Happy Tax Day! Are you looking for deductions, tax shelters, tax havens, any kind of tax relief? I certainly am….
Guess what? Rental properties are ripe with tax deductions to help relieve you of your annual tax burden. I am not an accountant but I do have my favorite deductions which provide low-hanging fruit-rationale for considering a rental property investment. My top five tax deductions are:
Your rental home, condo, or apartment building cannot be written off all in the year you purchased it; the IRS considers it to be long-term property. Technically, any item that lasts more than one year is considered to be a capital asset and therefore, long-term property. Examples of this are everywhere in a property: the building itself, the roof, the carpet, refrigerator, and on and on. Because these capital assets last more than one year, they are subject to depreciation, which is a process of writing off the asset every year over the general useful life of that particular asset. It is not complicated, but honestly, this can get pretty in-depth depending on how far you or your account might be willing to take it.
Depreciation starts with the property’s basis (what it’s worth today) and an IRS-mandated recovery period for the capital asset. For a building or home, the recovery period is 27.5 years and for capital assets, such as refrigerators, carpet, or roofs, the recovery period can vary from 5-27.5 years. So, in its simplest form, if the value of the building (not the land value) is $100,000 then every year, for the next 27 years, you can depreciate $3,636.36 ($100,000/27.5 years). Let’s say your rental home needs a new refrigerator. Generally (using the general method in accounting parlance), you can depreciate that refrigerator over 5 years. So your $500 refrigerator can be depreciated annually for $100 over the next five years ($500/5 years). Therefore, you are now depreciating $3,736.36 because of the building’s plus the refrigerator’s depreciation.
The rub to depreciation is called recapture. What you depreciate today needs to be recaptured by the IRS when you sell. So, using the example above, if you own the rental home for ten years and have depreciated $3,636.36 every year (let’s forget about the refrigerator or any other capital assets), then you have depreciated a total of $36,3636.00. If you purchased the rental home in 2005 for $150,000 and you sell it in 2015 for $250,000, you think you have $100,000 of profit that should be taxable. Not so fast……because of the depreciation you applied during those ten years, your taxable amount is now $136,363 because you sold for a $100,000 profit and you must recapture the $36,363. Recapture only exists for capital assets that have been following a depreciation schedule.
As you can see above, this can get quite hairy. It’s probably best you hire a solid accountant to help you manage and keep track of the complicated depreciation schedules that accrue. Regardless of the perceived complexity, it all adds up and provides a nice tax benefit for property ownership.
This is a big one – probably your biggest deduction. Basically, you can deduct any interest paid that you or your business accrues from 1) the purchase of a property through a personal loan or mortgage, 2) property improvements made from a personal loan or mortgage, or even 3) any general business services or products pertaining to your rental business, even if paid for with a credit card.
This is easier to calculate than depreciation but may require more documentation to back it up. Mortgage companies will provide you with a Form 1098 which will show how much interest was paid during a particular year. It is important to note that the principal payments do not qualify to be deducted – only the interest portion can be deducted. Instead, the principal amount typically gets added to the property’s basis. For example, if you were getting a $20,000 second loan to pay for a kitchen renovation, then the $20,000 would add to the property’s basis and follow it’s respective deprecation schedule, but any interest payments made during the life of the $20,000 loan can be deducted.
Again, it all adds up and interest is usually the largest deduction for most property owners.
Your home or building will require repairs and maintenance, all of which is deductible. This can be anything from a plumbing bill for a leaky sink to weekly lawn maintenance. The only place this gets tricky is when you add a capital asset to the repair, assuming you replace the faucet to repair the leak. The faucet can be put on a depreciation schedule while the general repair can be deducted.
Any travel activity pertaining to your rental business can be deducted – normally trips to your property or to the hardware store, etc. The deduction for this kind of local travel falls into one of two methods (not both!):
- Depreciating your vehicle and expensing gas, repairs, etc. This generally works well for “company cars” that are used primarily for the purposes of supporting your rental business. Depreciation schedules vary based on the type of car, SUV, or truck you buy, so it’s worth looking into it for your particular vehicle.
- Deducting mileage based on today’s standard mileage rate. This works well when you use your personal vehicle for the purposes of supporting your rental business. The mileage from any trips to your property, the hardware store, etc get added up and applied to the current mileage rate for reimbursement to you from the company; then, that reimbursement gets applied as a deductible expense.
Long distance travel that applies to your rental business also applies, including airfare, meals, hotels, car rentals, etc. It is very important that you document every receipt and every mile during your travel for your records. I highly recommend a simple application called Expensify to help manage all receipts digitally – I never deal with paper receipts…..ever.
If you have an office at your home and meet certain IRS requirements, you can deduct a certain portion of your home’s expenses for your home office. In my honest opinion, this one gets complicated and it further complicates things if you also own your personal home and are looking to take advantage of your capital gain benefits from your personal home. If you deduct your home office, you erode your cost basis on your personal home and may get you outside of your capital gain tax-free benefit. Again, talk with your accountant about this one.
Tax benefits are a great reason to invest in real estate and hopefully these five deductions can help you consider an investment property as you consider you next tax day.