. Whether you’re buying or selling, you can deduct these closing costs to minimize your tax liability.
If you’re selling a property, you’ll be responsible for paying capital gains tax, so it’s important to take advantage of any tax deductions you can. “The gain is computed by deducting the purchase price plus any improvements from the sales price,” says Poulos. “The investor should make sure to deduct any closing costs paid, including Realtor® fees, home warranties, attorney’s fees, state intangible taxes, appraisals, and other closing costs that might be incurred.”
Depreciation on a residential property is one of the most overlooked tax deductions available, according to Lloyd.
Poulos agrees. “Most investors don’t deduct the depreciation of the property – which includes the purchase price of the property plus the depreciation of any capital improvements to upgrade the value of the property — because they don’t know about the deduction.”
Tax Shelters for Real Estate Investors
As a savvy real estate investor, you know the home you live in provides a nice tax shelter for some of your money. But what about your fix-and-flip and rental properties? It’s no shock that you might have to pay capital gains tax when you flip a home—but there are ways around it that are perfectly legal.
Savvy investors use 1031 exchanges and other methods to reduce their tax liability, according to Steven Davis, 5 Arch Funding’s Chief Information Officer (CIO)/Chief Financial Officer (CFO).
How to Use a 1031 Exchange to Defer Capital Gains Tax
When you sell an investment property for a profit, you have to pay capital gains tax on the selling price. Depending on how much you sell the property for, you might actually pay more in taxes than your profit from the sale. The 1031 exchange lets you defer paying capital gains tax as long as you reinvest the money into another property within 180 days of the sale.
“It’s a smart move that many successful investors use to gain more leverage from their money,” says Davis. “This enables you to invest in another property that could put money in your pocket.”
To successfully execute a 1031 exchange, you’ll need to keep the following in mind—and consult a tax advisor for further direction:
Properties must be exchanged for “like-kind” properties.
You can sell a single family home and buy a multi-dwelling unit, or sell a duplex and buy five cottages. You can’t, however, sell property and buy a fleet of vehicles. Another caveat: “You can’t include your primary residence in any part of a 1031 exchange,” says Davis. “Beyond that, the definition is fairly broad.” If you aren’t sure what you can legally deduct and what you can’t, or if you want to make sure you’re executing a 1031 exchange properly, advises Davis, speak to a tax professional specializing in real estate.
The net market of the sold property must be the same as, or greater than, the purchased property.
Otherwise, the federal government will require you pay capital gains tax on the difference. The good news, according to Davis, is that inspection costs, broker fees, and any other expenses associated with the purchase may often count toward the price of the new property.
You must identify potential properties to purchase within 45 days of closing on the sale property.
You’ll have 180 days to close on the new property, but you must have three prospective properties lined up within 45 days.
Here’s another secret not every investor knows: “If the property you want to purchase turns out to cost less than the one you sold, you can do a construction/improvement exchange,” advises Davis. His advice: “Roll a loan for renovations into the purchase price to defer all the taxes on the sale of your property.”
Learn to Appreciate Depreciation
Many investors don’t understand how the depreciation of rental property works, which could cost them a bundle come tax time, says Davis. Not only can you deduct any improvements on the home over the lifetime of that improvement, but you may also be able to depreciate the building itself. It’s a complex matter, says Davis, so he urges you ask your tax advisor about way to depreciate the expense of a new roof over its lifespan, for instance, “usually 15 to 20 years.”
How New Tax Law May Affect Your Rental Property Business
When you heard that Congress was working to pass a tax reform law before the end of 2017, you may not have realized the new law could have a significant impact on your rental property business in 2018 and beyond. But the Tax Cuts and Jobs Act actually includes a number of changes that can help landlords like you save—and make—more money.
Here are three ways the newly passed tax reform could have an impact on your rental property business.
More Rental Income in Your Pocket
The tax credit for pass-through businesses means that most property owners who operate as sole proprietors, LLCs, partnerships, or S corporations can take an income tax deduction equal to 20 percent of their taxable rental income.
Rather than paying the regular income tax rate on your rental income, which could be as much as 37 percent, you can create an LLC or other pass-through business entity for your rental and deduct 20 percent from your taxable income.
However, there is a caveat: The pass-through deduction is only available to taxpayers who have a total taxable income less than $157,500 for individuals and $315,000 for married couples filing jointly.
Long-term Depreciation Can Be Avoided
Traditionally, when a landlord made improvements to a rental property, he or she could have to depreciate the cost of those improvements over 39 years—deducting a small portion of the cost from his taxable income each year for 39 years. However, with the new tax law’s changes to depreciation rules, in some cases, property owners can write off the full value of renovations or other improvements in a single tax year.
That means if you spend $30,000 remodeling the kitchen and a bathroom in your newest rental property, you may be able to deduct the entire $30,000 from your tax bill for the current year. This change is bound to encourage more landlords to upgrade their properties—or purchase more.
Demand for Rental Properties Will Increase
Finally, the new tax law makes owning a home less attractive for some would-be homebuyers. That’s because it reduces the value of the mortgage tax deduction and the property tax deduction. As a result, more people may choose to rent rather than buy, increasing demand for your rental properties. When demand increases, you may forget what it’s like to have a vacant property and see your profits continue to increase.
As you contemplate investing in more rental properties or improving your current properties, keep in mind that the new tax law may favor your investments. With extra tax advantages and the potential for greater rental demand, it’s an ideal time to be a real estate investor.
FAQ: Frequently Asked Questions
Is mortgage interest deductible on rental property?
Are closing costs tax deductible?
Can you write off loss on sale of investment property?
Who is exempt from paying property taxes?
What travel expenses are tax deductible for rental properties?
Are refinance costs tax deductible?
Get Professional Help
This article only begins to discuss some of the lesser-known tax deductions for real estate investors. Keep careful records, including mileage, of any investment-related expenses, and a professional tax accountant can help you sort through it all to reduce your tax liability and put you in a better position to move on the next great property that comes your way. Consult a tax professional for full details and advisement.
Real estate investors need to track expenses carefully so as not to miss any opportunities for deductions. Most importantly, find a tax professional that specializes in real estate and understands the finer points of depreciation, repair vs. capitalization, and passive activity to walk you through the maze.
The writer of this article is neither an attorney nor a CPA, and make no representations on the accuracy of the information contained. Please consult the appropriate professional when making said decisions.
CoreVest is a leading provider of financing solutions to residential real estate investors. We provide attractive long-term debt products for stabilized rental portfolios as well as credit lines for new acquisitions. For more information about how CoreVest can help grow your rental and rehab business, please call 844.223.2231 or submit our contact form.