Like any other business or investment, rental property investors want to make a profit. In general, to maximize profits, real estate investors need to increase annual income, reduce annual expenses, or both.
Since taxes are a significant part of the cost of ownership, reducing expenses includes reducing tax liabilities. Rental properties have unique tax advantages that allow you to reduce certain expenses and defer certain IRS-allowable taxes.
Keep reading to learn what those tax advantages are and whether they apply to you.
The Short Version
- Rental income is any payment you receive for the use and occupancy of your rental property.
- Rental expenses are ordinary and necessary expenses for managing, conserving and maintaining your rental property.
- Good records are necessary to accurately analyze your ROI, properly maintain your property and file your taxes. If you are audited and cannot provide support for reported expanses, you may be subject to additional taxes and penalties.
- Property improvement costs are not considered deductible rental expenses but are recovered through depreciation.
What Is Rental Income?
When people think of rental income, they think of the monthly rent payments made to you by your tenant. The IRS defines rental income as “any payment received for the use and occupancy of property”. Often, that includes income on top of monthly rent payments.
Here is a list of additional income that you must report, as detailed in IRS Publication 527:
- Tenant application fee. Many landlords charge potential tenants a fee to submit the initial rental application for review and approval.
- Lease cancelation fee. If your tenant pays you to cancel a lease, you must report that income.
- Property or services received instead of rent. If your tenant is a handy do-it-yourselfer and you agree to forgo a month or two of rent payments to compensate him for doing home improvements (painting for example), you must claim the amount of rent you would have received as rental income.
- Expenses paid by the tenant on your behalf. For example, many counties will only put the water/sewer bill in the name of the owner, not tenants. If you receive reimbursement from the tenant for usage, that’s rental income.
- Laundry and other service fees collected for the use of facility amenities. The revenue that’s generated by ancillary services provided on site is rental income.
- A security deposit is generally not considered rental income. Rather, it is money you receive and set aside in escrow during the terms of the lease. You eventually return this money to your tenant. If you earned interest on the security deposit while you hold it, then that interest is taxable rental income. If you keep part, or all, of the security deposit for repairs, the amount you keep is rental income (and the cost of repairs is a rental expense). And, if the security deposit is used as a final rent payment, it is considered advance rent and must be claimed as income.
Which Rental Property Tax Deductions Can You Take?
If you receive rental income from the rental of a dwelling unit, there are certain rental expenses you may deduct on your tax return.
As defined by the IRS, you can deduct the “ordinary and necessary expenses for managing, conserving and maintaining your rental property”. Ordinary expenses are those that are common and generally accepted in the business. Necessary expenses are those that are deemed appropriate, such the costs of certain materials, supplies, repairs, and maintenance that you make to your rental property to keep your property in good operating condition.
The most common deductible rental expenses include:
- Advertising. The cost of listing and marketing your property for rent.
- Auto and travel expenses. Only for the purpose of maintaining the property and collecting rent.
- Cleaning between tenants. While cleaning can be costly, is a deductible expense. I have the carpets professionally cleaned between tenants on all my properties and it runs a few hundred dollars on my largest rental.
- Depreciation. The IRS recognizes that real property depreciates over time so you are entitled to deduct depreciation annually. IRS regulations require rental property investors to recapture annual depreciation when you sell the property regardless of whether or not you used the annual depreciation benefit. So be sure you allocate a depreciation loss each year.
- Legal and other professional fees. Attorney fees, real estate commissions, and some closing costs like settlement company fees are deductible expenses.
- Mortgage interest paid on your loan. Therein lies one of the biggest benefits of rental property investor—leverage. Leverage is the use of borrowed capital to purchase and/or increase the potential return on investment. With an initial investment of $30,000 (20% down), you get the opportunity to get all the benefits of owning an asset worth $150,000. And since your mortgage payment is a deductible expense, your tenant essentially pays your mortgage for you.
- Lender fees. Loan origination points and other costs of securing the mortgage are deductible expenses.
- Maintenance and repair expenses. Expenses directly related to property upkeep and maintenance are deductible expenses, as are repairs you need to make to keep the property in rentable condition. If you pay premiums for a service company on call to fix major appliances (HVAC service warranty contract, for example), that is a maintenance expense.
