Do you own real estate that you rent out? Besides the potential for regular income and capital growth, real estate investments offer deductions that can reduce the income tax on your profits.
First, consider what kind of real estate investor you are. Are you a passive investor or a real estate professional? Your classification as one or the other determines how your income and losses are treated.
- Rental property owners can deduct the costs of owning, maintaining, and operating the property.
- Most residential rental property is depreciated at a rate of 3.636% per year for 27.5 years—what the IRS considers the property’s “useful life.”
- Only the value of the buildings can be depreciated. You can’t depreciate the land since it never gets “used up.”
- The tax treatment of income and losses depends on your level of involvement in the rental property.
- Specific costs like personal expenses, fines, fees, or uncollected rent accounted for on a cash basis can often not be deducted against your income for tax purposes.
Tax Treatment of Income and Losses
Real estate is generally considered a passive activity. However, your level of participation determines the tax treatment of the income and losses the property generates.
Real Estate Professionals
The Internal Revenue Service (IRS) defines a real estate professional as someone who spends more than half of their working hours in the rental business. This may include property development, construction, acquisition, and management. You must also devote more than 750 hours per year to working on your real estate rental properties to qualify as a professional.
Activities of real estate professionals are not treated as passive activities. Instead, the income you generate is characterized as active income (i.e., non-passive income). As such, you can use losses to offset other income (e.g., wages, salaries, interest, and dividends)—and avoid the 3.8% net investment tax if the rental generates income.
If you materially participated as a real estate professional, your rental property involvement will receive non-passive tax treatment. You can use any losses to offset other types of income, and you won’t be subject to the net investment tax.
According to the IRS, you materially participated in an activity if you satisfy any of the following tests:
- You participated in the activity for more than 500 hours during the year.
- You do all (or nearly all) of the work in the activity.
- You work 100+ hours in the activity during the year and work at least as much as anyone else.
- The activity is a significant participation activity (SPA) and you participated for at least 500 hours in SPAs.
- You materially participated in the activity for any five of the previous 10 years (whether consecutive or not).
- The activity is a personal service activity, and you materially participated for any three preceding tax years.
- Based on all the facts and circumstances, you participated in the activity on a “regular, continuous, and substantial basis” during the year.
Active participation is a lower standard of involvement than material participation. The IRS treats you as actively participating if you “make management decisions in a significant and bona fide sense.” Management decisions that count as active participation include things like:
- Approving new tenants
- Determining rental terms
- Approving expenditures
If you actively participate by making management decisions—and have at least a 10% interest in the investment—you might be able to deduct some of your passive losses.
This level of participation allows a special passive loss rule. In general, you can deduct up to $25,000 of passive losses if your modified adjusted gross income (MAGI) is $100,000 or less. The deduction phases out if your MAGI is between $100,000 and $150,000. Once your MAGI exceeds $150,000, you can’t take any passive losses. Losses of more than $25,000 can be carried over to the following year.
On the other hand, if your rental property is a sideline investment—and you don’t materially participate in the investment—it’s considered a passive activity. In this case, any passive activity losses can be used only to offset passive activity income. In other words, you can’t use any losses from the rental property to shelter other taxable income. Instead, the losses are carried forward until you generate passive income or sell the investment.
Rental Property Income Sources
If you own rental property, you have to report all of the rental income you receive—but keep in mind that includes more than just those monthly rent checks.
The money you receive for rent is generally considered taxable in the year you receive it, not when it was due or earned. This means any advance payments must also be treated as income.
For example, suppose you rent out a house for $1,000 per month, and you require new tenants to pay the first and last months’ rent when they sign a lease. In this case, you’ll have to declare the $2,000 you received as income, even though $1,000 of that $2,000 covers a period that might be several years in the future.
Expenses your tenants pay count as rental income if the expense is for something they’re not obligated to pay. For example, suppose your tenant pays the water bill and deducts it from their regular rent payment. In that case, you must include the amount in your rental income. Depending on the expense, you may then deduct the amount as a rental expense.
Trade for Services
If your tenant offers to trade services in exchange for rent, you must include the fair market value of the services as income. For example, if your tenant paints the rental house in exchange for one month’s rent (valued at $1,000), you must include the $1,000 as income even though you didn’t receive the cash. However, you will be able to deduct the $1,000 as an expense.
Security deposits are not taxable when you receive them if the intent is to return the money to the tenant at the end of the lease. But what if your tenant does not live up to the lease terms? For example, suppose you collect a $500 security deposit and your tenant moves out and leaves holes in the walls that cost $500 to repair. You must include the $500 as income for that year (but you can also deduct the repair costs).
