It may not surprise most that real estate investing can produce great returns. While real estate is a good vehicle for investing, it isn’t as straightforward as it may seem, and dealing with taxes is one of the most complicated issues. Real estate taxes, including those you pay when you sell a property or claim rental money as part of your income, can be hard for the average person to predict.
Rental property owners can expect certain tax advantageous deductions; however, certain situations can cost them extra tax dollars when they file.
While the only way to know what to expect at tax time is to consult with an expert, like an accountant or an enrolled agent, it's equally as important to understand the basics of real estate taxes before buying a house or investing.
How Tax Deductions Can Offset Rental Property Expenses
Buying a rental property is a great way to generate income, but there are always expenses the owner must shoulder to keep renters comfortable and happy. Over the course of a year, these expenses can add up to a lot, particularly if your rental property is older and requires several repairs within a short time span. Most tenancy laws dictate how fast you must respond to issues on the property, meaning you don’t always have the luxury of taking your time to fix things most affordably.
The good news for rental property owners is that the money you spend keeping your rental in good condition can be deducted. The IRS considers these legitimate business expenses and gives you a tax break for many of them. Some of the most common real estate rental deductions include:
- Advertising the property for rent and any commissions owed to real estate agents
- Interest paid on the mortgage
- Property taxes
- Cleaning and maintenance costs, like landscaping and pool care
- Repairs to plumbing or heating systems
- Utility bills paid for the rental property
Some of these deductions can be complex, and there are guidelines to follow to get every viable tax break you can. For example, if you increase the home's value while fixing the issue, the IRS will consider the expense an improvement. So, replacing a leaky toilet with a newer model is regarded as a repair, but if you decide to upgrade the shower while you’re at it, you’ve improved the bathroom instead. Improvements can be claimed under depreciation to help offset the money you put into the property.
Deductions for Running a Small Business
Off-site expenses can also be deducted if they are relevant to managing the property. Like many other small business owners, you can deduct any related expenses if you use a dedicated home office when managing your properties. This might include furniture, such as a desk and office chair, a dedicated phone and internet connection, and office supplies. The miles you accrue on your vehicle as you drive back and forth to manage the property can also be deducted. You should document the mileage used on each business-related trip to claim the appropriate amount.
Rental Property Deductions for Depreciation
Depreciation is a concept most people are familiar with since it applies to many kinds of property, including vehicles and electronics. The same concept applies to a home as it starts to lose value not long after you put in your down payment and get pre-approved fo3r a mortgage. As a property gets older, the materials can break down or become obsolete, and the asset's value decreases as it becomes more outdated. How fast it depreciates varies based on the type of property :
- If you own a residential property, you can claim depreciation over the course of 27 and a half years.
- If your rental property is a commercial one, you can claim depreciation for up to 39 years.
1031 Exchanges and Strategies to Offset Recapture
The important thing to remember is that depreciation is not a one-way street. The IRS eventually gets some of this money back from you through a recapture mechanism. When you sell the rental property down the line, the IRS is entitled to recapture the depreciation claimed over the life of the investment. This caps out at 25% of the total amount claimed in depreciation, which can add up to a lot over the years. Keep this in mind as you claim depreciation on your yearly taxes because if you plan to sell the property soon, you may need to find a way to avoid paying all of the recapture.
One popular way to do this is through a 1031 exchange. The 1031 exchange allows investors to use the profits from selling one property to buy another, thereby deferring taxes until the second property sells.
Several conditions apply for a transaction to be considered a 1031 exchange. For example, the new property must be similar to the old one, and the money used for the exchange must be placed with an intermediary or in an escrow account to ensure you don't touch it before buying the second property. There's also a time factor involved, as the closing for the second property has to happen within 180 days. You'll be responsible for the full tax on your sold property without meeting these conditions.
Paying Capital Gains Taxes on Real Estate Transactions
Selling a real estate investment often results in a large profit for the owner. The IRS claims a portion of this profit through capital gains tax. Capital gains can be taxed in two distinct ways: short-term or long-term. In the eyes of the IRS, if you own a property for a year or less before selling it, that is considered a short-term capital gain. Any property you sell after owning it for over a year falls into the long-term capital gains category.
If you can wait for more than a year to sell your property, the long-term capital gains tax typically charges a lower amount on the profits of the sale. Long-term capital gains are taxed at a maximum of twenty percent, while short-term capital gains are based on your yearly income tax bracket. This can vary from ten to more than thirty percent depending on your income over the past year.
There are also other ways to potentially avoid paying capital gains tax when selling, including owning the house for two years or longer, and deducting home improvement expenses.
» MORE: Guide to Selling Your House After Just One Year
How to Claim Vacation Rental Expenses on Your Real Estate Taxes
Deductions on a vacation rental property are similar to long-term rental properties, but more variables influence whether or not you’re eligible for those deductions. If you use the rental property often for your enjoyment or rent it out for less than two weeks of the calendar year, the IRS may not consider it a vacation rental.
Tax Benefits of Real Estate Investment Income
One of the major tax benefits of getting income from your real estate investments is that you avoid paying self-employment tax, which typically occurs on income from entrepreneurial activities.
In a traditional employer-and-employee relationship, the employer and employee both pay a portion of the Federal Insurance Contributions Act (FICA) tax. This is typically deducted right from the employee’s paycheck each pay period, which explains why many people do not know much about why it exists or how much gets deducted.
The total tax is 15.3%. This percentage is split evenly between the employer and employee. However, in cases where someone is considered self-employed by the IRS, that person becomes responsible for paying the full tax themselves. While there are exceptions to this rule, including establishing a corporation to manage the property and drawing a salary from this corporation, in the case of most rental property income, the self-employment tax isn't applicable.
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