Tip: Don’t confuse maintenance and repairs with home improvements. You handle the two differently for tax purposes. While expenses offset income in the year they happen, improvements are not direct expenses. Rather, you can “recover” some or all of the costs of improvements by using Form 4562.
- Utility costs and other fees paid by you as owner. If you pay for water, sewer, trash removal or other expenses associated with property ownership, these are tax deductible.
- Property taxes. This is an obvious cost of ownership that is deductible.
- Insurance. As a landlord/property owner, you need to carry homeowner’s insurance to protect your investment. The annual premium is a cost of ownership and therefore an expense that you can deduct on your tax return.
Tip: Require your tenant to get renter’s insurance to cover their personal belongings. Your homeowner’s insurance will not cover their items in the event of loss and most tenants don’t realize this. Getting their own policy is crucial.
- Property management fees. Property managers typically charge 8-10%. For that fee, they screen and place tenants, provide financial accounting statements and manage maintenance requests and repairs. Their fee is 100% deductible as a property ownership expense.
- HOA and or condo fees. This includes annual or semi-annual recreation fees that are sometimes levied if there’s a community pool associated with owning the property.
- 1031 Exchange fees. If you sell a property and reinvest the proceeds in another like-kind property, you might benefit from a 1031 Exchange. The fees involved are deductible as a real estate expense if you follow all the rules and successfully complete the exchange. You may not deduct the cost of improvements to your rental property as annual expenses unless the amount paid is for a “betterment, restoration or adaptation to a new or different use.” Generally, you can recover the cost of improvements through depreciation, not by claiming it as an expense.
Important Tax Forms and Publications for Rental Property Owners
These IRS Publications can help you understand what you need to claim as income and what expenses can be legally deducted on your tax return. And there are specific forms for reporting rental income and expenses.
The relevant forms and publications are:
- IRS Publication 527 provides the details for rental property accounting.
- Schedule E (Form 1040) is used to report income and expenses from rental real estate. If you have more than one rental property, complete Schedule E forms to document each property.
- Publication 925, Passive Activity and At-Risk Rules. If your rental expenses exceed your rental income, the IRS may allow you to claim that loss as a deduction. Stipulations in the Passive Activity Loss Limitations (Form 8592) and At-Risk Limitations (Form 6198) may limit the amount of loss you can deduct.
- Schedule A (1040) addresses real estate the rules for personal use of a dwelling you rent.
- Net investment income tax may apply to net rental income. Use Form 8960, Net Investment Income Tax Individuals, Estates and Trusts, to determine the amount of this tax.
- IRS Publication 946, How to Depreciate Property explains the ins and outs of property depreciation. You must take annual depreciation and are required to recapture depreciation when you sell the property.
- Form 4562 allows you to recover some or all of your property improvements beginning in the year your rental property is first placed in service and beginning in any year you make an improvement or add furnishings.
- To deduct travel expenses which you incur for rental property repairs, you must follow the rules detailed in chapter 5 of Publication 463, Travel, Entertainment, Gift and Car Expenses.
Many of the most popular tax software companies can help you fill out these forms, but you may need to upgrade to a paid version of their products. With TurboTax, for example, you'll need to sign up for “Premier” in order to maximize your rental property tax deductions. And with H&R Block, you'll need to choose the “Premium” version.
Read more >>> How to Invest in Single-family Rental Homes
The Bottom Line
Whether you're using tax software to prepare your own annual tax returns or you hire a professional, we cannot stress enough how crucial it is crucial to keep good records documenting all rental income and expenses related to each property you own.
In addition to helping you file your taxes, good records help you monitor the progress of your rental property. They are necessary for you to accurately analyze your ROI so that you can maximize income and reduce expenses.
You must be able to substantiate expenses to deduct them. That means you must have documentary evidence such as receipts, canceled checks or bills to support all expenses. The IRS audits you and if you can't provide support for items you reported on your tax returns, you may be subject to additional taxes and penalties.
Please note that while I own and manage a portfolio of rental properties, I am not a tax accountant and tax laws are constantly changing, so be sure to consult a qualified tax expert and review the IRS rules yourself to assure compliance with the IRS statutes when you file your taxes.
- Tax-Loss Harvesting Guide: Capitalize on Your Investment Losses
- 9 Ways to Reduce Your Taxable Income in 2022
- Long-Term vs. Short-Term Capital Gains Tax