Note that a security deposit used as a final rent payment is considered advance rent. Hence, you include it as income the year you receive it.
Rental Property Tax Deductions
As a rental property owner, you can deduct various expenses related to buying, operating, and maintaining the property. Here’s a rundown of the most common deductions.
Mortgage Interest Deduction
Expenses to obtain a mortgage—such as commissions and appraisal fees—are not deductible when you pay them. Instead, these costs are added to your basis in the property.
Still, you can deduct interest on up to $750,000 ($1 million if you took out the mortgage before Dec. 16, 2017) of secured mortgage debt on your first or second home. For investment properties, you can deduct mortgage interest as a business expense.
Your mortgage company will send you an IRS Form 1098 each year showing how much you’ve paid in interest throughout the year. If part of your payment includes money that goes into an escrow account to cover taxes and insurance, your mortgage company should report that to you as well.
While home mortgage interest is reported on Schedule A of the 1040 or 1040-SR tax form, rental property mortgage interest is reported on Schedule E.
The Tax Cuts and Jobs Act (TCJA), passed in 2017, reduced the maximum mortgage principal eligible for the deductible interest to $750,000 (from $1 million) for new loans. The TCJA also nearly doubled the standard deduction, making it unnecessary for many taxpayers to itemize.
Rental Property Depreciation
Another key tax deduction is the allowance for depreciation. Rather than taking one large deduction when you buy (or improve) a property, depreciation lets you deduct the costs over the property’s useful life. The IRS lets you depreciate a rental property if it meets these requirements:
- You own the property.
- You use the property in your business or income-producing activity.
- The property has a determinable useful life—meaning it’s something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
- You expect the property to last for more than one year.
- The property was not placed in service and later disposed of (or no longer used for business) during the same year.
Land is not depreciable since it never gets used up. Likewise, you generally can’t depreciate the costs of clearing, planting, and landscaping since those activities are considered part of the cost of the land, not the buildings.
Residential rental property placed in service after 1986 is depreciated using the Modified Accelerated Cost Recovery System (MACRS). This method spreads costs (and depreciation deductions) over 27.5 years—what the IRS considers the “useful life” of a rental property.
While depreciation saves you money now, the IRS might want some of that money back. If you depreciate property and then sell it for more than its depreciated value, you’ll owe depreciation recapture taxes on the gain. Many real estate investors use 1031 exchanges to defer taxes—including depreciation recapture and capital gains taxes.
Repairs and Improvements
Rental property owners may assume that anything they do on their property is a deductible expense. Not so, according to the IRS.
A repair keeps your rental property in good condition and is a deductible expense in the year when you pay for it. Repairs include painting, fixing a broken toilet, and replacing a faulty light switch. On the other hand, improvements add value to your property and are not deductible when you pay for them. Instead, you recover the cost of improving (and buying) a property by depreciating the expense over your property’s useful life. Improvements might include a new roof, patio, or garage.
From a tax standpoint, you should make repairs as problems arise instead of waiting until they multiply and require renovations.
Property taxes are an ongoing expense for rental property owners. Homeowners can deduct up to a total of $10,000 ($5,000 if married filing separately) for property taxes and either state and local income taxes or sales taxes. However, that limit doesn’t apply to business activities. Depending on your level of participation in the property, you may be able to deduct the full amount as a business expense.
Money you spend on travel to collect rent or maintain your rental property is deductible. However, if the purpose of the trip was for improvements, you must recover that expense as part of the improvement.
There are two ways to deduct travel expenses: using the actual expenses or the standard mileage rate. The latest details about the IRS’s requirements and current mileage allowance are in IRS Publication 463.
Other Common Expenses
In addition to mortgage interest, repairs, and depreciation, some other common expenses you can deduct include:
- Employees and independent contractors
- Home office expenses
- Insurance premiums
- Lawn care
- Losses from casualties (hurricane, earthquake, flood, etc.) or thefts
- Professional services (e.g., accountants, tax preparers, property managers, attorneys)
- The cost of personal property (e.g., appliances and furniture) used in rental activity
What Is Not Deductible?
IRS regulation may vary based on different specific situations, but there are general expenses often not allowed to be deducted. Those general categories are discussed below.
In general, you cannot deduct expenses that are solely personal in nature and unaffiliated with the rental property. These could include personal purchases of food, clothing, or travel. In many cases, you may find yourself temporarily staying at a rental property you own; consider an example of you staying on site to perform repairs on your own. The personal expenses of your stay are not deductible.
