Rental real estate remains one of the best classes of investment, despite the downside of having to deal with tenants. Besides the additional monthly cash flow and the appreciation potential, rental properties are also appealing because of their advantageous tax treatment. However, this is only true if you don't pay more tax on your rental income than you have to.
To do that, it's crucial to identify the proper deductions available to you as a landlord. Generally speaking, since renting property is a business activity, deductible are those expenses which are considered "ordinary and necessary" for the business (which is not a very definitive explanation and can incorporate a wide range of deductions). This article deals with deduction rules as they apply to rental homes and not partial home or vacation rentals which follow a slightly different set of rules. So here are some of the main deductions owners can take advantage of starting with the largest two:
As with your personal residence, you can deduct interest paid on loans used to purchase or improve a rental property. Additionally, points representing prepaid interest are deductible ratably over the term of the loan.
This is probably one of the most overlooked deductions by taxpayers, which is a shame considering its size. When a property is being used for business, its cost is deductible over a certain period of time. In the case of residential rental real estate, that period is 27.5 years. Thus, a $300,000 property sitting on a $100,000 plot of land will bring you about $11,000 of depreciation deduction per year. Since land doesn’t deteriorate, only the building portion of the property can be depreciated and not the land. Depreciation deductions can be accelerated further by separating the personal property, such as kitchen appliances, from the building and depreciating it over its much shorter useful life of 5 or 7 years. Because depreciation is a not a cash deduction, it will often drive an otherwise economically profitable property into a tax loss, saving you lots of tax dollars.
A very important thing to note is that claiming depreciation is not optional and failing to do so can lead to a lot of tax complications. For example, upon a potential sale of the home, part of the gain called “depreciation recapture” will be calculated as if you took depreciation on the property, even if you didn't! This would essentially result in you having to pay tax on something you never took advantage of. If you have missed this deduction on past returns, talk to your tax advisor about ways to catch up on depreciation.
Another item that is subject to depreciation besides the original cost of the property, is the cost of improvements you make. Improvements generally are "updates" that add value to the property or materially increase its useful life. Examples of improvements are kitchen remodeling, roof or windows replacement, appliance replacement, patio or room addition.
Landlords often assume that any work they do on the property is automatically deductible. Unfortunately, that is not always true. Only changes to the property representing true repairs, and not improvements, are deductible right away. Unlike repairs, improvements are not fully deductible in the year when they occur but are rather depreciated over as many as 27.5 years.
So what are repairs? Repairs are generally what they sound; they are fixes that keep the rental running in proper operating condition. They don't add material value to the property nor do they prolong its useful life. Some examples are repainting, fixing a leak, repairing appliances, fixing roof shingles and gutters.
Cleaning and Maintenance
Not to be confused with repairs, this category of deductions is not related to fixing anything but rather to maintaining the property in good state. Examples include HOA dues, landscaping and cleaning fees, HVAC filters, pest control treatment, etc.
State and local real estate taxes are deductible in the year when paid. When the taxes are processed through an escrow, only the amount that was actually remitted to the taxing authorities is deductible.
Hiring a lawyer or tax advisor is always a good idea when it comes to dealing with any business including rental property. The value of a professional advice often exceeds it cost, and being able to deduct the expense provides even further incentive.
As a landlord you can deduct the cost of home owners insurance of you rental property. Mortgage insurance premiums are also deductible.
A lot of people prefer to hire a management company to help alleviate some of the landlord responsibilities, especially when they live far away, and especially when they can deduct the cost.
The cost of utilities such as electricity, gas, water or trash services are deductible only when paid for by the landlord. No deduction is allowed for bills paid by the tenant.
As a result of taking this many deductions it would not be surprising if you end up in a tax loss, even if you have positive cash flow. Unfortunately, since renting real estate is considered a “passive activity” for most people (except real estate professionals), such loss is limited to only passive income and cannot be used to offset income from other sources. An exception to this rule are taxpayers with modified adjusted gross income of less than $150,000 who may be able to deduct up to $25,000. Landlords whose income exceeds these levels are left with paper losses that are carried over and may be used in future years against positive passive income. If you don't expect to have such income in the future, don't worry, the losses will eventually be realized when the property is sold.
While it's impossible to put together an all-inclusive list of permissible deductions, the above covers the most material and frequently used ones. It's important to remember that no matter how many, or how big or small the deductions you claim are, the key to any valid deduction is to keep good documentation; this is the only way to substantiate it in front of the tax authorities.