A rental property can be a fantastic investment–if everything goes your way. However, there are numerous expenses associated with running a rental property. As the landlord, you are responsible for these expenses, which can include paying for any maintenance or repairs.
As frustrating as this can be, these aren’t sunk costs. In fact, there are several tax benefits that can offset some of the costs of running a rental property, and that can help you maximize your profits.
The Financial Rewards Of Owning Rental Property
Owning a rental property is a great way to earn passive income, as long as you have tenants. On top of that, the longer you keep your property, the more likely it is to appreciate in value, making it an excellent asset to have as part of your investment portfolio.
According to the Federal Reserve Survey of Consumer Finances, people who own investment properties are more likely to have a greater net worth than those who do not.
To maximize your investment in a rental property, you can take advantage of a handful of tax benefits.
1. Claim Numerous Deductions
As a citizen and homeowner, you are subject to taxes. But your status as a rental property owner can give you an advantage over other regular homeowners. Rental property owners are allowed to claim deductions for certain expenses in their rental property. These deductions can be used to reduce your taxable income.
Take Advantage Of These Deductions
The following are some of the tax deductions you can take advantage of as a rental property owner:
- Loan Interest: You can deduct the interest on any loans that were taken out to secure the property. These loans include mortgage, construction, and home improvement loans, as well as any refinancing loans.
- Taxes and Licenses: You can deduct taxes and license fees, such as sewage charges, fire and flood insurance premiums, and real estate taxes.
- Rent Expense: This deduction is available for rental property owners who rent out their homes to vacationers for fewer than 15 days per year. You can deduct the total amount of rent you receive from your gross income.
- Depreciation of Rental Property: As an investor, you can write off the depreciation of your property every year.
- Utilities: You can deduct the cost of water, electricity, and any other utilities that may be required for your rental property.
- Insurance Premiums on Your Rental Property: If there are any premiums for insurance protection on your rental property, such as fire or theft insurance, you can deduct these expenses from your taxable income.
- Mortgage Interest Credit: You may be eligible for a tax credit if you purchased your rental property through a “shared equity mortgage” with the U.S. government or through a nonprofit organization designated by the U.S. Housing and Urban Development Secretary.
Claim Passive Activity Loss Deductions
If you have a rental property and a business, the IRS will expect you to report both income and losses from each activity.
However, suppose you have a rental property with no other business activity. In that case, a special rule applies to passive activities that will allow you to claim passive activity loss deductions for all expenses related to the rental property.
A rental property is considered a “passive activity” if you are not involved in the daily management of the property. If your rental loss exceeds your passive income by $25,000 or less for the year, you will not have to pay taxes on the excess because it is perceived as a loss from a passive activity.
The maximum annual loss you can claim in a year this way is $25,000. If your losses exceed $25,000 for the year, you will have to deduct the excess from the passive income you receive from other rental properties or businesses.
2. Avoid The FICA Tax Despite Being Self-Employed
The FICA (Federal Insurance Contributions Act) tax, is a payroll tax imposed on the earnings of an employee and the employer. Almost everyone has to pay FICA taxes–and self-employed individuals typically have to pay both the employer and the employee amounts. However, this does not apply to rental property investors.
Although you may be a self-employed investor, rental property income is not classified as earned income in most cases. As such, you will not have to pay FICA or payroll taxes on your rental property income.
3. Defer Capital Gains Taxes Owed Via A 1031 Exchange
A 1031 exchange is a tax law that allows you to postpone the income taxes on the profits made when you sell your property.
When you sell your rental property, you can use this law to defer paying taxes on your capital gains by buying another eligible investment property within 180 days of selling the previous one.
The 1031 exchange is helpful if you need to liquidate some properties but don’t want to pay all the taxes at once. This way, you can reduce your taxable income by selling your rental property for cash and using the proceeds to buy another investment property.
Although this law is helpful if you need to sell properties quickly, there are restrictions. For example, the new property must be “similar or related in service or use” to the previous property that you sold.
4. Avoid Capital Gains By Investing In Opportunity Zones
Opportunity zones are large areas of land designated by the U.S. Department of Treasury to foster economic development. These zones tend to be located in more rural areas that are in need of economic development.
The main goal is to encourage long-term investments to help develop these communities. Several tax benefits are available to investors who decide to invest in an opportunity zone.
For instance, if an investor buys a property for $10 million and holds on to it for more than 10 years, they could save $3 million on taxes owed. These incentives are designed to promote long-term investments and help revitalize communities that are economically disadvantaged.
There are approximately 8,700 opportunity zones spread over 22 states. However, the U.S. Department of Treasury is expected to designate more areas in the coming years.
