7 Tax Benefits of Owning a Rental Property
Owning rental property not only generates income and increases owner equity over the long term, but it also provides numerous tax benefits compared to other income-producing assets. The U.S. tax code is particularly friendly to real estate investors, and there are seven key tax benefits that every investor should be aware of.
Key Takeaways
The main tax benefits of owning rental property include deducting operating and owner expenses, depreciation, capital gains tax deferral, and avoiding FICA tax.
Income from a rental property is typically treated as ordinary income and taxed based on the investor's federal income tax bracket.
Capital gains tax and depreciation recapture tax can be deferred through a 1031 tax deferred exchange.
Real estate investors must keep good records and maintain a paper trail to claim the tax benefits of owning a rental property.
Qualify for the pass-through deduction to deduct up to 20% of net business income from income taxes. Keep good records to support tax deductions and avoid penalties during an audit.
7 Tax Benefits of Owning Rental Property
As tax season approaches, it's important for investors to understand the tax benefits and deductions available for rental property. Here are seven key tax benefits that every real estate investor should know:
1. Operating Expenses Are Deductible
Operating expenses for managing and maintaining a rental property are tax deductible. These expenses can include advertising costs, leasing commissions, property management fees, repairs and maintenance, landscaping, property taxes, and more. Keeping good records of these expenses is essential for claiming deductions.
2. Mortgage Interest Is Deductible
Mortgage interest paid on a loan used to purchase a rental property is fully tax deductible. This includes interest paid on credit card balances and reasonable interest paid to a member of an LLC who loans money to the company. It's recommended to use a business credit card for major purchases related to the rental property to keep personal and business expenses separate.
3. You Get a Depreciation Deduction
One of the significant tax benefits of owning rental property is the ability to claim depreciation expenses. 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. Only the cost of the home and other items that increase the cost basis, such as a new roof or appliances, can be depreciated. Calculating depreciation can help reduce taxable income.
4. You Can Defer Capital Gains Tax
Owning rental property can also provide tax benefits when it comes to capital gains. If an investor decides to sell their rental property, they may be eligible for favorable tax treatment on the profits. The IRS allows investors to defer capital gains taxes by utilizing a 1031 exchange, which allows them to reinvest the proceeds from the sale into a similar property. By doing so, investors can defer paying taxes on the capital gains and potentially increase their overall wealth.
5. Deductible Owner Expenses
Travel Expenses
If you travel to your rental property for maintenance or management purposes, you may be able to deduct your travel expenses. This can include airfare, hotel accommodations, meals, and even mileage if you drive to the property. However, it's important to keep detailed records and receipts to support your deductions.
Home and Office Expenses
If you have a dedicated space in your home that is used exclusively for managing your rental property, you may be eligible for a home office deduction. This deduction allows you to deduct a portion of your home expenses, such as mortgage interest, property taxes, utilities, and insurance. To qualify, the space must be used regularly and exclusively for your rental property business.
In addition to deducting operating expenses, rental property owners can also deduct certain owner expenses. These expenses may include property insurance premiums, legal and professional fees, homeowner association fees, and even travel expenses related to managing the rental property. However, it's important to keep detailed records and have documentary evidence to support these deductions in case of an audit by the IRS.
6. Avoid Paying FICA Taxes
Another tax benefit of owning rental property is the ability to avoid paying FICA taxes on rental income. Unlike self-employment income, rental income is not subject to FICA taxes, which can save investors a significant amount of money. Additionally, rental property owners may also be eligible for the pass-through deduction, which allows them to deduct up to 20% of their rental income from their taxable income. This deduction can further reduce the investor's overall tax liability.
7. Pass-Through Deduction
Under the Tax Cuts and Jobs Act, real estate investors may be eligible for a pass-through deduction. This deduction allows certain business owners, including rental property owners, to deduct up to 20% of their qualified business income. However, there are income limitations and other requirements that must be met to qualify for this deduction.
Tax Bracket Flexibility
Owning rental property can provide flexibility when it comes to tax brackets. Rental income is typically taxed at the investor's ordinary income tax rate. However, by strategically managing expenses and deductions, investors can potentially lower their taxable income and move into a lower tax bracket. This can result in significant tax savings and allow investors to keep more of their rental income.
Record Keeping Tips for Rental Property Owners
To fully take advantage of the tax benefits of owning rental property, it's crucial to keep accurate and organized records. Here are some record keeping tips to help you maximize your deductions:
Keep all receipts and invoices related to your rental property expenses. This includes receipts for repairs, maintenance, property management fees, advertising costs, and more.
Maintain a separate bank account for your rental property income and expenses. This will make it easier to track and document your financial transactions.
Use accounting software or spreadsheets to keep track of your income and expenses. This will help you calculate your net rental income and determine your tax liability.
Keep copies of your tax returns and supporting documents for at least seven years. This is the recommended timeframe in case of an audit by the IRS.
Consult with a tax professional or accountant who specializes in real estate taxation. They can provide guidance on maximizing your deductions and ensuring compliance with tax laws.
By following these record keeping tips, you can ensure that you are taking full advantage of the tax benefits available to rental property owners. Remember, the more organized and accurate your records are, the easier it will be to claim deductions and minimize your tax liability.
Conclusion
In conclusion, owning rental property comes with numerous tax benefits that can help investors maximize their profits. From deducting operating expenses and mortgage interest to taking advantage of depreciation deductions and deferring capital gains tax through a 1031 exchange, there are various ways to reduce taxable income. Additionally, owners can deduct owner expenses, avoid FICA taxes, and qualify for the pass-through deduction. However, it is crucial for investors to maintain good record keeping and consult with professionals like Derek Fujikawa to ensure they have the necessary documentation to support their claims and take full advantage of these tax benefits.
