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The Tax Implications of Owning Rental Properties

By: Raquel Tennant, CFP®

Chances are you’ve heard somewhere that buying multiple properties is a surefire way to become a millionaire. While owning a rental property is indeed one way to kickstart the wealth building process, it is imperative to fully understand the costs included, which expenses are deductible and the best tips on how to manage what will effectively be considered running a new business. As the April 15 tax deadline looms closer, let’s consider these four key implications.

  1. Understanding the Expenses that Offset Rental Income

Rental income and expenses are reported on Schedule E of your Tax Return, and is considered “passive income” not “earned income.”

This distinction is key, especially when it comes to evaluating the losses from your rental property. Passive losses can only offset passive income - and have no bearing on income from nonpassive activities such as a day job or additional business. Passive losses also cannot offset against investment or dividend income.

However, there are many common deductible expenses that can work in your favor, including:

  • Advertising - e.g.. listing fees to online services to advertise your rental

  • Auto and travel - e.g.. local and overnight travel expenses for managing your rental

  • Insurance (does not include PMI) - insurance that protects your property like homeowner’s and renter’s insurance if paid on behalf of the tenant

  • Legal and other professional fees - CPAs, lawyers, real estate agent commissions paid to find a tenant

  • Management fees - rental agencies and property management companies

  • Mortgage interest - use your 1098 for the total interest paid in that tax year

  • Property Taxes - an ongoing expense of ownership

  • Cleaning and maintenance/repairs - costs of keeping your rental in good condition

    • Pro tip: budget 1% of your rental property’s value for repairs and maintenance annually

    • Do not deduct home improvements. These are a depreciated expense (we’ll talk about this next)

Basis is defined as the cost to acquire any given property (excluded closing costs/fees). This is important when calculating both your annual depreciation amount and your capital gains upon selling the rental.

It is helpful to understand that certain events can either increase or decrease your basis. Most commonly, your basis will increase when you undertake home improvement projects, renovations, or conduct major electric or plumbing work (aka capital expenses).

Capital expenses are typically not deducted in one year, but rather depreciated across multiple years.

Instead of taking one large deduction in the year you buy and/or make improvements to the property, depreciation spreads a deduction expense across the useful life of the property, which for residential real estate is 27.5 years. Consider:

  • You can only depreciate the cost of the building and certain personal property of the rental, not the land since it never gets "used up.”

  • Appliances like stoves and refrigerators or furniture used in a rental property can be depreciated sooner over 5 years instead of 27.5. Your CPA will know which things fall under different depreciation timelines.

  • When a rental property is sold, a real estate investor must “recapture” the depreciation expense taken over the previous tax years.

3. Determining Eligibility for a Qualified Business Income Deduction

The qualified business income deduction (QBI) is a tax deduction that allows eligible self-employed and small-business owners to deduct up to 20% of their qualified business income on their taxes.

Landlords may assume their rental income can qualify for this deduction, however, passive rental activities are not considered a trade or business unless they are a RREE, rental real estate enterprise. Be sure to confer with your CPA on if the QBI will be a deduction you can count on.

4. Investing in Bookkeeping

You may be wondering how can I keep track of all these incomes, expenses and home improvements? The answer is bookkeeping, the holy grail of a smooth tax season.

In order to prove that you qualify for the aforementioned tax benefits, you need to keep records of everything, including receipts, invoices, and rent collection. A great way to do this is by investing in bookkeeping software. Here is a list of highly rated ones by Investopedia.

Other low-cost property management software for landlords include Cozy, Housters, Rentler, Stessa, and TenantCloud. The options are endless, the point is you need it.

Pro tip: Be sure to keep a separate account where all your income and expenses come out of as this helps prevent “commingling of assets”.

If you treat your business' money the same as your own, then you risk the exposure of your personal assets in a lawsuit (even if you have an LLC). The IRS may also try to deem certain business expenses as personal during a future audit if you aren’t careful.

Planning Ahead

We love a good plan at 2050 Wealth Partners. If owning a rental property is a dream of yours, consider the above tips before beginning. Like owning any other asset, being aware of the tax implications, liabilities and benefits before making the purchase will ensure smooth sailing leading up to tax time.

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