Owning investment real estate can provide excellent opportunities to build long-term wealth and passive income streams. However, the tax implications of rental property ownership are complex and often misunderstood. As a real estate investor, properly utilizing deductions can save you thousands come tax time. This comprehensive guide will explore the most common and advantageous tax deductions when you own rental property.
In this article we'll cover the key point to know about rental property tax deductions which include:
Deductible Expenses
One major benefit of rental real estate is the ability to deduct related expenses on your annual tax return. Allowable deductions fall into two main categories:
Operating expenses - These are recurring annual costs like property taxes, insurance, utilities, advertising, maintenance, supplies etc. They are fully deductible in the year paid, regardless of whether you make a profit.
Financing expenses - This includes mortgage interest, property management fees, legal fees and depreciation. These are deductible against your rental income.
Pro tip: Be sure to keep excellent records and receipts for all your rental property expenses. Documentation is key to justifying deductions claimed.
Repairs vs Improvements
A common point of confusion is determining whether an expense should be deducted as a repair or capitalized as an improvement. The distinction comes down to whether the expense maintains the property or improves it.
Repairs - Deductible expenses that restore your property to its previous condition (e.g. fixing a broken appliance).
Improvements - Not deductible. Expenses that add value, prolong the property's life, or adapt it to new uses (e.g. a remodel). These must be depreciated over time.
Pro tip: Small repairs like painting or minor maintenance can be deducted. Major renovations and replacements like a new roof must be depreciated.
Depreciation Deductions
One of the most valuable deductions for a rental property owner is depreciation. It allows you to deduct a portion of your property's cost over time.
Here's how it works:
The purchase price paid for the rental property can be depreciated over a 27.5 year recovery period. This allows you to deduct 3.636% of the cost each year.
Items within the property like appliances and flooring can be deducted over 5 to 15 years. This is done via a cost segregation study.
When you sell the property, you may have to recapture the depreciation taken by reporting it as a capital gain.
Pro tip: Perform an annual cost segregation study to identify property components with shorter depreciable lives, yielding larger deductions.
Active vs Passive Income
How the IRS classifies your real estate activities will impact your ability to use rental property losses to offset other income.
Active participation - If you materially participate by working over 500 hours/year, losses up to $25k can offset other income.
Passive activity - If you don't meet material participation standards, losses can only offset passive income sources.
Pro tip: Group multiple rental properties into one activity to meet material participation hours and maximize loss deduction potential.
At-Risk Rules and Deduction Limits
At-risk rules limit loss deductions to the amount of personal capital invested. Losses can't offset other income beyond cash contributed.
The passive loss limit caps deductions if you don't materially participate and have over $150k modified AGI for joint filers.
Investment interest deduction limits interest expense deductions to net investment income.
Pro tip: Carry over suspended passive losses to future years when offsetting rental income. Leverage the real estate professional designation to avoid passive loss restrictions.
Putting It All Together
Strive to generate net taxable losses on your property by maximizing expense deductions. This shelters rental income.
Consult a qualified tax professional to implement tax planning strategies like cost segregation, 1031 exchanges, installment sales etc.
Classify your participation correctly and keep good records to support deductions claimed.
Be aware of IRS audit red flags like large losses, major expenses, or lack of rental income.
With proper planning, rental real estate investors can utilize tax deductions to generate losses, lower tax bills, and maximize after-tax returns. But caution must be taken to accurately document expenses, make legitimate deductions, and know the deduction limits. Consult a tax professional to ensure you maximize savings while staying compliant.
Frequently Asked Questions
What are some examples of deductible rental property expenses?
Deductible rental expenses include mortgage interest, property taxes, insurance, maintenance and repairs, utilities, travel to the property, legal and professional fees related to the property, and depreciation of property components.
Can I deduct rental property losses against my personal income?
Yes, but the amount of loss that can offset other income depends on your level of participation. Active participation allows up to $25k in losses deducted. Under passive participation, losses can only offset other passive income sources.
How does depreciation on a rental property work?
Depreciation allows you to deduct a percentage of your rental property's purchase price, improvements, and assets over the course of several years. The property itself is depreciated over 27.5 years. Improvements are depreciated over 15 years. Assets are depreciated over 5 to 7 years.
Should I do a cost segregation study?
A cost segregation study can maximize your depreciation deductions by accurately identifying property components with shorter depreciable lives. This gives you higher depreciation deductions in the early years of rental property ownership. The upfront cost for the study is far outweighed by the tax savings.
What are the most common audit triggers for rental properties?
Frequently claimed audit triggers include excessive losses compared to income, lack of rental income, deductions exceeding gross rents, major one-time expenses, and discrepancies between real estate professional designation and participation claimed.
The Bottom Line - Rental Property Tax Deductions
At United Tax, our specialists are here to compliantly take advantage of every possible deduction and minimize your tax obligation. By harnessing the power of strategic deductions and expert tax planning, real estate investors can transform their financial outcomes.
If you own rental real estate and want to capitalize on legal tax deductions, contact us today to discuss your situation. Our team of experts will ensure you keep more of your hard-earned income.
