Your guide to rental property tax deductions
Owning rental property can be a great way to generate regular income, but what about tax deductions? Here’s what you need to know.
When you own real estate that you rent out, the potential for both regular income and capital growth can make it a sound investment. But there’s more good news. Real estate investments offer tax deductions that can reduce the income tax on your profits.
What is rental income?
If you own real estate, any rental income must be reported on your tax return. If, like most people, you’re a cash-basis taxpayer, you should report this income in the year you receive it and deduct any rental expenses. So, what is considered as rental income?
Essentially, you need to include all money you receive as rent – in other words, any income you receive as payment for the use or occupation of property. You also need to report advance rent regardless of the period that it covers. So, for example, if you sign a 10-year lease to rent your property and receive $5,000 for the first year and $5,000 for the last year of the lease, you must declare all $10,000 as income in the first year.
Security deposits used as a final payment are also viewed as advanced rent, but you don’t need to include any security deposit if you plan to return it to your tenant at the end of the lease.
You’ll also need to include any payment made by a tenant for canceling their lease early or if they cover any expenses, such as water bills. Sometimes, you might have a tenant who pays via a service instead of money – perhaps they’re professional painters and offer to paint your property. If you accept this service, you’ll need to include the amount the tenant would have paid in dollars in your rental income.
Don’t forget, even if you only own part of a rental property, you must still report your part of the rental income.
Five rental property tax deductions
So, what deductions can help you soften the impact of income tax on your rental income? Here are the big five:
1. Mortgage interest
This is tax deductible on your rental property’s mortgage and is considered a business expense. You can receive a deduction for mortgage interest paid on the first $750,000 of mortgage debt, or if you bought your property before December 16, 2017, you can deduct interest on the first $1 million. Naturally, your deduction should be itemized on your tax return. If you’re married and filing separately, you can deduct $375,000 each.
To qualify, your rental property must be a house, co-op, apartment, condo, mobile home, house trailer or houseboat. It must also include sleeping, cooking and toilet facilities.
It’s common to think of your property as an appreciating asset that gains value over time. Still, it’s better to consider rental property a business asset – like a vehicle or office equipment. You are allowed an allowance for depreciation, but rather than taking it out all at once, you deduct the amount over the property’s useful life, which is usually calculated to be around 27.5 years.
To benefit from tax deductions through rental property depreciation, you need to meet these requirements:
You’re the property owner
The property is for your business or activity that generates income
The property has a useful life – meaning that it can wear out, get used up, become obsolete or lose value through natural causes
You expect the property to last for more than one year
The property was not placed in service and then disposed of during the same year
It’s important to know that while depreciation can save you money in the short term, the IRS might want some of that money back if you sell it for more than the depreciation value. This is called depreciation recapture tax.
3. Property taxes
This is a tax on real estate, based mainly on how much your property is worth and where it’s located. You can deduct up to $10,000 on a rental property, although this doesn’t apply to business expenses. If your participation level in the property is high – as a real estate professional, for example – you could claim a lot more.
Not all repairs and improvements are deductible expenses. Basics like fixing holes in walls or replacing light bulbs should be tax deductible in the year you incur the expense, but you need to be careful with some larger changes.
Say you spend $25,000 adding a fourth bedroom to a house you paid $300,000 for. You probably won’t get to deduct that $25,000 because, to the IRS, you’ve now paid $325,000 for the house, which could mean a higher depreciation write-off. People often mistakenly deduct these capital improvements, but there’s a strong chance the IRS will not accept them. Here are some examples of changes that the IRS says should be capitalized:
A new roof
Heating and A/C
There are plenty of other common expenses you can use as rental property tax deductions, including:
Employees and independent contractors
Home office expenses
Losses from hurricanes, earthquakes, floods, or theft
Professional services such as accountants or attorneys
How do you claim rental property tax deductions?
In most cases, you should file your rental property tax deductions in the same year you pay the expenses, using the Schedule E Form 1040. Always remember to keep well-organized, detailed records regarding income and costs on your rental property, making the whole process much easier.
If you use your rental property as your primary residence at some point in the tax year, things are a little more complicated. The Schedule E form shows the number of days you can use your home and the percentage of days the property can be rented at a fair market value before anything changes. You won’t normally be able to deduct expenses or losses for personal use through Schedule E, but you might be able to file them using the Schedule A 1040 form as itemized deductions.
The bottom line
There are many different expenses you can deduct related to running your rental property as a business, and they can help reduce your total tax bill significantly. The key to claiming the right expenses and amounts without hassle or misunderstanding is clearly understanding the ground rules and keeping good records of all your activities.
There’s a lot to take in, and it’s important to do things right, so talking to a financial advisor if you’re in doubt about your tax position and rental income is best. Find a qualified financial advisor here.
Senior Content Writer
Rachel is a Senior Content Writer at Unbiased. She has nearly a decade of experience writing and producing content across a range of different sectors.