Generating income and increasing owner equity over the long term aren’t the only ways investors hope to profit by owning a rental. Investing in rental property also provides numerous tax benefits compared to many other income producing assets.
In fact, beginning real estate investors are often pleasantly surprised to learn just how friendly the U.S. tax code is to real estate investors. Keep reading to learn 7 of the biggest tax benefits of owning rental property.
- Main tax benefits of owning rental property include deducting operating and owner expenses, depreciation, capital gains tax deferral, and avoiding FICA tax.
- In most cases, income from a rental property is treated as ordinary income and taxed based on an investor’s federal income tax bracket.
- Capital gains tax and depreciation recapture tax may be deferred when an investor conducts a 1031 tax deferred exchange.
- To claim the tax benefits of owning a rental property, the IRS requires real estate investors to keep good records and a paper trail.
7 tax benefits of owning rental property
Before you know it, tax season will be here. To help investors avoid paying more taxes than required, let’s take a look at 7 tax benefits and deductions for rental property that every real estate investor should know.
1. Operating expenses are deductible
Operating expenses for managing and maintaining a rental property are tax deductible. As the IRS explains, ordinary and necessary expenses may include:
- Advertising costs
- Leasing commissions
- Property management fees
- Repairs and maintenance
- Pest control
- Property taxes
- Homeowner and landlord liability insurance
- Utilities paid directly by the landlord
- Professional service fees, such as an accountant or real estate attorney
2. Mortgage interest is deductible
Mortgage interest paid on a loan used to purchase a rental property is fully tax deductible. Interest paid on a credit card balance and reasonable interest paid to a member of an LLC who loans the company money are two other examples of tax deductible interest expense.
Investors who use a credit card to purchase major items, such as appliances or fixtures, may wish to obtain a business credit card to help keep business expenses separate from personal expenses.
3. You get a depreciation deduction
Another tax benefit of owning rental property is the depreciation expense.
The IRS allows real estate investors to depreciate rental property over a period of 27.5 years to recover the cost of wear and tear. Because land does not wear out, only the cost of the home plus other items that increase the cost basis such as a new roof, appliances, or carpeting may be depreciated.
To illustrate, let’s assume an investor paid $150,000 for a single-family rental home. The lot value is $15,000, which means the cost basis used for depreciation is $135,000. When the home was purchased, the investor replaced the roof at a cost of $20,000 and installed brand new kitchen appliances at a cost of $4,000.
According to IRS Publication 527, Residential Rental Property, appliances are depreciated over a period of five years, while the cost of the roof uses the same depreciation period as that of the property.
Here are the steps to follow to calculate the depreciation for the rental property for the first full year of ownership:
- Add cost of the roof to the property cost basis: $135,000 + $20,000 = $155,000 adjusted cost basis
- Calculate annual depreciation expense: $155,000 cost basis / 27.5 years = $5,636
- Calculate appliance depreciation: $4,000 kitchen appliances / 5 years = $800
- Calculate total depreciation expense: $5,636 + $800 = $6,436
Assuming the rental property in this example generated a pre-tax income of $8,000, an investor could deduct the total depreciation expenses of $6,436 to reduce the amount of taxable income to $1,564.
After five years, the depreciation expense for the appliances would be used up, and the investor’s annual depreciation expense would decrease to $5,636, assuming no other capital improvements are made to the property.
4. You can defer capital gains tax
Another tax benefit of owning a rental property is the ability to defer paying capital gains tax and 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 long-term capital gains tax of 0 percent, 15 percent, or 20 percent on any profit from the sale.
With a 1031 exchange, instead of paying taxes, an investor can put the money to work by investing in another rental property. The rules and restrictions relating to a Section 1031 exchange are complex and an investor may wish to consult a licensed professional. However, there are three main 1031 exchange rules to follow:
- Replacement property must be of equal or greater value to the one being sold
- Replacement property must be identified within 45 days
- Replacement property must be purchased within 180 days
Rental property owners can conduct 1031 exchanges indefinitely to defer paying capital gains and depreciation recapture taxes. If an investor decides to sell the properties, any taxes owed will need to be paid.
