Being a landlord takes a lot out of you! Even if you hire a property management company, there are still many resources that a real estate professional needs to expend. Luckily, the IRS lets you write off the cost of those expenses when filing a tax return. Unfortunately, not everyone knows just how much tax relief they can get and just how accessible, as a result, investing in property can be!
What qualifies as an expense?
There are two broad types of real estate expenses: current expenses and capital expenses. A current expense tends to be a one time deal that keeps your rental property habitable or keeps your business running. A capital expense is anything that increases your property’s value or extends its life.
Current expenses can be deducted the tax year they’re paid. That’s why it’s called a “current” expense. To be deducted, however, the expense must meet the following criteria:
Necessary and Ordinary
When used for tax purposes, “necessary” and “ordinary” are technical terms. An ordinary expense is one that’s expected for your industry. For example, it makes sense for a landlord to pay a plumber to fix a leak. A necessary expense is one of the expenses presupposed by the very idea of running a business in the first place, like advertising, insurance, interest, maintenance, income tax, and utilities.
The expense’s short-term effect must be greater than its long-term effect. Think of the difference between repairing a roof and replacing a roof.
Your spending must be directly related to managing your investment property to be a deductible expense.
Reasonable in Amount
You want to pay a reasonable amount for any goods or services you pay for. But you also want to spend a fair amount so you don’t get audited. Can you imagine the double whammy of being ripped off and audited?!
Capital expenses are improvements that add value to your rental property. They must be capitalized and depreciated. Suppose you don’t feel like depreciating them for whatever reason. In that case, you still should make use of your depreciation deduction because the government will treat you as if you did and, as a result, charge you a tax on the amount you would have deducted thanks to depreciation.
1. Deduct Mortgage Interest Payments
A landlord can deduct mortgage interest payments, as well as the interest accumulated on credit cards when you pay for goods or services related to your rental property. The Tax Cuts and Jobs Act (TCJA) capped interest deductions for landlords who yearly earn over $25 million from their rentals. Still, you can get around that by depreciating your rental property for 30 years instead of 27.5 years.
In January or early February, you’ll get a Form 1098 from your mortgage lender telling you how much interest you’ve paid in the year. Then, when you file your income tax return, you’ll take the deduction, in most cases, using IRS Schedule E, which is designated for residential property owners.
2. Depreciation for Rental Real Property
Depreciation is a property tax deduction that lets you deduct the cost of owning and maintaining your rental property over the useful life of your property. Your property’s useful life is designated as 27.5 years for rental properties and 30 years for commercial and retail properties (useful life being the IRS’s term for the amount of time a property can generate cost-effective income). Land doesn’t count toward depreciation, so when you calculate how much you’re going to deduct from your taxes, you first have to subtract the cost of land. After that, you just divide your property’s cost by its useful life, and that’s how much you deduct yearly.
Keep in mind that when you sell your property that you’ll have to pay what’s known as depreciation recapture on the amount you deducted thanks to depreciation. This tax is 24%. As previously mentioned, but worth repeating, the IRS will charge this amount regardless of whether you take advantage of depreciation. So, you might as well take advantage of this deduction since you can.
A landlord can get around paying depreciation recapture and capital gains tax by doing a 1031 exchange. That’s when you use the profits from your property’s sale to purchase a property (or properties) of equal or greater value soon after the sale. A 1031 exchange is a great way to diversify your investment or get a property that’s easier to manage. And if you die after having made a 1031 exchange but without having finally collected your profit, then your heirs don’t have to pay the deferred taxes!
They may still have to pay the estate tax, though, so consulting with a tax professional is a good idea.
3. Repairs & Maintenance
So long as the repairs are ordinary, necessary, and reasonable in amount, you can 100% deduct their cost in the year that you made them. This includes fixing gutters or floors, plastering, repainting, regular fall maintenance, etc. It does not include something like installing a hot tub!
4. Personal Property
Personal property used for your rental activity can be deducted over the course of a single year thanks to the de minimis safe harbor deduction (for property up to $2,000 in value). Examples of personal property are appliances, furniture, and gardening equipment. A landlord can also take advantage of a 100% bonus depreciation or a Section 179 deduction.
