7 Tax Questions You Need to Ask as a Landlord
October 5, 2022
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What Are The Important Tax Questions You Need To Ask?
No matter who you are, you probably have at least one frustrating story regarding taxes.
As a landlord, taxes can be quite daunting.
However, if you ask yourself the right questions and gain the proper knowledge, taxes can be an advantage.
Let’s look at seven tax questions you should consider to better prepare yourself for tax season.
Question #1: What is Rental Income?
You pay tax on your net rental income every year (total income minus deductible expenses). The main portion of rental income is tenants’ rent. Rental income can also include other payments like security deposits, property or services in place of rent, lease cancellation payments, fees, and more.
It’s important to note that, as a rule, rent and other kinds of payments landlords receive aren’t reported by tenants or anyone else to the IRS.
Question #2: Is Rental Property Tax Deductible?
Is rental property tax deductible? It’s a deceptively simple tax question. The answer, of course, is yes. But there’s more to it than that.
Rental property isn’t just deductible; it’s depreciable. Depreciation is the process utilized to deduct the costs of purchasing and improving a rental property over the course of its useful life. It’s a critical piece of your taxes as a landlord. Buildings and property wear down over time, and depreciation gives you a way to get back some money that will naturally vanish with the wear and tear.
To be eligible for depreciation, you must own a property you use in your rental business. It must have an expected useful life of more than a year. If you meet these criteria, look into depreciation; it can save you valuable money in the long run. Check out this article – The Basics Of Depreciation – to learn more about depreciation and what it entails.
Question #3: What Rental Property Expenses are Tax Deductible?
There are nine major categories of expenses that are tax deductible related to rental properties.
The first is property taxes. Practically every state government collects property taxes. The area of your property will determine the price, but it typically runs anywhere from a hundred dollars to hundreds of thousands of dollars. A tax professional can help you figure out the exact amount. And, if the state has rental licensing requirements, you can deduct those fees as well. The IRS does, however, restrict the deduction of state and local income, including sales and property taxes, to a total of $10,000.
The second expense category is mortgage interest. As a landlord, your loan interest will probably be your highest deductible expense. You cannot deduct the part of your mortgage payment that goes toward the principal loan amount (I.e., the money you borrow when you first take out the loan). This deduction relates strictly to payments for interest charges.
The third expense category is insurance premiums. Any kind of insurance is an ordinary and necessary rental property expense, which means it’s deductible. This deduction covers basic homeowners’ insurance and special peril and liability insurance.
The fourth expense category is depreciation. As mentioned earlier, this expense relates to the continued devaluation of your property over time. This doesn’t include the value of the land, though. It relates to the structure and equipment that helps you in your business.
The fifth expense category is maintenance and repairs. While home improvements are deductible through depreciation, maintenance and repairs can be deducted separately. Maintenance and repairs keep your property in livable condition but aren’t major in scope and don’t improve your property significantly.
The sixth expense category is utilities. No matter how you approach charging for utilities, you can deduct utilities like electricity and water.
The seventh expense category is transportation expenses. Transportation expenses include trips to collect rent, show your property, and visit your office. There are exclusions to this category, though, so it’s important to do your research. For instance, trips to the grocery store aren’t going to count.
The eighth expense category is legal and professional fees. For instance, if you use a CPA or software to file your tax return, you can deduct that expense. You can also deduct the cost of a lawyer who helps review rental documents. On the other hand, you cannot deduct legal fees for the defense of your property’s title or for recovering and improving the property.
The ninth expense category is your office. Square footage or the rent will probably account for most of this expense. However, you can also deduct the cost of a printer, software, and many other items you use for your business.
Question #4: What Are Operating Expenses in Real Estate?
Operating expenses are the costs related to managing and maintaining a property. Because an exorbitant amount of operating expenses exist, the tax code gives you the definition instead of providing an exhaustive list.
To qualify, an operating expense must be ordinary and necessary, current, directly related to your rental activity, and reasonable in amount.
Ordinary and necessary means that it is “helpful and appropriate” for your activity. Even a minor expense that helps your property counts. Most of the common landlord operating expenses can be found on IRS Schedule E.
Operating expenses must also be current, which means they’ll benefit your rental business for under a year. Think of daily costs to maintain your rental business, like small repairs and replacements.
If an expense is business-related, it’s directly related to your rental activity. So, personal expenses aren’t deductible. For instance, a personal computer is only deductible if you use it for your rental activities; it’s not deductible if you use it to watch Netflix or surf the internet.
The last factor is if the expense is reasonable in amount. While there isn’t a restriction on the amount you can deduct, it should be close to average amounts others would spend for the same items and cannot be more than you spend. Generally speaking, the deduction is acceptable unless there are more economical and pragmatic ways.
Question #5: What are the Key Tax Documents You Need to File?
Preparation is the first step in reporting your taxes. Make sure you keep track of rent payments, security deposits, withheld security deposits for damages, and advance rent payments. Up-to-date files are critical to getting the most out of your taxes.
The first form you must complete is Form 1040. The 1040 is a standard personal income tax form anyone who files federal taxes needs to fill out. You will need your Social Security Number, dependents and relevant information, and earnings to properly complete the 1040. Also, your situation may require additional forms, so it’s important to see a tax expert if you have questions.
Schedule E is another also critical form when filling out taxes. Also referred to as the Supplemental Income and Loss form, it allows you to report income or loss from rentals, royalties, partnerships and S corporations, and estates and trusts.
For most private landlords, Part One of the Schedule E form is all you’ll need to fill out. However, we recommend consulting with a tax expert to ensure you’re filling out the correct forms and doing so properly.
Question #6: What Records Should I Keep?
Records are a vital part of taxes. The better your records, the better your chances of a good return.
You’ll want to keep records of your income and expenses to determine whether your rental business earned a taxable profit or sustained a deductible loss for the year. Additionally, you’ll need to summarize your rental income and expenses for every property on Schedule E.
Receipts and documentation are vital (e.g., credit card records) because you never know when you might be audited. These documents provide assurance and proof in the event the IRS comes knocking. Furthermore, you could miss out on valuable deductions without great records.
It’s important to note that if you own more than one property, you need to track your income and expenses for each property separately. The IRS will want to see the specific information on the different properties on your Schedule E.
Question #7: What is Your Tax Classification?
This question has important implications for your tax return. Landlords can be business owners, real estate investors, or a person who owns a rental property as a not-for-profit activity.
Most landlords are business owners. Business owners receive key tax deductions that investors cannot. These critical deductions are invaluable to your bottom line.
But what is the difference between the two? The difference between business owners and investors is that business owners earn income by actively running a business. Investors, on the other hand, are passive because they give money to someone else’s business to hopefully increase their earnings in the future.
If you own a property that doesn’t have profit as the primary motivation (which isn’t common), then you won’t qualify as a business owner or investor. This isn’t an ideal place when it comes to taxes. Your deductions will be almost non-existent.
To learn more about tax classifications, read this article – Understanding Landlord Tax Classifications
These seven questions will help you understand what you should look out for regarding taxes. Preparation is a key part of taxes.
The questions we’ve gone through are foundational. They can serve as a baseline for you to conduct more research and make sure you’re getting the most out of your returns.