US Tax Law is most friendly to Two Groups of people, Rental Property Owners & Small Business Owners. In this article we will discuss “Biggest Tax Advantages of Rental Property.” Many Real estate owners & investors wisely use rental property to reduce taxes.
These Tax Deductions apply whether you own One Rental or Multiple Rental Properties. These Tax strategies for real estate investors helps Landlords as well as Real Estate Investors who simply buy fix, Hold and then Flip.
Tax Benefits of Owning Rental Property
- Main tax benefits of owning rental property include reducing or eliminating taxable income by offsetting Rental Income with deductions such as operating expenses & depreciation
- Avoiding Self Employment Tax, FICA(Social Security & Medicare) Taxes
- Ability to Defer Capital gains tax and depreciation recapture tax when Landlord or Real Estate investor conducts a 1031 tax deferred exchange.
- Step Up Basis when Real Estate Properties are Passed from one generation to Another.
- Tax Benefits can only be maximized if you keep good records and a paper trail for each Rental Real Estate Property.
What is considered Rental Income?
Your Rental Income includes the monthly Rents you receive from your Tenants as well as any advance rents paid by the tenants. If a tenant pays you security deposit its typically not taxable but It may be considered rent if it is used to pay for final months rent or unpaid rent.
Reimbursed Expenses paid by Tenant such as repairs, are required to be included in the total Gross Rent and any expenses you reimbursed will go into expenses on your tax return.
If a Tenant pays you Parking Fees or you have laundry machines and receive income from them, that is also considered taxable Income.
Some Landlords in California Rent their California Basements to earn extra rent. This is also considered taxable income.
Rental Real Estate Expense List
We have compiled a comprehensive list of rental expenses that are tax deductible against rental income.
- Mortgage Interest: You are allowed to deduct mortgage interest you pay for purchasing or improving the rental property.
- Advertising & Marketing: These expenses Include advertising expenses such as online advertising, yard signs, Post Cards and other News Paper Ads.
- Repair & Maintenance: This includes regular maintenance and Repairs such as Electrical work, painting, plumbing, cleaning, Yard maintenance & landscaping, and pest services such as Terminix are all tax deductible.
- Travel and Vehicle Expenses: If you travel to your rental property to Oversee repairs, maintenance, Construction, equipment delivery, repairs, or for another reason, your travel and vehicle expenses are also deductible.
- Depreciation: Normal depreciation of your property is also tax deductible as an expense for your rental. And you can also claim depreciation deductions for the value of improvements you make to the property such as a new roof, furniture, or new appliances.
- Residential Rental(4 Units or Less) Can be depreciated over 27 Years
- Commercial Rental 39 Year Depreciation
- Land Cannot be depreciated
- Leasehold Improvements Typically 15 Years
- Equipment Typically 5 to 7 Years
- Furniture Fixtures Typically 7 years.
- Taxes & Licenses: If you pay any taxes or licenses to County, City
- Home Owners Association(HOA) If your rental property is a condo or single family home that falls under a Home Owners Association, you can deduct your HOA Dues.
- Property Management: If you pay for property manager to manage your rental property you are allowed to deduct the fee you pay them for managing and renting your property.
- Utilities: You are allowed to deduct any utilities you pay such as Electricity, Water & Garbage
- Professional Fees Such as Accountant and Attorney Fees are fully deductible as long as it pertains to your rental property. For example cost real estate attorney for drafting lease or eviction cost
- Escrow & Closing Costs: If you pay any closing costs when you buy the property or you refinance, you are allowed to Amortize the closing costs typically over the Loan period.
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Save Self Employment Taxes & FICA (Social Security & Medicare)
Rental Income is subject to Income taxes but it is not subject to Self employment or FICA(Social Security & Medicare Taxes).
This is huge benefit for Rental Property Owners. If you Employed as an Employee of a Company and earn wages you have to pay Social Security Taxes(6.2%) and Medicare Taxes(1.45%), You don’t have to pay this on the income you earn from Rental Properties. This can add up to thousands of dollars over time.
Taxpayers who are self-employed are normally required to pay the employer and employee portion of Social Security and Medicare taxes, also known as FICA or payroll tax. Since they are paying both sides they have to pay 15.3% total Self Employment tax
For example, if the taxpayer owns a business and receives $100,000 in earned annual income, the payroll tax would be 15.3 percent or $15,300. On the other hand, if the same $100,000 was income generated from rental properties, there would be no FICA or Self Employment tax due.
Self employed taxpayers can work hard and replace their earned income with rental income overtime resulting in huge tax savings.
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Deferring Capital Gains Tax
Another tax benefit of owning a rental property is the ability to defer paying capital gains tax and regular income tax on depreciation recapture by conducting a Section 1031 Tax deferred exchange.
Normally, when a rental property is sold, the depreciation expense is recaptured and taxed as ordinary income to an investor, up to a maximum rate of 25 percent (depending on the investor’s federal income tax bracket).
In addition to paying tax on depreciation recapture, an investor also pays a Short term or long term capital gains tax on the sale of the property.
By Strategically using a 1031 exchange, instead of paying taxes, a real estate owner/investor can put the money to use by rolling the gains into another rental property or Real Estate Investment Property.
1031 Rules tend to be very complex. We highly recommend you seek advice of a Tax Professional such as a CPA, EA or a tax attorney.
Step Up Basis
Instead of selling rental property, some investors keep their portfolio and draw rental income until eventually passing the property to their heirs.
IRC §1014 provides that the basis of property acquired from a decedent is its fair market value at the date of death, so there is usually little or no gain to account for if the sale occurs soon after the date of death. Learn more about Step up Basis
In other words, when a property is inherited, the cost basis is stepped up to the current market value of the property, and any outstanding capital gains tax and depreciation recapture tax liability is eliminated for the heir.
How to Claim Rental Property Tax Deductions?
In general, you should file rental property tax deductions the same year you received the rental income and pay the expenses using a Schedule E on Form 1040.
If you hold property under a Partnership/LLC(1065) you will file for 8825 and claim income and expenses.
What Records Should I Keep for your Rental Real Estate?
In order to satisfy IRS Requirements, Keep copy of your Lease agreements, Bank Statements, Credit Card Statements, Copy of Invoices for Repairs, Maintenance, Attorney fee and so on.
Also keep copy of your Escrow Final Closing Statement that show how much you purchased the property for and any closing costs associated with the closing.
If you do any cost segregation to speed up the depreciation or any appraisals, keep those as well. You may be required to produce those in case of an Audit.
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Rental Income Tax Rate
Rental Income is treated a Regular Income and Regular Income Tax Rate Applies. In General Rental Income is treated as passive income.
For Example: You will pay regular income tax Rate on Income you receive after offsetting any expenses, Mortgage interest, Property Tax and Depreciation. So, if you are in 24% tax bracket for federal you will pay 24% on any taxable income from Rental Real Estate properties.
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