100% Bonus Depreciation
The 100% bonus property write-off allows for eligible items to be depreciated in their entirety at the time of purchase instead of over the course of their useful life. This tax break is applied in the first year of its purchase using Form 4562.
As of this writing, the ability to apply 100% bonus depreciation is scheduled to be phased out between 2023 and 2027. This will be done in 20% increments, such that 2023 will see the tax break reduced to 80% bonus depreciation, 2024 will see 60% bonus depreciation, etc.
Until 2027, however, this tax benefit can be applied to both new and used property. The exception for used property is:
- The property owner who would be filing the deduction has already used the property.
- The property was acquired using exempt means (like tax-free acquisitions or someone related to the taxpayer).
Bonus depreciation is automatically applied, so if you want to opt-out, you have to choose to do so. Why would you want to? One reason is that your business may become more profitable in the future, in which case you can offset even more cash flow with depreciation.
Also, since it is depreciation, you’ll have to pay depreciation recapture at the time of the property’s sale. Keep in mind that bonus depreciation is an all or nothing tax deduction. The deduction has to be applied to all ten printers if you buy ten printers.
The Section 179 deduction’s official website explains that the deduction is limited to cars, office equipment, business machinery, and computers. Section 179 lets you make an immediate business expense deduction when you buy depreciable business equipment (as opposed to depreciating the item over time). In 2020, the maximum deduction was $1,040,000 for a property valued at $2,590,000 at purchase.
One of the advantages of bonus depreciation is that you can use it even if your business isn’t profitable, unlike a section 179 deduction, which requires that you be profitable. If your business makes $20,000 and you buy a piece of machinery that costs $30,000, you can only deduct $20,000 using Section 179. The remaining sum can be claimed using regular depreciation, or you can complete the Section 179 deduction the following year. To use the deduction, you have to start using the property in the same tax year that the deduction is claimed.
You may have an asset that’s eligible for Section 179, bonus depreciation, and regular depreciation. If your item is eligible for all three, you must apply them in the following order: Section 179, bonus depreciation, and then regular depreciation. A Section 179 deduction is also made using Form 4562.
5. Pass-Through Tax Deduction
This is a special rental property tax deduction that’s in effect until 2025. It allows you to deduct the lesser of 20% of your net rental income or 2.5% of how much you paid for your rental property plus 25% of what you pay your W-2 employees. That 2.5% is important because most landlords don’t have W-2 employees. Even if you hire a property manager, you’re likely to do so through a separate entity, and, as a result, they wouldn’t count toward your deduction.
6. Real Estate Related Travel Expenses
Travel is a tricky deduction for landlords, which is just one more reason to consider managing a property remotely. You can deduct most of the driving you do for your rental property, like if you have to check out a complaint and then drive to pick up some replacement parts. However, the cost of travel to make the improvements is deducted using depreciation.
To calculate how much you’d deduct, you can use the expenses incurred (gas, repairs, upkeep) or the standard mileage rate, which you should confirm on the official website of the IRS since it changes yearly. To use the standard mileage rate, you have to use it in the first year that you start to use your vehicle as part of your rental business.
If your travels require overnight activity, then you can deduct the whole shebang- airfare, lodging, food, etc. You can even have some fun during the trip and still count your journey as a deduction so long as everything is planned outright. Just make sure you document everything because if the IRS audits you, you’ll want all of your bases covered. Otherwise, you may have to pay more taxes or even fines.
7. Home Office
A home office, workshop, or any other home workstation can be deducted so long as it meets minimum requirements. This is true even if the workspace exists within an apartment, home, or rental unit.
8. Employees and Independent Contractors
You can deduct what you pay anyone who performs any sort of service toward your rental business. This covers everyone from a property manager to a plumber.
Fire, flood, theft, you name it. Almost any type of insurance you pay for your rental property can be deducted from your taxes. This also includes the cost of the health and workers’ compensation insurance you pay for any of your employees.
