What Landlords Need To Know About Taxes
September 30, 2022
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Everything You Need To Know About Taxes
Every landlord needs to understand taxes.
Taxes are a crucial part of your business, and the money you can save is substantial.
And you don’t want to wait until tax season rolls around to take them seriously.
The more you know, and the earlier you know it, the better.
Taxes may not be the most fun or the sexiest topic, but their importance cannot be overstated.
Your business cannot succeed without a foundational knowledge of taxes.
Landlord Tax Classifications
Before you can make the most of tax deductions, you need to determine your IRS classification for tax purposes. The general rule of thumb is if you’re a landlord who makes a profit (or a new landlord trying to make a profit), you probably qualify for deductions available to rental property owners.
Motive and behavior are the two factors the IRS pays the most attention to, in order to establish your classification. Essentially, they want to make sure you’re running a business with the intention to make money and acting accordingly.
The three main classifications are investors, not-for-profit owners, and business owners. For tax purposes, you want to be classified as a business owner. This is why it’s vital that you, or someone you hire, engage in rental activities on an ongoing basis with the intent to turn a profit. This classification will put you in the best position to maximize tax deductions related to rental income taxes.
Rental Property and Rental Income Taxes
You pay tax on your net rental income every year, which is your total income minus deductible expenses. The key part of rental income is tenants’ rent payments. Furthermore, rental income can include other payments like security deposits, property or services in place of rent, lease cancellation payments, fees, and more.
At this point, you’re probably asking yourself, is rental property tax deductible? The answer is yes. But there’s more to it than that.
Rental property isn’t simply deductible; it’s depreciable. Depreciation is the process utilized to deduct the costs associated with buying and improving a rental property over the course of its useful life. It’s an integral piece of your taxes as a landlord. Buildings and property lose value over time as they experience wear and tear, and depreciation gives you the means to increase your return when tax season rolls around. We’ll come back to depreciation later.
So, what are examples of deductible expenses? Let’s look at the nine most important.
The first is property taxes. Almost every state government collects property taxes. The location of your property will determine the price, but it usually runs anywhere from a hundred dollars to hundreds of thousands of dollars. A tax professional can help you figure out the exact amount.
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).
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 also extends to 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. 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. Regardless of 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.
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.
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.
Rental property operating expenses are the ongoing, everyday expenses that all landlords have. Typical examples include repairs, maintenance, management, advertising, supplies, utilities, and salaries. Most operating expenses qualify as rental property tax write-offs.
In order to qualify as rental operating expenses, these expenses must be ordinary and necessary, current, business-related, and reasonable in amount.
Ordinary and necessary means the expenses are “helpful and appropriate.” The IRS Schedule E supplies a list of the most common types of operating expenses, so you can get a better idea of what qualifies.
An expense is current if it improves a business for under a year. It needs to be a day-to-day expense that gets used up or made obsolete within a year.
Business-related simply means that the expense is directly related to your rental activity. If you buy something for personal use, then that isn’t business-related.
For an expense to be reasonable in amount, it just needs to be sensible and less than you spend. The IRS will typically allow an operating expense deduction as long as there isn’t a more economical way to get the same outcome.
Now that we’ve discussed what is included in operating expenses for rental properties, it’s important to mention that some expenses aren’t deductible for any reason. Look at this article for an extensive list of these expenses.
Now that you know operating expenses are deductible and what that means, it’s time to look at other valuable deductions, especially for smaller landlords.
One of the Tax Cuts and Jobs Act benefits that helps many small landlords is the pass-through deduction. Most landlords qualify for this deduction.
How does the pass-through deduction work? It helps qualified individuals deduct up to 20% of their income through entities like limited liability corporations and partnerships. A pass-through business is a business that doesn’t pay taxes; instead, the income and tax liability go directly to its owners.
You qualify for the pass-through deduction by meeting three different factors:
- You must have a for-profit business. You can locate the specific criteria for this one in IRS Reg. 1.199A-1(b)(14). Essentially, though, this won’t be a problem for most landlords because you’re trying to turn a profit with your rental business.
- You must have a pass-through business. This simply means the profits and losses go through the business, and the owner pays tax on the money on the individual tax return.
- You need qualified business income. QBI is the net profit your rental business earns during the year.
Start-Up Expense Deduction
Repairs and operating expenses that occur before a building is placed in service can’t be used as standard deductions, but they qualify for the start-up expense deduction.
Start-up expenses are costs you take before your units are ready to rent. Here are some examples of these:
- Office supplies and equipment
- Minor repairs
- Investigative costs
- Insurance premiums
- Expense of hiring and training employees
Home Office Deduction
The Home Office Deduction is another useful deduction for small landlords because most work out of a home office. This is particularly common for those who manage their properties remotely.
