Do you own real estate that you rent out? Besides the potential for regular income and capital growth, real estate investments offer deductions that can reduce the income tax on your profits.
But first, consider what kind of real estate investor you are. Are you a passive investor or a real estate professional? Your classification as one or the other makes a big difference in the number of tax breaks that you get.
Passive Investor vs. Professional
If you spend most of your work hours in the real estate business as a real estate professional, then your rental losses are not passive. This means that your losses are fully deductible against all income, passive or nonpassive.
- Repairs to your property are deductible. Improvements are depreciable.
- Mortgage interest is sometimes deductible. Principal payments are not.
- Insurance, lawn care, and local taxes are deductible.
If it’s a sideline investment, then your losses are passive and may be deductible up to $25,000 against the income from your rentals. The deduction phases out if your modified adjusted gross income (MAGI) is between $100,000 and $150,000. Losses of more than $25,000 can be carried over to the following year.
The Internal Revenue Service (IRS) defines a real estate professional as someone who spends more than half of his or her working hours in the rental business. This may include property development, construction, acquisition, and management. You must also spend more than 750 hours per year working on your real estate rental properties to qualify as a professional.
Common Income Sources
The money that you receive for rent is generally considered taxable in the year when you receive it, not when it was due or earned. This means that any advance payments must be treated as income.
For example, suppose you rent out a house for $1,000 per month and you require that new tenants pay the first and last months’ rent when they sign a lease. In this case, you’ll have to declare the $2,000 you received as income, even though $1,000 of that $2,000 covers a period that might be several years in the future.
Expenses that your tenant pays for you are considered income. This would include, for instance, an emergency repair on a refrigerator that a tenant has to have done while you are out of town. You can then deduct the repair payment as a rental expense.
Trade for Services
Your tenant might offer to trade services in exchange for rent. You must include a fair market value of the services as income. As an example, if your tenant offers to paint the rental house in exchange for one month’s rent (valued at $1,000), then you must include the $1,000 as income even though you didn’t receive the cash. However, you will be able to deduct the $1,000 as an expense.
Security deposits are not taxable when you receive them if the intent is to return this money to the tenant at the end of the lease. But what if your tenant does not live up to the lease terms?
For example, suppose that you collect a $500 security deposit and your tenant moves out and leaves holes in the walls that cost $400 to repair. You can deduct that amount from the security deposit during the year when you return it. At that time, though, you must include the $400 that you used to repair the wall as income. You also will be able to show the $400 as a deductible expense.
Repairs vs. Improvements
Rental property owners may assume that anything they do on their property is a deductible expense. Not so, according to the IRS.
Expenses of obtaining a mortgage, like fees and appraisals, are not deductible.
A repair keeps your rental property in good condition and is a deductible expense in the year when you pay for it. Repairs include painting, fixing a broken toilet, and replacing a faulty light switch. Improvements, on the other hand, add value to your property and are not deductible when you pay for them. You must recover the cost of improvements by depreciating the expense over your property’s life expectancy. Improvements might include a new roof, patio, or garage.
From a tax standpoint, you should make repairs as problems arise instead of waiting until they multiply and require renovations.
Mortgage Expenses: Expenses to obtain a mortgage are not deductible when you pay them. These include commissions and appraisals.
Once you start making mortgage payments, not all of the payment is deductible. Since part of each payment goes toward paying down the principal, this amount is not a deductible expense. The portion paid toward interest is deductible.
Your mortgage company will send you an IRS Form 1098 each year that shows how much you’ve paid in interest throughout the year. This is deductible. Also, if part of your payment includes money that goes into an escrow account to cover taxes and insurance, then your mortgage company should report that to you as well.
Home mortgage interest is reported on Schedule A of the 1040 tax form. Mortgage interest paid on rental properties that is deductible is reported on Schedule E.
The Tax Cuts and Jobs Act (TCJA), passed in 2017, reduced the maximum mortgage principal eligible for the deductible interest to $750,000 (from $1 million) for new loans. The TCJA also nearly doubled the standard deduction, making it unnecessary for many taxpayers to itemize.
Travel Expenses: Money that you spend on travel to collect rent or maintain your rental property is deductible. However, if the purpose of the trip was for improvements, then you must recover that expense as part of the improvement and its depreciation.
You have two choices on how to deduct travel expenses: the actual expenses, or the standard mileage rate. The latest details about the IRS’s requirements and current mileage allowance are in IRS Publication 463.
Other Common Expenses: In addition to repairs and depreciation, some of the other common expenses that you may be able to deduct are:
- Lawn care
- Tax return preparation fees
- Losses from casualties (hurricane, earthquake, flood, etc.) or thefts
Condominiums and Cooperatives
If you own a rental condominium or cooperative, each has some special rules.
Condominiums: If the rental is a condominium, then you probably pay dues or assessments to take care of commonly owned property. This includes the building structure, lobbies, elevators, and recreational areas.
When you rent out your condominium, you can deduct expenses, such as depreciation, repairs, interest, and taxes that relate to this common property.
However, just as with a single-family rental, you cannot deduct money spent on capital improvements, such as an assessment for a cabana at the clubhouse. Instead, you must depreciate your cost of any improvement over its life expectancy.
Cooperatives: Expenses for a cooperative apartment that you rent out are deductible. This includes the maintenance fees paid to the cooperative housing corporation.
Capital improvements are treated differently. You cannot deduct the cost of the improvement, nor can you depreciate it. You must add the cost of the improvement to your cost basis in the corporation’s stock. This will reduce your capital gain when you sell the apartment.
Keep Good Records
Under the IRS's Schedule E, there are spaces for miscellaneous categories of expenses. That gives you flexibility in the items that you can deduct.
But be prepared to back up your claim and to break out expenses that are for repairs and maintenance from those that are capital improvements. Remember, the money you spend on improvements could reduce your tax liability when you sell.
In addition, if you claim to be a real estate professional, then you should keep supporting documentation (like appointment books, diaries, calendars, and logs) to prove your active participation and the time spent on your properties each year.
The Bottom Line
All in all, there are quite a few deductions available to real estate investors, and it pays to know which ones you qualify for.