Fortunately, you don't have to pay tax on all of your rental income. In fact, many landlords don't have any taxable rental income year after year, even if their properties are profitable. The reason? There are many rental property tax deductions owners can use to reduce or even eliminate their taxable rental income, including:
- Mortgage interest
- Property taxes
- Maintenance expenses
- Landlord-paid utilities
- Property management
- Legal expenses
- Advertising costs
- Travel expenses
- Insurance premiums
- Qualified business income (QBI)
There's obviously more to know about each of these in terms of exactly what's deductible and what's not, so let's take a closer look at each one.
If you're like most people, you had to obtain a mortgage when you bought your investment property.
Most homeowners are familiar with the mortgage interest deduction, but it works a little differently for investment properties. Instead of having to itemize deductions on your tax return, any investment property owner can use their mortgage interest as a business expense on IRS Schedule E, which is the form where you'll calculate your taxable rental income.
This is a better deduction than is available for primary and secondary homes for a few reasons:
- First, it's available regardless of whether you itemize deductions or not.
- Second, it isn't subject to the $750,000 principal cap that applies to homeowners.
- Third, you can deduct the interest on other loans (even credit cards) if the expenses were incurred to make repairs or improvements to the property.
Property taxes you pay to your local government are also deductible as a business expense on Schedule E. You can also deduct any taxes you have to pay in order to be allowed to rent the property, such as local licensing fees or occupancy taxes.
You can deduct any routine maintenance you pay for on your rental properties. Examples might include lawn care, pest control, and pressure washing of the exterior, just to name a few. This includes the cost of labor, as well as any supplies.
If you pay for repairs on your investment property, you can use that expense to reduce your taxable rental income. For example, if a toilet stops working and you pay a plumber $100 to fix it, it would be considered a repair expense.
On the other hand, you cannot deduct the cost of property improvements, which are anything that adds substantial value to the property or makes it more usable. These expenses need to be added to your cost basis and depreciated, which we'll get into later. While there is certainly some gray area here, a good rule of thumb is that a repair is necessary to keep the property in good working order but doesn't really increase its market value, while a capital improvement is a modification that adds significantly to the fair market value of the property.
It's worth pointing out that all deductible rental property expenses (repairs and otherwise) must be ordinary and necessary. If you need to repair a $100 toilet and replace it with a top-of-the-line $500 model, it might not qualify as a deductible expense.
If you pay any of the utilities on your investment property, you can deduct the cost on Schedule E. For example, it's quite common for landlords to pay for sewer service or garbage collection.
If you hire a property manager, their fees are deductible against your rental income. Most property managers charge between 8% and 12% of the collected rent for their services, so it's nice to be able to deduct this significant (but often worthwhile) expense.
Hopefully, you won't have to hire a lawyer to help deal with your investment properties. However, if you do, you can deduct the cost as a business expense. The category of legal expenses also includes any fees you pay to have your taxes prepared.
If you hire a property manager, they'll generally market your property on your behalf. However, if you pay any out-of-pocket advertising expenses, such as buying yard signs or taking out a classified ad in your local newspaper, those are deductible business expenses.
Rental property owners can deduct their expenses incurred while getting to and from their properties. This includes vehicle mileage (the Internal Revenue Service allows a deduction of $0.575 per mile in 2020), airfare, and half of the meals you purchase while traveling. If your rental properties are local, this isn't likely to be a major expense, but if you own faraway vacation rentals, it could add up to a substantial deduction.
Virtually all rental property owners maintain insurance policies on their properties. Depending on where the property is located, you may have flood or windstorm insurance policies as well. Regardless of the insurance you have (and whether or not it's mandatory), insurance premiums are deductible as a rental property business expense.
Qualified business income (QBI)
The newest deduction on this list, the qualified business income (QBI) deduction, is also commonly referred to as the pass-through tax deduction. In a nutshell, taxpayers who receive business income through a pass-through entity like a sole proprietorship, partnership, LLC, or S-corporation can deduct as much as 20% of it. Rental income can qualify, so if you own rental properties, it's certainly worth familiarizing yourself with this deduction that was created as part of the Tax Cuts and Jobs Act of 2017.
Last, but certainly not least, the depreciation deduction can be one of the biggest tax benefits of owning rental property.
When a business buys a capital asset, it typically doesn't deduct the entire cost right away. Instead, it deducts a portion of the cost each year until the entire amount has been deducted, a process known as depreciation.
When you buy a rental property, the same concept applies. Real estate investors' capital assets are the properties they own, so their cost is deductible over time. Residential rental property is depreciable over a 27.5-year period. So, on a $200,000 investment property, this translates into a $7,273 annual deduction. In fact, the depreciation deduction is one of the best tax advantages of real estate investing, and it isn't uncommon for profitable investment properties to even show a loss (negative real estate income) for tax purposes because of it.
What if your deductions exceed your rental income?
As I just mentioned, it isn't uncommon for rental properties to show a loss for tax purposes, even if they earned a profit. In other words, it's fairly common for all of these deductions to add up to more than the property's rental income. This is known as a passive activity loss.
How you handle these losses depends on your total income and your level of involvement in the property, and there are three categories of investment property involvement:
- First, if you are a passive real estate investor, you cannot use a passive loss (like from a rental property) as a deduction against anything but other passive income. So if your rental property shows a $5,000 loss for the year but you have no other passive income, you can't use it to reduce your other taxable income (but you can carry it forward to future tax years).
- Second, if you actively participate in the rental property, meaning you make management decisions about it, you can deduct as much as $25,000 in rental real estate losses. However, this deduction allowance begins to phase out for modified adjusted gross income (AGI) above $100,000 and disappears entirely with modified AGI above $150,000.
- Third, if you or your spouse are a real estate professional, meaning that you spend more than half of your total working hours on real estate businesses (defined as a minimum of 751 hours), you can deduct any amount of rental losses against your income.
This isn't an exhaustive list
As a final point, it's important to emphasize that this is intended to be a list of the most common types of deductible rental property expenses, not an exhaustive list. You might have other expenses associated with the operation and maintenance of your rental properties that don't fit into one of these categories. For example, if you use a portion of your house exclusively to work on your rental property business, you could potentially qualify for the home office deduction. The key test is whether the expenses are "ordinary and necessary" in the context of your business. If they are, there's a good chance you can deduct them.
There can, of course, be quite a bit of gray area here, so be sure to seek the advice of a qualified tax professional or Certified Public Accountant (CPA) -- preferably one with lots of experience dealing with rental property owners.
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