There are four criteria you must meet to use the Home Office Deduction.
- You must be classified as a business for tax purposes.
- You must use your home office specifically for rental activities.
- You must use your office on a regular basis.
- You must meet one of the following four requirements:
- You constantly and exclusively use your home office for management and administrative purposes
- You perform your most crucial rental activities at that location
- You hold business meetings there or meet with important stakeholders like tenants at that location
- You use a separate building on your property just for rental business purposes
Car and Local Transportation Expenses
IRS auditors often keep a close eye on car and local transportation expenses. Local trips for your rental activities are the exclusive expenses you can deduct under this expense category. You can deduct any business-related trips where it isn’t necessary for you to stay the night anywhere. Examples include trips to and from:
- Your rental property
- A critical place of business (including your home office)
- Sites where you meet tenants, vendors, suppliers, maintenance crew, attorneys, etc.
- The garbage dump that you take trash to from the rental property
- A store where you buy materials and supplies expressly for real estate purposes
The Standard Mileage Rate
The Standard Mileage Rate is the rate set by the IRS that allows you to deduct every mile driven related to your rental activity multiplied by the specific rate. There are rules, though:
- You must use it in the first year you use the car for your rental business, or you can never use it. (However, you can go from standard mileage rate to expense rate. Thus, if you’re unsure which method to use, start with the standard rate.)
- It cannot be used if you have over five cars used concurrently for rental activity.
Important Note: What is the standard mileage rate for 2022? It’s 62.5 cents per mile.
Actual Expense Method
Using the alternative option, the actual expense method, you’re able to deduct costs to operate your car each year. These will most likely include things like:
- Oil and fuel
- Repairs and maintenance
- Depreciation of your original vehicle and any improvements
There are two main kinds of travel expenses: transportation expenses and destination expenses.
Transportation expenses include plane/train fares, luggage shipping costs, half your meal expenses, and temporary lodging as you head to your destination. Destination expenses cover lodging, half your meal costs, transportation at the destination, laundry expenses, and fees for phone, internet, fax, and computer rental.
The IRS is strict about deducting travel expenses.
However, your expense has to meet these requirements before it’s deductible:
- The expense is mainly for business activity.
- It’s ordinary and necessary.
- You are a current landlord with properties in service.
- Travel to view a property you later purchase is not deductible.
- Travel to perform an improvement is not deductible.
Casualty Loss Deductions
A casualty is any damage or loss of property due to a sudden, unexpected occurrence. For example, property damage due to theft, vandalism, accidents, or natural disasters is considered a casualty loss.
Casualty loss expenses can be deducted if they meet certain criteria, but understand that the IRS keeps a close eye on them.
How To Qualify
Property damage must occur suddenly to qualify as a casualty loss. Losses due to your property’s deterioration over time aren’t deductible. The casualty loss must relate to an external force. However, routine wear and tear could build up to a sudden event.
For example, the general entropy of your property’s roofing isn’t deductible as a loss. But, if wind and rain damage the roof over time until it caves in during a particularly rough storm, you could make a case that the loss was a sudden casualty loss.
Interest payments are a typical expense for landlords. For instance, you may have interest payments on a car loan, mortgage, business credit card, or government/personal loans you use for rental purposes.
How To Qualify
For the most part, any interest related to your rental activity qualifies for this deduction. There are a few rules, though.
These are the instances where the interest cannot be deducted:
- Interest on money you don’t owe. If you aren’t on the hook for over half of the debt, by law, you can’t deduct its interest.
- Interest that you pay with money you got from the lender. You must wait to deduct the interest until you begin paying off that loan.
- Income tax interest. Your income tax amount relates directly to your rental activity, but you cannot deduct interest on your personal tax return.
Rental Loss Deductions
Rental losses are a different kind of federal tax deduction. A rental loss happens when all your deductions increase above the rent and other revenue you pull in from your properties. If you are like most new landlords and have a rental loss at the close of the year, you can use the IRS’s rental real estate loss allowance.
Passive Loss Rules
Regarding rental loss deductions, you have to follow the passive loss (PAL) rules. These rules are complex and have many exemptions, so let’s look at them below.
The Passive Loss Rule states that you cannot deduct passive (or rental) losses from your active or portfolio income.
At the risk of oversimplification, the PAL rules essentially require money in the passive category to stay there. You can’t use losses in the passive category to counterbalance your active income, nor can you use active or portfolio losses to counterbalance your passive income.
So, if you have a rental loss, you must deduct it from other passive income.
Unfortunately, the PAL rules had unintended consequences for small landlords working hard to improve their businesses.
Because many smaller rental businesses typically have losses for multiple years, Congress implemented exemptions to relax the PAL rules and assist people who probably aren’t exploiting the rules anyways.
