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By Adam Eiseman
Every year, millions of Americans circle April 15th on their calendar in frustration and despair. Our beloved Uncle Sam asks working Americans to stroke a check for all of the hard earned income for the previous year. However, the old adage of "turning something negative into a positive" may just apply in reference to tax deductions on rental property. So, before you attempt to "cancel your subscription" to the IRS, we encourage you to understand why so many accountants develop into successful real estate investors.
1. Depreciation Regardless of the success or failure of the current real estate market, an owner/investor can write off depreciation expense. Most accountants encourage an investor to depreciate the cost of their real estate property over the course of 27.5 years. So, every year of ownership a (1/27.5) portion of the cost is deductible.
2. Interest Often times, interest is an investor's single largest deductible expense. The most common thought of variation of deductible interest expense is in relation to the mortgage/loan from purchase or refinance. However, another deductible component is the interest paid on credit cards for any goods or services related to landlord activity. A related topic is that the lender's origination points charged to a borrower and some additional closing costs may also be deducted during the year of purchase.
3. Insurance & Casualty Losses Premiums for almost any type of insurance coverage related to rental activity is tax deductible. Property, liability, rent loss, flood, fire and theft are some of the policies that can be written off. Should an investor's rental property be damaged or destroyed from a sudden event like a fire, flood, or natural disaster, they can obtain a tax deducation for all or part of the loss. The amount of the loss that becomes deductible is typically determined by the amount that was covered by insurance and extent of destruction.
4. Property Taxes On almost every parcel in the United States, the local or state government want their piece of the action as well. Any property taxes paid during the calendar year are also tax dedcutible when filing your federal income taxes. This includes CDD (community development) and HOA (homeowners association) fees as well.
5. Independent Contractors Whenever an investor hires anyone to perform services for their rental activity, the expense paid to the independent contractors is tax deductible. A common example of this includes a maintenance person or handyman.
6. Repairs Assuming the repairs are necessary, ordinary and priced reasonably, the cost of any repairs to a rental property are fully deductible for the year in which they occurred. Examples of maintenance includes re-flooring, re-painting, replacing broken windows, repairing old siding, fixing leaks, etc. It is important to distinguish a repair from an improvement. Improvements that are deemed to add significant value to the property are not deductible. Some examples of improvements would be additions, new roof, pool, patio, etc. The cost of these improvements should be added to the cost of the real estate property when calculating depreciation each year (essentially increasing the amount of the depreciation expense deducted).
7. Legal and Professional Services Any fees paid to an attorney, accountant, property manager, real estate investment advisor or other professionals related to rental activity are tax deductible. The fees can deducted as operating expenses as long as they are tied to real estate. In relation to a property manager, tenant placement fees and monthly management fees are both deductible.
8. Short on Cash, Just Refinance When an investor sells a property, they must pay taxes on the profit at capital gains rate. However, instead of taking the cash from the sale and paying taxes on the profit, an investor has the option to refinance a rental property. By executing a refinance, an investor can take the cash out without losing an income producing asset or paying taxes on the profit from the sale. If an investor holds the property forever and passes it down to their heirs, they will never pay the tax from taking the cash out. As mentioned above in reason #2, any interest paid as part of the new loan is tax deductible.
9. When Selling Time Comes, Consider a 1031 Exchange By definition, a 1031 exchange is a process where an investor can sell a rental property and put the proceeds of the sale into another property purchase without paying any taxes on the proceeds. The replacement property must also be an investment property and must cost more than the property that was sold. A 1031 exchange comes with strict timelines to buy the replacement property and an investor does pay property taxes on the profits of both properties, when the replacement property is sold. However, an investor may continue to perform 1031 exchanges, permanently avoiding paying capital gains tax as opposed to deferring the taxation.
Renting out real estate is generally considered a passive income activity even if you devote a substantial amount of time to the investment. This is pertinent because the IRS limits the amount of tax deductions from rental properties to $25,000 per year under the "Passive Activity Losses" regulation. All good things come with limitations! So, now that you have familiarity with the tax deductions of rental properties, you can go back to your accountant with a little eye to eye wink about allowing Uncle Sam to work for you.