Owning real estate has tremendous benefits and can be a great source of acquiring wealth. Additionally, there are numerous tax related deductions that investors can utilize to significantly reduce their taxable income helping to improve their cash flow.
While the 2021 tax deadline has come and gone it is never too early to start thinking about 2022 and ensuring all of your rental properties are being evaluated to maximize the tax deductions.
In this article we lay out some of the more common tax deductions investors have access to, as well as some that are less well known!
Tax Benefits of Owning Investment Properties
Understanding depreciation and how it can help reduce your overall tax burden is one of the more important tax benefits to know and understand. The IRS allows you to deduct taxable income due to the reduction in the value of property over time due to typically wear from use.
For residential properties, the IRS allows you to spread the deduction over a period of 27.5 years. It is important to know that the value of the land is not consider when calculating the depreciation deduction, only the value of the property. As an example, a property valued at $250,000 with the land value of $30,000, the cost of the property used for depreciation is $220,000. If you’ve made any modifications or improvements on the property those can likely be included in the cost basis. If we added a bedroom for $10,000 our new cost basis would be $230,000. This would lead to an annual depreciation deduction of about $8,363 ($230,000 / 27.5 years).
Taxes and Insurance
Most taxes amassed as a result of owning rental property are deductible. Certain examples would include property taxes, land taxes or possibly school district taxes. Compared to your primary residency, there are no limits on the amount of property tax expenses that can be deducted when the property is held as a rental.
When looking at insurance premiums paid for owning investment properties, homeowners’ insurance as well as mortgage insurance are tax deductible according to the IRS. As long as the deduction occurs in the year they are paid – any prepayments will not be tax deductible.
Repairs and Maintenance
Often termed “operating expenses”, repairs and maintenance are costs incurred to maintain the investment property. It’s important to know the distinction the IRS sets forth when trying to use as a tax deduction: “incidental repairs to their property used in carrying on any trade.” Essentially, the repair and maintenance of ordinary wear and tear seen with rental properties is deductible but if theses repairs are used for capital improvements, they would not be tax deductible and must be filled in different fashion.
Mortgage interest is the interest paid on the loan used to purchase the rental property. While most understand a higher your interest rate (APR) equates to higher interest payments what may not be as common knowledge is the more interest paid, the larger the deduction can be.
In 2017, the Tax Cuts and Jobs Act (TCJA) reduced the mortgage deduction limit as well as putting a limit on home equity loans. After the TCJA, homeowners can only deduct mortgage interest paid on home loans up to $750,000 (previously $1 million).
A home equity loan is a specific loan that allows an individual to borrow money from the current equity in their primary residence. To utilize the interest paid on a home equity loan as a tax deduction, the loan must be used to buy, build or “substantially improve” one’s home. Outside of these specific cases, the interest would not qualify as being tax deductible.
Understanding the value and utility of 1031 exchanges is an important tool that investors have to help them grow their portfolio and obtain wealth from real estate investing. The specifics of 1031 exchanges are beyond the scope of this discussion but we briefly highlight the tax implications.
In short, a 1031 exchange allows an investor to sell their rental property and use the proceeds to purchase another “like-kind” rental/investment property. To qualify, investors must follow strict guidelines which should be completed under the advisement of a professional.
With the sale of a rental property, homeowners are required to pay capital gains tax and depreciation recapture. To avoid paying the depreciation recapture, taxed at a rate up to 25%, as well as capital gains, taxed at a rate of 15-20%, at the time of the sale, many investors will delay these taxes by performing a 1031 exchange.
The beauty of the 1031 exchange, is investors can avoid the large taxes incurred at the time of sale of rental property and use more capital to purchase a new property or properties. Having more of the proceeds will allow them to increase the size of their portfolio at a much quicker rate!
Furthering one’s knowledge and understanding to help grow their skills is an essential component of becoming a successful real estate investor. There are also tax deductions available if the educational expenses are used for the purpose of maintaining or improving the skills necessary for your rental property business.
There is a clear distinction that the deduction can only occur after you have started your rental property business. They cannot be deducted if you have yet to purchase or put a property into service. Also, if it is a new skill set the cost for attending a course or training is generally not deductible.
If you were to attend a training program designed for growing your business through 1031 exchanges then you could deduct the cost of the program as well as all travel related costs!
This could also fall under “operational expenses”. Owning your business requires the help of team to support and help you grow. Key people might include property managers, accountants, and legal personnel. Fees incurred for their services are fully deductive if they are related to rental properties.
The expenses related to traveling as related to rental properties are another deduction real estate investors are entitled to. In order to qualify, the IRS lays out guidelines that you must meet. Most notably the trip must be for business reasons as well as being ordinary and necessary.
Meeting the guidelines will allow investors to expense most of the related travel expenses including vehicle expense, airfare, lodging and meals.
Home Office Fees
Utilizing your home as an office can provide additional tax benefits. As with many details discussed thus far, understanding the requirements is important to ensure you qualify for the deduction.
First, to qualify for what the IRS calls “business use of your home” the term “home” must provide basic living accommodations. Additional requirements needed to be considered a home office and receive the deduction include:
- Regular Use – Is there a designated place in your home to conduct business?
- Trade or Business Use – Are the activities performed in this area related to an established trade or business?
- Principal Place of Business – Is your home the primary workplace for conducting activities related to your business?
Once you deem you qualify for the deduction, most of the home expenses could be included as part of the deduction.
Become a Real Estate Professional
For more savvy real estate investors, becoming a real estate professional can provide even more tax benefits. This status might not be for everyone as there are certain requirements that need to be accounted for including the number of hours dedicated to real estate as well as percentage of time doing real estate business during a given year. However, qualifying will allow passive losses to be deductible which can be very helpful in lowering your tax liability!
Putting It Together
Taxes can become daunting as you add more and more properties to your portfolio and when you create a real estate business. It is important to work with a tax professional to ensure that you are receiving all the tax deductions you are entitled to. Additionally, many have strict guidelines must be followed to receive tax deductions and a tax professional will know how to ensure these are met.
Understanding the tax deductions associated with rental properties is an essential asset to growing your rental portfolio. The lower you can make your taxable income the more money it can save you which can then be used to buy more rental properties!