Apartments for rent, houses for rent whatever the case... as a rental property owner, it's important to understand the various tax benefits and deductions available to you. Not only can these help to reduce your tax liability, but they can also help to improve your cash flow and make owning rental property more financially viable.
So first let's get this out of the way: there's really only so many images of calculators and tax forms we can all take, it's a stressful time so we've sprinkled images of peace and serenity throughout this post... you're welcome. Second: We are not tax professionals and this is not tax advice so you should consult with a certified tax professional before making financial decisions. Now... put down that calculator, sit back and get ready for some tax-saving tips and tricks:
1. Mortgage Interest
Today's mortgage rates could be better but, one of the easiest tax benefits for rental property owners is the ability to deduct mortgage interest. This includes interest paid on loans used to purchase or improve the property, as well as any home equity loans used to finance the property. This can provide a significant reduction in your tax liability, especially if you have a high mortgage balance. It's like getting a "discount" on your mortgage payments.
Related: To Pay-Off the Mortgage or Not?
One of the most significant tax benefits for rental property owners is the ability to deduct depreciation. This is a non-cash expense that allows you to spread the cost of your property over a period of time. The purpose of depreciation is to account for the wear and tear of the property over time and to acknowledge that the value of the property decreases as it ages. Even if your rental property is increasing in value, you can still claim a deduction for the portion of the cost that has been used up. For rental properties, the recovery period is typically 27.5 years for residential properties and 39 years for commercial properties. This means that over the course of 27.5 years or 39 years, the property owner can deduct a portion of the cost of the property each year. This can provide significant tax savings, especially for properties that have a high initial cost. Think of it as the "anti-aging cream" for your property.
"...work with a tax professional to ensure you're taking advantage of all the deductions and credits available to you."
In addition to deductions, rental property owners may also be eligible for various tax credits. These include the energy efficient property credit, the rehabilitation credit, and the low-income housing credit. The energy-efficient property credit allows you to claim a credit for 10% of the cost of certain energy-efficient property placed in service during the tax year, with a lifetime limit of $500. The rehabilitation credit is a dollar-for-dollar reduction in taxes for certain expenses incurred in the rehabilitation of certified historic structures. The low-income housing credit is a dollar-for-dollar reduction in taxes for certain expenses incurred in the development of low-income rental housing. These credits can provide even more tax savings, think of it as "icing on the cake" on top of the deductions.
4. Cost Segregation
Consider using a cost segregation study. A cost segregation study is a detailed analysis of the costs of a building and its components, which allows for the accelerated depreciation of certain assets. This can result in significant tax savings for the property owner by allowing them to take larger deductions in the early years of the property's ownership. This is particularly beneficial for new properties or properties that have undergone significant renovations or improvements. It's important to note that a cost segregation study should be done by a specialist with experience in this area, and the results should be reviewed by a tax professional to ensure proper implementation and compliance with tax laws.
5. 1031 Exchange
A 1031 exchange, also known as a like-kind exchange, allows property owners to defer paying taxes on the sale of a rental property by using the proceeds to purchase a similar property. This can be a powerful tax savings tool for rental property owners looking to upgrade or diversify their portfolio, as it allows them to reinvest their profits into another property without paying taxes on the sale of the original property. To qualify for a 1031 exchange, the properties must be held for investment or business purposes and the exchange must be completed within strict timeframes and guidelines set by the IRS. It's important to consult with a tax professional and a qualified intermediary to ensure compliance with 1031 exchange rules and to properly structure the transaction.
6. Passive Activity Loss
Another strategy for maximizing tax savings for rental property owners is to take advantage of passive activity loss (PAL) rules. Passive activity loss rules allow rental property owners to offset income from other passive activities, such as investments, against the losses from their rental properties. This can help to reduce overall tax liability and improve cash flow for the property owner. To qualify for PAL treatment, the property owner must not be considered a "material participant" in the rental activity, which generally means they cannot spend more than 500 hours per year on the management of the property. It's important to consult with a tax professional to ensure compliance with passive activity loss limitations and rules and to properly document and report the rental activity for tax purposes.
7. Section 179 Expense
Another strategy for rental property owners to consider is taking advantage of the Section 179 expense election. This allows rental property owners to deduct the cost of certain property and equipment, such as appliances, furniture, and other items used in the rental property, in the year the items are placed in service, instead of spreading the cost out over several years. This can provide a significant tax savings for the property owner, especially for new properties or properties that have undergone significant renovations or improvements. The Section 179 expense election is subject to limits and restrictions, so it's important to consult with a tax professional to ensure that you qualify and that you properly calculate the amount of the deduction.
8. Pass-Through Deduction
This deduction allows rental property owners to deduct up to 20% of their qualified business income (QBI) from their rental property on their personal income tax return. To qualify for the pass-through deduction, the rental property must be considered a trade or business, and the property owner's income cannot exceed certain thresholds. It's important to consult with a tax professional to ensure that you are eligible for the pass-through deduction and to properly calculate the amount of the deduction. This can provide significant tax savings and help improve cash flow for the rental property.
We got through it... Phew!
So there you have it folks, a smorgasbord of tax-saving strategies for rental property owners. From depreciation to cost segregation, 1031 exchanges to passive activity loss, and on, there are plenty of ways to reduce your tax liability and improve your cash flow as a rental property owner. You should certainly consult with a certified tax professional... if you don't have one you can certainly find easy options via TurboTax, Jackson Hewitt or really any certified tax professional competent in real estate... just make sure you don't try to navigate it on your own as things can get complicated depending on your situation.
Remember, it's important to work with a tax professional to ensure you're taking advantage of all the deductions and credits available to you regarding property taxes. And who knows, with all these tax savings and possible IRS refund, you might even have some extra cash to treat yourself to a fancy vacation to one of these imaged locations in this post! Happy tax saving season!
Related: How to Analyze a Rental Property
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About Ricardo Reis
Ricardo is a member of G3 Management & Investments and a real estate professional. He has been a successful property manager and real estate investor for over 10 years.