Rental property ownership is an excellent means of earning passive income, but it does result in taxes. Thankfully, the U.S. tax code offers many incentives that enable rental property owners to lower their taxable income and retain more of their profits. Knowing these tax-saving methods can enable landlords to maximize their returns while remaining within IRS guidelines. From depreciation and deductions to business structuring and 1031 exchanges, here's how rental property owners can maximize tax benefits.
Knowing Rental Income and Tax Requirements
Rental income is any payment made by tenants, such as monthly rent, advance rent, cancellation fees for breaking a lease, and services rendered in place of rent. Rental income is treated as taxable income by the IRS, and landlords are required to report it on their tax return. Not all money received, however, is taxable—security deposits, for example, are not income unless kept. Knowing what is considered taxable rental income and what can be deducted is the first step in reducing tax liability.
Best Tax Deductions for Rental Property Owners
One of the greatest benefits of rental property ownership is being able to write off many costs of owning and operating the property. Some of the most significant deductions are:
- Mortgage Interest: A mortgage interest payment on a rental property is entirely deductible.
- Property Taxes: Property taxes paid at the state and local level are deductible.
- Depreciation: Landlords are permitted by the IRS to depreciate the value of their property over a period of 27.5 years, lowering taxable income.
- Repairs and Maintenance: Costs associated with required repairs, including repairing plumbing or painting walls, can be entirely deducted.
- Utilities and Operating Expenses: If the landlord is responsible for utilities, HOA fees, or property management, these expenses are deductible.
The Benefits of Depreciation
Depreciation is a tax power that enables landlords to write off the slow deterioration of their rental property. Although land can't be depreciated, the IRS does allow owners to depreciate the building and some property improvements over the years. For instance, if a rental house is worth $275,000 (not including land), the yearly depreciation deduction would be $10,000 ($275,000 ÷ 27.5 years). Depreciation claim decreases taxable income regardless of whether the value of property is increasing in the real estate market.
Pass-Through Deduction for Rental Income
The Qualified Business Income (QBI) deduction, or pass-through deduction, enables qualified rental property owners to take a deduction of up to 20% of the net rental income. To be qualified, rental activity should qualify as a trade or business, which entails continuous and regular efforts in managing properties. Keeping proper records and being active in managing properties can assist landlords in claiming such a beneficial deduction.
How to Deduct Travel and Home Office Expenses
Landlords will sometimes visit and leave their rental properties for repairs, inspections, and meetings with tenants. The IRS permits deductions for travel expenses such as mileage, flight, accommodations, and meals related to property management. Also, landlords who work from home and have a designated area for running their rental business can claim the home office deduction, which permits them to deduct part of their rent, utilities, and internet charges.
Utilizing 1031 Exchanges to Postpone Capital Gains Tax
A 1031 exchange is a tax-deferred tactic used by owners of rental properties to sell an investment property and invest the proceeds in a replacement property of similar type without capital gains tax imposition at sale. To be qualified, the replacement property must be identified within 45 days and acquired within 180 days. The tactic permits investors to increase their real estate holdings without being subject to tax right away.
Organizing Your Rental Business for Tax Efficiency
The way a rental business is organized can have a major impact on tax burden. Most landlords opt to organize under an LLC (Limited Liability Company) for liability protection and possible tax benefits. An LLC does not have direct tax benefits but can make record-keeping easier and provide legal protection. Investors with multiple investments can consider incorporating an S-Corp if they actively manage their investments and are looking to cut self-employment taxes. Individual circumstances should be determined by speaking with a tax professional.
Garden Variety Tax Blunders Property Owners Should Try to Avoid
Even seasoned investors can commit tax blunders at a high expense. Some regular errors include:
- Not Keeping Timely Records: Inadequate record-keeping can result in lost deductions as well as the attention of the IRS.
- Misclassifying Repairs vs. Improvements: Repairs are tax-deductible in the year they are incurred, whereas improvements have to be depreciated over time.
- Ignoring State and Local Tax Implications: States have different tax rules for rental properties.
- Missing Out on Deductions Due to Poor Documentation: Landlords need to keep receipts, invoices, and detailed records to support deductions.
Conclusion
Optimizing tax savings as an owner of rental property involves careful planning and detailed knowledge of the tax code. By leveraging deductions, depreciation, the QBI deduction, and 1031 exchanges, landlords can minimize their tax burden. And by structuring a rental business correctly and avoiding popular tax errors, long-term fiscal success is achievable. Remaining current on shifting tax legislation and using a tax expert can further boost profitability and savings in the rental business.
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