Some Additional Deductions
While meeting the criteria for an operating expense is a given, some categories also have other rules. Let’s look at a couple of key ones.
Meals and Entertainment
The IRS is extremely stringent about deducting meals and entertainment expenses. The Tax Cuts and Jobs Act limited many of the deductions under this group.
Entertainment expenses aren’t deductible even if they lead to business (e.g., a recreational tennis match leads to a discount on a contractor’s next job).
Most meal expenses, on the other hand, are at least partly deductible if they meet a few conditions. The meal must not be too lavish or excessive, the taxpayer (or employee) must be present, and the meal must be served to a business associate, such as a consultant or tenant.
Most taxes related to your rental business are fully deductible.
Real property, water, sewer, and other service taxes are deductible operating expenses. Taxes used to fund local improvements, though, aren’t deductible (think funds used for sidewalks, sewer lines, roads, etc.).
Depreciation and Cost Basis
Over time, assets experience wear and tear, losing some of their value. Depreciation is how that is accounted for when it comes to taxes.
Depreciation is one of the most important annual tax rental property deductions that landlords and investors can take advantage of regarding their taxes.
How Depreciation Works
At a high level, cost basis and the recovery period are the two key elements that contribute to depreciation. Four things help make up these elements:
- The depreciation’s starting and ending points are key. Depreciation begins when a property is “placed in service.” It must be at least available to rent for this to be possible. The ending point happens when you recover the full value or retire it from service.
- Your property’s adjusted cost basis is the amount invested into the property. Improvements will be a piece of this figure.
- The recovery period depends on the kind of property. The major one most landlords need to be aware of is for residential real property, which the IRS designates as 27.5 years.
- Finally, the depreciation deduction is a fixed percentage of the basis of your property each year. The depreciation method you use contributes to this figure. The rental property depreciation schedule most commonly used by landlords is the straight-line method, which means you deduct an equal amount every year over the useful life of the property.
When you sell a rental property, you figure out your capital gain or loss by taking your cost basis minus your selling price. Depreciation and improvements are the two main things that impact your cost basis.
The key takeaway is that depreciation lowers your cost basis, which increases capital gains and will most likely lead to a higher tax bill. Conversely, improvements increase your cost basis, which means lower capital gains and typically leads to a lower tax bill.
Your cost basis will change over time. This is why it’s referred to later as your adjusted cost basis. There will be adjustments as you make improvements.
The real profit you earn only comes to fruition after you pay all your taxes. Understanding cost basis and its implications will help you figure out the best time to sell a property. Keep improvements and depreciation in mind as tax season approaches. And never be afraid to consult with a tax professional if you have questions about anything.
What About Recapture?
Depreciation accounts for the declining value of assets over time. But many properties increase in value due to improvements over time.
The IRS came up with a way to recoup the money they lose to taxes you avoid paying through depreciation. They look to get back this money when you sell a property. This is what rental property depreciation recapture refers to.
You’re probably a bit frustrated now. What’s the point of depreciation deductions if the IRS is just going to negate the money you save through recapture of depreciation? It’s important to keep in mind that property often appreciates over time, so that helps balance things out. Furthermore, depreciation is just a short-term deferral of taxes, and that doesn’t make it any less advantageous.
Repairs and Improvements
We mentioned improvements in the previous section. That being said, it’s of the utmost importance that you understand the difference between repairs and improvements. This is because these aren’t treated the same when it comes to taxes.
A repair is any consistent upkeep for your property that’s ordinary, current, rental-related, and reasonable. These are the simple fixes. A couple of examples are filling a hole in a wall, fixing a leaky faucet, or replacing HVAC filters.
Improvements, on the other hand, significantly increase property value. If you install new components, renovate rooms, or greatly prolong the life of the property, then that’s an improvement. Things like installing a new bathroom or adding a pool in the backyard are improvements.
Both of these are key elements for your tax return. Differentiating between them will save you money and time (because no one wants to have to go back and correct tax forms).
The Importance of Record-Keeping
A foundational part of setting yourself up for tax season is excellent record-keeping. Everything we’ve discussed up to this point hinges on keeping detailed records. If the IRS audits you, your records will make all the difference.
Maximizing your deductions and credits relies on the condition of your records. The better your records, the better your return. Deductions should always have a paper trail, including information like what you purchased, the amount you paid, and from whom you bought it. Items such as canceled checks, sales receipts, account statements, credit card sales slips, and invoices should be your steadfast companions.
While taxes may not be glamorous, they’re pivotal to your rental business. Everyone has to pay them, and understanding your advantages and the answers to your tax questions will only improve your operations.
So, put this article in your toolbox and get to work. You have money to save and knowledge to build upon.
Lastly, always consult with a tax professional if you feel uncertain about any part of your taxes. Taxes are extremely complicated, and there’s no shame in leaning on an expert.