5. Take Advantage Of The Long-Term Capital Gains Tax Rate
There are two types of capital gains tax rates. The first is the short-term capital gains tax rate. If you sell an investment property within a year, then the profits you generate will be taxed like traditional income. Your short-term capital gains could be taxed as high as 39%, depending on your regular income tax rate.
Conversely, if you hold the property for at least a year before you sell, it will be considered a long-term investment. As such, you’ll be taxed at the long-term capital gains tax rate, which is often a lower tax rate. You will be subject to either 0%, 15%, or 20% tax rate, depending on your taxable income.
6. Tax Sheltered Cash Flow
Tax sheltered cash flow refers to the profits you generate from a rental property. As long as you don’t sell your rental property, you only pay tax on the rental income you’re earning–not the value of the property itself.
Although you only have to pay tax on your rental income, you are still able to subtract your expenses. These expenses can include any repair and maintenance costs, management fees, property taxes, mortgage interest, and even travel expenses (as long as they are related to the management of the property).
Additionally, you can write off a part of your rental property purchase price every year as depreciation. With that in mind, the longer you hold the property, the more money you can write off for depreciation, allowing you to save more money on your taxes in the long run.
7. Leverage Pass-Through Deductions
Any business that is not subject to corporate income taxes (such as sole proprietorships and partnerships) are considered “pass-through” businesses. Pass-through entities are also called “passive” entities because landlords are not obliged to pay taxes on their profits. Instead, these owners use the net profits to calculate their personal income tax.
As a result, you’re likely eligible to claim a pass-through deduction. Pass-through deductions are essentially deductions based on the owner’s business income. There are two ways to take advantage of pass-through deductions when it comes to rental property:
1. Landlord Expenses
If you itemize your expenses as a landlord, you can deduct any expenses related to your rental property, including repairs, maintenance, and utilities. Itemized deductions can be used to reduce your taxable income.
If you do not itemize your expenses, these expenses are considered “miscellaneous” deductions and can be subtracted from your adjusted gross income (AGI) instead.
2. Rental Income And Losses
As a landlord, you can also deduct any expenses and losses related to your rental property that aren’t considered normal expenses.
For example, if a tenant is responsible for causing damage to the unit, you can deduct the cost of repairing the damage. If the tenant doesn’t pay rent for the unit, you can also deduct these losses. Landlords are also allowed to deduct interest on loans used for rental purposes.
Tips For Filing Taxes And Claiming Tax Benefits
The following are a few general tips for filing your real estate taxes and claiming any tax benefits you are eligible for:
- Understand the depreciation guidelines: You can only depreciate the value of the building–not the land it is on. Additionally, you can depreciate your rental property 3.636% every year for 27.5 years; however, this amount will be taxed once you sell the property. The IRS calls this tax “depreciation recapture.”
- Keep your property for at least a year: You can save a significant amount of money on your capital gains taxes if you hold your investment property for at least one year.
- Keep records: Keep records of all expenses related to your investment property. These expenses include travel costs. If you drove to your property to speak with a tenant, you can write off the cost of gas that was used. If you took a taxi, you could write off the cab fare.
Keep every single record related to your property you have so that you can deduct all your expenses and reduce your taxable income. - Write off management and maintenance costs: These costs include property taxes, insurance, mortgage interest, repair costs, property maintenance costs, and property management costs.
- Write off marketing costs: The cost of marketing a property, whether you’re advertising it to sell or to rent, can be written off as an expense.
- Write off legal fees: If you have to commission a lawyer to take legal action against a tenant, you can write off any associated legal fees, including attorney fees and court fees.
- Liaise with a financial advisor: A financial advisor can help you develop a long-term tax strategy so that you know how to prepare for your real estate investment taxes and so you can take advantage of as many tax benefits as possible.
Learn Your State’s Regulations
As a landlord, it is prudent to be aware of the real estate regulations in your state. The information may help you find more tax incentives that you can leverage if you rent property within that state.
For example, many states offer different property tax exemptions for property owners. Some states also have specific rental property deductions or carry-over losses for landlords who rent out their properties.
There are also certain states with “safe harbor” laws that protect landlords against certain tenant-caused damages, which could lower your taxable income as a landlord at the end of the financial year.
Get Resources To Manage And Grow Your Business
If you are a rental property owner, there are many different tax benefits you can take advantage of to reduce your taxable income. As a landlord, you should take the time to research specific tax benefits for the state in which you have a rental investment property.
By knowing more about the federal and state laws that pertain to your investment, you can find ways to lower your taxable income and benefit from different deductions related to your property.
With these strategies in mind, you can get more out of your investments as a landlord.
At Pine Financial Group, we can provide you with resources to help you learn more about the advantages of managing and growing your rental property business.