What You Need To Know About Operating Expenses For Tax Purposes
September 30, 2022
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Things All Landlords Need To Know About Operating Expenses
In this article, we went over how you can qualify as a business based on rental activities.
If you qualify, you’ll need to understand some key elements regarding rental expenses before you do your taxes.
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 are deductible, but you must know the types of expenses that qualify and what categories they fall into.
What Qualifies as an Operating Expense?
Every operating expense is deductible for the year in which it was incurred. Thus, you can take your total taxable income minus these expenses in a single year as you would with a depreciable asset.
Many things can be defined as operating expenses. Rather than listing everything that qualifies, the IRS created a definition of an operating expense with four main criteria. To qualify, the expense must meet all four:
- Ordinary and necessary
- Directly related to your rental activity
- Reasonable in amount
Let’s dive into each one individually for a deeper understanding.
Ordinary and Necessary
This requirement means that the rental operating expenses are “helpful and appropriate” for your activity. These expenses don’t have to be essential to count as operating expenses. They only need to help your rental business.
It’s simple to determine whether an expense meets this requirement. The IRS Schedule E lists most of the common kinds of landlord operating expenses:
- Advertising your rental units in papers or online
- Auto and travel expenses incurred by you or your workers
- Cleaning and maintenance
- Commissions you pay to rental brokers (if you utilize them)
- Insurance, including property and commercial general liability insurance, and a portion of your automotive insurance, if you drive your car for rental activities
- Legal and professional fees, like accounting fees
- Management fees, if you hire a manager to conduct day-to-day activities
- Mortgage interest paid to banks or other financial institutions
- Other interest expenses, e.g., interest on a credit card you use to purchase things for rental activity
This isn’t an exhaustive list; it’s a guide. If you avoid absurd expenses that don’t serve a business purpose, your claims will probably be accepted.
Current items must be things that improve your business for less than a year. The expense must be a daily expense that gets exhausted, used up, or made obsolete within a year.
Examples of current expenses include cleaning fees, isolated roof repairs, or preventative maintenance. The benefits of the cleaning, roof repair, or preventative maintenance likely won’t last beyond a year, which is why they’re current expenses.
The point of this qualification is to differentiate operating expenses from capital expenses. For instance, if you purchase a power washer to use for your rentals, that purchase is a capital expense. It’s not an operating expense because you expect to use the device for many years. The machine must be depreciated over several years (or, if it’s your personal property, it may be deducted through bonus depreciation).
Repairs are another example of current expenses that can be deducted in one year. If you fix a few shingles on your roof, that is considered a repair. On the other hand, buying an entirely new roof would have to be depreciated over multiple years.
An operating expense must also be directly related to your rental activity. This means you cannot buy something for personal use and deduct it.
For instance, the rent you pay on the office you use to manage your properties is related to your rental activity. Therefore, you can deduct this monthly expense from your taxable income.
However, if you use that same office to run an afterschool daycare, your office isn’t always directly related to rental activity. This means you may only deduct the part of that expense that’s used specifically for your rental business.
For example, let’s say you rent a small office for $100 a month. You spend five hours a week at the office doing tasks related to your rental business. You spend 15 per week on the daycare. This means you use it 25% of the time for your rental business and 75% for other reasons. So, all in all, you can only deduct 25% of the cost of the office in this example.
Landlords may not deduct the value of their own time and personal labor spent on rental activities. For example, if you spend hours painting a room, you cannot deduct that from your taxes. However, you can deduct the cost of the materials used to paint the room.
It’s also important to know that certain categories of expenses are regulated more strictly by the IRS regarding this rule. For example, meals, gifts, education, and travel expenses may or may not be directly related to your rentals. Conduct careful research if you find yourself questioning whether something meets this criterion.
There’s technically no limit on how much you can deduct, given it’s reasonable and doesn’t exceed more than you spend. Generally speaking, an expense is reasonable unless there are more economical ways to get the same outcome. The IRS will reject your claims if they’re too large.
Travel and meal expenses are closely scrutinized by the IRS. They won’t allow ridiculous expenses in any category, but they’re particularly stringent when it comes to these two kinds of expenses. You must abide by strict rules that include thorough documentation.
The IRS also looks for outrageous salaries, like paying your 16-year-old son $50 an hour to mow the lawn on your rental properties.
For several specific operating expenses, the IRS limits the amount you can deduct. These include:
- The home office deduction, which is restricted to the profit from your business
- Business meals, typically only 50% deductible, but 100% deductible from restaurants from 2021 to 2022
- Travel expenses, restricted depending on how far the trip is and the time you spend on business while gone
- Business gifts, restricted to a $25 maximum deduction per individual each year
What Operating Expenses Aren’t Deductible?
Now that we’ve looked at what is included in operating expenses for rental properties, it’s important to highlight that some operating expenses aren’t deductible under any circumstances. These non-deductible items are:
- Business-related entertainment expenses like country club or ski outings, theater or sporting events, nights out at nightclubs, or hunting, fishing, or vacation trips
- Fines and penalties owed to the government for violating laws
- Illegal bribes, kickbacks, or private parties for government workers
- Lobbying expenses or political contributions
- Real estate examination or licensing fees, or other professional examination fees
- Athletic club, country club, or social club membership fees or dues
- Federal income taxes paid on your rental income
- Certain interest payments
Ongoing, daily expenses are always going to be a part of your business. However, knowing how to leverage them for tax season will help you save money.
At the end of the day, understanding operating expenses as they relate to landlord taxes is critical to your rental business. While this article provides a foundation for understanding operating expense deductions, you may want to consult a tax professional to get the most out of these deductions.