Instead of selling rental property, some investors keep their portfolio and draw rental income until eventually passing the property to their heirs.
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.
5. Owner expenses are also deductible
Even when a real estate investor hires a local property manager to take care of the tenant and home, there may still be expenses an owner can deduct to reduce taxable income:
Money spent on dues to belong to a real estate investing club, subscriptions to real estate or business periodicals, and tuition paid for continuing education like the Roofstock Academy can normally be deducted from income generated from a rental property business.
Rental property owners can generally deduct travel expenses, such as airfare and lodging, provided they meet the following criteria described in IRS Publication 463:
- Travel must be mainly for business and have a clear business purpose
- Majority of the time must be spent on business activities and not leisure activities
- Travel expenses must be ordinary and necessary for the real estate business but not be overdone, such as staying an reasonably-priced hotel versus a five-star resort
Owners may also be able to deduct auto expenses related to traveling to the rental property.
The standard mileage deduction is the simplest way to deduct business-related travel expenses, with a rate of 56 cents per mile (for 2021). Another way of deducting auto expenses is by keeping track of actual itemized expenses such as gas, insurance, and car payments and deducting the pro rata share used for business at the end of the year.
Rental property owners may also be able to deduct for the home office use of a portion of a residence, provided the portion is used exclusively and on a regular basis for business purposes.
With the simplified option for home office deduction, the IRS allows taxpayers to claim a standard deduction of $5 per square foot, up to a maximum of 300 square feet.
6. You avoid FICA taxes
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. Fortunately, income from a rental property is usually not classified as earned income, which means the income is not subject to FICA 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 tax due.
7. You can qualify for pass-through deduction
Real estate investors who qualify for the pass-through income deduction may deduct up to 20% of their net business income from their income taxes, subject to certain restrictions. In order to qualify, the investor must own a pass-through business and have qualified business income (QBI).
A pass-through business includes a partnership, limited liability company (LLC), S corporation, or even a sole proprietorship. QBI is the net income or profit that the pass-through business earns. However, QBI does not include income from a short-term or long-term capital gain, or dividend or interest income received by the pass-through business entity.
For example, assume Bob owns a portfolio of single-family rentals in an LLC. If the net income generated is $50,000 per year, Bob may be able to use the pass-through deduction to write-off $10,000 on his personal tax return.
This article from the IRS Newsroom provides more information about the qualified business income deduction.
How is rental income taxed?
In most cases, income received from a rental property is not classified as earned income, which means that an investor does not need to pay FICA or payroll tax.
Rental income is reported on Form 1040, Schedule E and lists the revenue, expenses, and depreciation for each rental property owned. The income or loss from Schedule E is then reported on Schedule 1 (Form 1040), and on line 8 of Form 1040, 1040-SR, or 1040-NR as additional income.
Income from a rental property is included as part of an investor’s total income and taxed according to the investor’s federal tax bracket.
Record keeping tips from the IRS
In order to profit from the tax benefits of owning a rental property, the IRS requires investors to keep good records. Good records help investors to:
- Monitor rental property performance
- Prepare financial statements
- Identify the source of income and expenses
- Track deductible expenses
- Prepare tax returns
If a tax return is selected for an audit, investors must be able to provide documentary evidence such as receipts, canceled bills or proof of payment, and support for travel expenses. Investors who are unable to provide evidence to support tax deductions may be subject to additional taxes, penalties, and interest.
There are a variety of tax benefits that come with owning a rental property, but in order to claim them investors need to have the back-up to support their claims.
A good way to automatically keep track of income and expenses for a rental property is by using Stessa to track real estate investments.
Stessa is free and makes it easy for investors to track property performance, export tax-ready financials at tax time, and create a paper trail that all rental property owners need. Rental property owners can also securely organize and store all real estate documents online.