The investment properties you own today could finance a very comfortable retirement down the road. Maximize your investment by taking advantage of every deduction you’re eligible for and avoiding expensive tax missteps. Tax filing can become complicated for owners of investment properties, especially in the first few years of ownership. Work closely with your tax advisors to make sure you’re not leaving any money on the table at tax time.
Deductions and Investment Properties
Assuming you’re not a real estate professional, you and your tax advisors will probably use Schedule E to report your rental income and deductions. Some of the costs owners of investment properties may be able to deduct include:
Necessary expenses. These include many of the basic costs associated with owning a property, such as mortgage interest, property taxes and property insurance premiums. For rental properties, expenses like advertising and some cleaning costs can be deductible too.
- Maintenance and management costs. Materials, repairs and other expenses that are necessary to keep the property in good condition can be deducted.
- Certain expenses paid by tenants. If a tenant pays any expenses that the property owner would have to pay if they inhabited the property (like utilities or HOA fees), the owner has to report those expenses as rental income and may then deduct them.
- Legal fees. Investment property owners may deduct legal fees incurred in relation to business activity. For example, a landlord can deduct their attorney’s fees for an eviction hearing, even if they don’t ultimately win their case. Certain closing costs are also deductible when investors buy new properties.
- Travel expenses. You may be able to deduct travel expenses incurred by visiting rental properties, when the purpose of your travel is to collect rental income and/or maintain the property.
Another deduction available to rental property owners was established by the Tax Cuts and Jobs Act and is set to expire in 2025. Until it does, a property owner may be able to deduct 20 percent of qualified business income earned through rental properties, if they own the property in their name or through a pass-through business. Many factors, including the owner’s income, determine eligibility for this deduction; talk to your tax advisor for specifics.
One thing you can’t deduct is the costs of any improvements to your investment properties. Even travel expenses are nondeductible if you’re traveling to make improvements to properties you own. Improvement expenses can be partially recovered by claiming depreciation on your tax return starting in the tax year improvements were made.
More Tax Considerations for Investment Properties
There’s a lot to know about tax preparation and filing for income and losses from investment properties. Here are just a few of the important points.
Passive activity rules can get complicated. Unless you’re considered a real estate professional for IRS purposes, any money you earn from renting out your property is considered passive income. There are a lot of complicated rules around tax reporting for passive activities. One thing property owners should know is that passive losses can only be used to offset passive income, not income from other sources. In other words, if you spend $20,000 in expenses for a property this tax year and only earn $5,000 from rent, you may be able to carry the $15,000 loss over to next year but can’t use it to lower your income tax bill this year.
Reportable rental income includes more than just rent payments. Make sure you’re clear about what the IRS considers rental income and when it must be reported. Some things to keep in mind:
- Advance rent should be reported as rental income for the year in which the property owner receives it.
- If a tenant pays their last month’s rent when they first sign a lease, it’s reportable rental income for the year in which the property owner receives it. However, a security deposit that you plan to return at the end of the lease is not rental income. It only becomes income if you withhold some or all of it because the tenant causes damage. In that case, report the withheld amount as income for the year in which it’s withheld.
- Any money a tenant pays to cancel their lease early is rental income.
- If a tenant provides any services in exchange for some or part of their rent, report the full fair-market value of their rent as income.
Your tax obligations change if you use the investment property for personal use too. If you rent out a vacation home or other property for at least 14 days of the year and also use the property yourself for at least 14 days, reporting expenses on your taxes gets a little complicated. You’ll need to figure out how many days you spent using the property and break down the year’s expenses to calculate how much of those costs can be attributed to your personal use and how much can be attributed to rental use. Speak to your advisors about how using a property for both renting and personal use affects your deductions
Don’t forget about estate planning.
What happens to your investment properties if you’re incapacitated or die? As with any other real estate you own, rental properties should be included in your estate plan. Using trusts and other estate planning tools allows you to transfer property to your heirs in a way that doesn’t increase your estate tax liability.
Sachetta, LLC works with clients to solve tax questions before they become tax problems. Talk to us about your investment properties now to make sure you don’t get any surprises when it’s time to file next year’s tax return. Contact us today.
Ann Sachetta, CPA, MSA is a Certified Public Accountant, and holds a Master’s Degree in Accounting from Bentley University. After working in private industry with small businesses for over 25 years, she joined our firm in 2015. Ann specializes in helping our small business clients create solid, efficient accounting systems, and in working with them to better understand how this can improve their overall business performance.