“One penny may seem to you a very insignificant thing, but it is the small seed from which fortunes spring.”
Those words were spoken over 100 years ago by Orison Swett Marden, the founder of SUCCESS magazine who is often considered the father of modern-day inspirational talks. His words still make sense to this very day, especially for real estate investors seeking to maximize returns.
In this article, we’ll explain how rental property owners can track every expense down to the last penny, claim every tax deduction possible, and save time and increase rental property financial performance by automatically keeping track of rental property expenses.
- The IRS defines rental property expenses as operating expenses, repairs, and depreciation.
- Benefits of accurately tracking the expenses of a rental property include monitoring profit or loss, claiming every possible tax deduction, and creating a paper trail for audit purposes.
- Manual spreadsheets, off-the-shelf software, or real estate-specific software are three main ways to keep track of rental property expenses.
- Financial metrics such as NOI, cap rate, operating expense ratio, and cash on cash return all depend on having accurate rental property expenses.
What are Rental Property Expenses?
IRS Topic No. 414 Rental Income and Expenses lists several types of rental property expenses an investor may deduct from the total rental income received:
- Operating expenses necessary for the operation of the rental property, including property managers, landscaping and utilities, property taxes and insurance, and mortgage interest expense.
- Repair costs needed to keep the property in good working condition, excluding work that adds value to the property, such as a new roof or air conditioning system.
- Depreciation expense allowance for exhaustion, and wear and tear of the property.
According to the IRS, most real estate investors are cash basis taxpayers. That means income is recorded when it is received, and expenses are booked when bills are actually paid.
A refundable security deposit returned to a tenant is neither income nor an expense. Instead, when the deposit is received, it is recorded on the balance sheet as a liability because the security deposit is meant to eventually be returned.
How to Keep Track of Rental Property Expenses
Even with just one rental property, it’s easy to lose track of deductions that could decrease taxable net income. Or even worse, accidentally double-book an expense only to have it discovered during a tax audit.
There are three main ways to keep track of rental property expenses:
Many beginning investors create a simple spreadsheet using programs such as Microsoft Excel, Numbers, Google Sheets, or OpenOffice. Manually entering expenses on a spreadsheet may work fine at first, but many investors feel like doing this kind of back office work isn’t the best use of their time.
However, if you’re looking for a simple template to use, just search in Google for “rental property expense worksheet template.” Keep reading to learn about some better alternatives.
Generic Accounting Software
Generic, off-the-shelf software such as Quickbooks are purchased by millions of people worldwide, including rental property owners. Programs like these are a good match for real estate investors who have a good grasp of accounting and have the time to customize the software to meet their needs.
Before purchasing general purpose software, download a trial version to make sure the program works as intended. Create a rental property and tenant, enter bank and mortgage information, receive rent payments and book expenses, and generate financial reports to ensure the software accurately tracks every transaction and books it to the correct expense account.
Rental Property Software
Real estate-specific software runs the gamut from full-blown property management programs to software designed for the independent real estate investor.
For example, there are services like AppFolio that offer an end-to-end solution for property management companies and investors with large rental property portfolios. Fees to use AppFolio begin at $280 per month with 50 rental units required for onboarding.
Smaller investors looking for cost-effective rental property software often opt for Stessa. The system is absolutely free and is used by both novice and sophisticated investors to make informed decisions about their property portfolios.
Stessa was designed by rental property owners for rental property owners to provide tools to the real estate investment community at the lowest possible cost. After signing up for a free account with Stessa, simply enter the property address, connect bank, credit card, and mortgage company accounts, and run real-time financial performance reports from the owner dashboard. Income and expenses are automatically updated, tracked, and categorized for easy reporting and tax preparation, and a paper trail is created.
Rental Property Expenses to Keep Track Of
Rental property expenses are recorded in an itemized list or report format, along with a paper trail that provides back up to prove that every expense claimed is true and correct. Although tracking expenses can be time consuming, it’s well worth the effort.