Repairs vs. Upgrades
While upgrades that increase a property’s worth or lengthen its useful life are normally deductible, they may need to be capitalized and depreciated over time rather than being entirely deducted in the current year. This is different from repairs which do not lengthen the useful life of the asset nor enhance the usefulness of the property. Therefore, while both types of charges may be deductible, certain types of costs may not be fully deductible in a single period but must instead be spread out over time.
Expenses During Vacancy
You might not be able to deduct expenses associated to a rental property when it is empty or not earning rental income. This may include costs like mortgage interest or advertising costs. Be mindful that depending on your jurisdiction, there can be exclusions or particular laws. In addition, if you are a cash basis taxpayer, you can’t deduct uncollected rents because these rents have not been capture or accrued in income.
Cost of Travel
In general, travel costs from your home to the rental property are regarded as personal expenses and are not tax deductible. You might be able to deduct the cost of getting to and from the property for upkeep or management.
Fines and Penalties
As is the case with other types of tax deductions, you likely are not allowed to deduct the cost of fines and penalties. Some fines and penalties may not be deducted as expenses for a rental property if they were incurred as a result of breaking laws, rules, or homeowner association guidelines. In many of these situations, the fines or penalties could have been avoided with simple compliance with prevailing regulation.
Condominiums and Cooperatives
If you own a rental condominium or cooperative, each has some special rules:
- Condominiums: If the rental is a condominium, you probably pay dues or assessments to maintain common areas—such as lobbies, elevators, and recreational areas. When you rent out your condominium, you can deduct expenses, such as depreciation, repairs, interest, and taxes that relate to this common property. However, just as with a single-family rental, you can’t deduct money spent on capital improvements, such as an assessment for a cabana at the clubhouse. Instead, you must depreciate your share of the cost.
- Cooperatives: Expenses for a cooperative apartment you rent out are deductible. This includes the maintenance fees paid to the cooperative housing corporation. Capital improvements are treated differently. You can’t deduct improvement costs, nor can you depreciate them. Instead, you must add the cost of the improvement to your cost basis in the corporation’s stock, reducing your capital gain when you sell.
Under the IRS’s Schedule E, there are spaces for miscellaneous categories of expenses. That gives you flexibility in the items that you can deduct. But be prepared to back up your claim and separate costs for repairs and maintenance from those that are capital improvements. Remember, the money you spend on improvements could reduce your tax liability when you sell.
Plan to keep supporting documentation (like appointment books, diaries, calendars, and logs) to prove your active participation and the time spent on your properties each year.
Where Do I Report Rental Income?
You report rental property income, expenses, and depreciation on Schedule E of your 1040 or 1040-SR (U.S. Tax Return for Seniors). You’ll have to use more than one copy of Schedule E if you have more than three rental properties.
What Deductions Can I Claim for Rental Property?
As a rental property owner, you can claim deductions to offset rental income and lower taxes. Broadly, you can deduct qualified rental expenses (e.g., mortgage interest, property taxes, interest, and utilities), operating expenses, and repair costs.
You can also depreciate the cost of buying and improving the property over its “useful life,” generally 27.5 years. You may also be able to deduct an additional 20% of your qualified business income (QBI). However, to qualify for the QBI deduction, the rental real estate must “rise to the level of a trade or business under section 162” of the Internal Revenue Code, among other restrictions.
What Is a 1031 Exchange?
When you eventually sell your rental property, you could be on the hook for capital gains and depreciation recapture taxes. Many real estate investors defer these taxes by using a 1031 exchange, which lets you swap one investment property for another. According to the IRS, the exchanged properties must be “like-kind,” meaning “they’re of the same nature or character, even if they differ in grade or quality.” In general, properties are considered like-kind, whether they’re improved or unimproved.
Is Rental Income Taxed as Ordinary Income?
Maybe. If you rent out a property for more than 14 days during the year, you must report the rental income on your tax return—and the net income is taxable as ordinary income. You don’t have to report or pay taxes on the income if you rent out the property for 14 or fewer days.
The Bottom Line
Rental property ownership tends to be most profitable when you consider the tax rules before jumping in. Since there are quite a few deductions available, it pays to know which ones you qualify for so you can maximize your bottom line. Moreover, it’s essential to understand how taxes work on your rental income and the eventual sale of your property. For more guidance and help with deductions, taxes, and planning, be sure to consult a qualified tax professional.