10. Legal Fees
Being a rental property owner takes a lot of resources. It also takes a lot of know-how! Luckily, you can outsource everything to professionals, including knowledge experts. Given how critical such services are, it makes sense that you can deduct the cost of accountants, attorneys, financial advisors, property managers, and anyone else whose help you pay for. The fees count as operating expenses so long as they’re related to your rental activity.
11. Losses from Theft or Casualty
In the event of a catastrophic event, like a hurricane or an earthquake, you might be able to deduct a portion of or even all of your rental property losses. The amount you’re able to deduct will depend on your insurance and how much damage your property incurs.
Utilities can be deducted as well. This includes air conditioning, cable, internet, electricity, recycling collection, trash removal, etc. If the utilities get lumped into monthly rent, then the landlord must count that as rental income from the tenant.
13. Closing Costs
You can deduct a lot of closing costs, while many others qualify for depreciation. Win/win!
14. Mortgage Insurance (PMI/MIP)
Mortgage insurance can be deducted from the income you make from your rental property.
15. Property Management Fees
It’s hard but not impossible to document the active management of your property, even if you’re a sole proprietorship. Tenant screening systems and property management software make it easier to back up your claims because they provide documentation.
To make taxes easier to file, many investors who decide to manage their properties themselves establish an LLC or corporation. If your LLC employs you as the property manager, your entire salary is tax-deductible! If you decide to hire a management firm, then the fees you pay them are 100% tax-deductible.
16. Tenant Screening
All the usual steps you take to screen your tenants are tax-deductible. Background checks, eviction history reports, and all sorts of verification (employment, identity, income, and housing history). To make things easier, you can have the potential tenant to cover those costs directly. Software and websites exist that streamline this process and make it possible for the applicant to easily pay the fees themselves.
17. Phones, Tablets, Computers, Phone Service, Internet
Given that we’ve almost entirely shifted to a technology-oriented society, it makes sense that your phone, laptop, tablet, etc., are things you’d be using for business. So long as you document that you’re using these devices for business, you should be able to write them off your taxes. After all, if you can write off printer paper, then why not the device from which you send the documents you print?
18. Licensing Fees
If you have to pay a fee to renew or purchase your landlord or rental license, that fee is deductible. If you have to pay for a vacation rental license, which you may have to do if you intend to use your property for short term rentals, like an Airbnb, then you can deduct those fees as well.
19. Occupancy Tax
A tax comparable to sales tax is collected on rental amounts in some states. This is more often done in states where short-term rentals are popular. Arizona, Florida, and New Jersey are three examples of such states. If you’re charged an occupancy-like tax, then you can deduct the amount you pay. Keep in mind, though, that the tax will vary from state to state and from local jurisdictions as well
A real estate professional can depreciate a business vehicle’s cost, but the actual vehicle’s upkeep can be deducted the year the upkeep is performed. And, as you already know, travel expenses can be deducted using the standard mileage rate.
Any form of advertising you use can be written off. This includes mailers, newspapers, online ads, and radio. Remember that even if you know how to write a great rental listing, printed rental ads have much more limited reach than online ads.
If you offer a commission or monetary incentive to your tenants to find their replacements before they move out, then that amount can be claimed as a rental expense and deducted from your taxes. So, if you offer $50 to your occupant if they get a friend to move in after them, then that’s a deduction! It also saves you far more than $50!
23. Start-up expenses
Start-up expenses are any expenses that are spent before a business begins. Were your business already running, there’s a good chance your startup expense would just be an operating expense. Although, what makes start-up expenses different is that they can’t be automatically deducted in just one year. That’s because a start-up expense is a capital expense, which will benefit you for more than one year. You can deduct upwards of $5,000 as a startup expense in your first year.
Is there a Tax Limit on Loss?
There’s a $25,000 limit on losses. If, however, your losses exceed $25,000, then you can deduct the remainder the following year. You can keep doing this every year until you sell your property, and then you can recapture the sum of your unused losses against the profits you make from the sale.
Bottom Line on Landlord Property Tax Deductions
Now that you know how to shrink your tax bill as a landlord generating passive income with rental properties should appear more manageable. There’s even more to learn about how rental property income and sales are taxed, making investment simultaneously easier and more challenging. Harder because taxes require effort to file, but easier because there are so many opportunities to save money!