There are four good reasons why experienced real estate investors keep accurate rental property expense records:
- Monitors profit or loss of a rental property
- Provides data to strategize on ways to maximize profits
- Allows investors to claim every possible tax deduction
- Creates a paper trail for audit purposes
Main Types of Rental Property Expenses
There are over two dozen rental property expenses a real estate investor could deduct. Some of the most common expenses of a rental property include:
- Accounting and legal expenses
- Advertising and marketing costs
- Maintenance expenses
- Mortgage interest
- Property management fees
- Property taxes
- Travel expenses
- Utilities paid by the landlord
Other Documents and Rental Property Records
Some rental property expenses can be claimed the year they are paid, while others must be added to the property basis and depreciated over 27.5 years. Rental property documents and records also provide backup to verify the expenses are claimed by an investor are accurate:
- The settlement statement from when the property was purchased helps determine which costs to expense and those that must be added to the property basis.
- Mortgage documents, property tax assessments, and Form 1098 provided at year-end are used to verify the annual mortgage interest deduction.
- Federal and state tax returns for the past several years document income and expenses claimed.
- Back-up copies of use or sales tax returns show the amount of rental tax collected and remitted to the city and state.
- Property management agreement(s) confirm the new account start-up and monthly management fees.
- Initial invoices from utility companies document refundable security deposit collected to begin service.
- Documents showing expenses incurred to lease a vacant property, including application fees, security deposits collected, leasing commissions paid, and legal costs of evicting a tenant.
- Copies of current and previous tenant leases and correspondence going back three to five years provide a record of lease terms and maintenance issues.
- Bank statement records for checking and savings accounts set up for a rental property business.
Normal rental property operating expenses, along with documents and records, generate a tremendous amount of paperwork. The more paperwork there is, the easier it is for something to get lost.
That’s why Stessa provides free cloud-based document storage to real estate investors. The system was designed from the ground up with security in mind, using multiple layers of security to keep data safe and secure.
Rental Property Depreciation
Another great feature about Stessa is how it automatically tracks rental property depreciation and updates the real estate balance sheet.
Residential rental property is depreciated over a period of 27.5 years to compensate the investor for property exhaustion, and wear and tear. The annual depreciation expense is deducted from pre tax net income to reduce the amount of personal taxes a real estate investor pays.
Here’s a quick look at how rental property depreciation works.
Assume a home is purchased for $120,000. After subtracting the value of the lot (because land doesn’t depreciate) and adding in capitalized closing costs such as owner’s title insurance, the cost basis used for depreciation is $110,000.
By dividing $110,000 by 27.5 years, an investor may claim an annual depreciation expense of $4,000 until the property is sold or the depreciation allowance is gone. While this example is simple enough, the challenge is that the cost basis of a rental property changes over time.
Each year a depreciation deduction is claimed, the basis decreases. When a capitalized expense like new carpeting or new roof is installed in the rental property, the cost basis increases and so does the annual depreciation amount.
Stessa makes rental property depreciation simple by automatically calculating the annual depreciation expense each year, to help make tax time a breeze.
Accumulated depreciation under the asset section of the real estate balance sheet is updated at the end of the year, plus the property value is periodically updated or ‘marked to market’ to more accurately report owner’s equity.
Reporting Rental Property Expenses to the IRS
Income and expenses on a rental property are reported to the IRS using two main forms:
- IRS Form 1040 or Form 1040-SR, Schedule E, Part I is used to report income, expenses, and rental property depreciation. Additional Schedule Es can be attached if an investor has more than three rental properties.
- Form 4562 is used to calculate and report the amount of rental property depreciation shown on Schedule E.
Investors can fill out these forms by hand and file them with the IRS, or visit the Stessa Tax Center to claim a free tax package.
Tax resources for the Stessa community include a suite of tax resources created in partnership with The Real Estate CPA, a firm that specializes in real estate investment, plus an exclusive TurboTax discount and helpful how-to articles and videos.
Why Accurate Expenses Matter
By accurately keeping track of expenses, a real estate investor can identify potential opportunities to increase revenues and the overall return on investment (ROI) of a rental property:
- Operating expense ratio (OER) is calculated by dividing operating expenses (excluding any non-cash depreciation expense) by operating income to measure how well expenses are being controlled.
- Net operating income (NOI) is calculated by subtracting operating expenses (excluding the mortgage) from income.
- Capitalization rate measures the return or profit on investment by dividing NOI by property value.
- Internal rate of return (IRR) estimates the interest or return received for each dollar invested in a rental property over the holding period.
- Cash flow is the money remaining at the end of each month after the rent has been collected and all of the bills have been paid.
- Cash-on-cash return compares the cash received each year to the amount of cash invested.
Of course, keeping accurate track of every expense helps a real estate investor to claim every possible tax deduction to keep more profit instead of unnecessarily giving money to the government.