Purchasing a rental property is one of the promising strategies for protecting and diversifying your wealth. It can help you achieve a valuable, recurring cash flow from a steady passive income and open up a treasure chest of tax advantages more than any other investment.
Additionally, compared to short-term capital gains, long-term gains have lower tax obligations. However, landlords are often unaware of the tax advantages offered due to owning a house and end up paying more than required. Therefore, it is crucial to understand how you can benefit from these deductions.
Here is an overview of all the benefits you can receive that you should know:
1. Deduction in Mortgage Interest
Mortgage interest is the single-largest deduction landlords can take. However, there are other types of interest deductions you should consider. You can write off your home improvement loan interests and credit card interest on products and services used in your rental and mortgage interests.
HMID allows itemizing homeowners to cut mortgage interest paid on up to $750,000 worth of their loan principal. Along with that, The Tax Cuts and Jobs Act (TCJA) which was passed in 2017, allows for reducing the maximum mortgage principal eligible for deductible interest to $750,000 from $1 million for new loans.
2. Depreciation Allowance for the Rental Property
A rental unit has a productive life span of 27.5 years. Your investment loses value each year, but you can get back the cost of real estate through depreciation. You can depreciate any property you use for your rental activity, including houses, duplexes, condominiums, apartment buildings, swimming pools, parking lots, and other facilities for your tenants. You can also depreciate structures you own and use for business purposes even though your tenants do not use them.
You can calculate your depreciation expense using the formula below:
Depreciation expense = The value of a property divided by 27.5 years.
For example, if you purchased a property at $200,000, your depreciation expenses would be:
Annual depreciation expense = $200,000 / 27.5 = $7,273
You can deduct a $7,273 depreciation expense from your annual taxable income.
3. Deductible Repairs Costs
The cost of rental repairs is also fully deductible while getting a tax write-off. You need to write off these expenses in the year they are incurred. Typical examples of deductible repairs are:
- Fixing gutters or floors
- Replacing broken windows.
- Cleaning costs
- Electrical repairs
The significant repairs are categorized as improvements, which you can depreciate rather than deduct.
4. Pass-Through Tax Deduction
Passive income is any money earned from business activity landlords do not physically participate in. The typical form of passive income is rent and income earned through real estate investment. In 2018, The Tax Cuts and Jobs Act (TCJA) set a new pass-through tax deduction, enabling landlords to deduct up to 20% of their net rental income and 2.5% of the initial cost of their leased house, including 25% of the amount they pay their employees. However, this deduction will expire after 2025.
5. Traveling Expense Deduction
Landlords can keep a record of their mileage while traveling because they are entitled to a tax deduction for most of the traveling they do for their business purposes. You can deduct your expenses whenever you drive to your investment building for several things, such as dealing with tenant issues, delivering supplies, collecting rent, and addressing repair tasks. Apart from this, you can deduct for mileage or the wear and tear on your car if you have local properties. For distant properties, you can deduct travel and the cost of renting a room.
6. Deductible Insurance Premium
The premiums you pay for almost any insurance for your rental activity are tax-deductible. It includes liability, casualty, fire theft, flood insurance, and any other insurance related to the unit. Additionally, if you have hired employees, you can cut the cost of their health and workers’ compensation insurance.
7. Lower Tax Rates on Long-Term Capital Gains
Capital gain is the profit landlords make when they sell their real estate, which is generally taxed in two ways – short-term and long-term capital gains. Since there is no specific tax treatment for short-term capital gains, owners must pay taxes at their regular IRS-defined tax bracket. Depending on your rental income, if you make a long-term investment, you have to pay long-term capital gains of 0%, 15%, or 20% on any profit from the sale. However, long-term capital gains are more favorable for property owners as they lower tax rates than short-term gains.
8. The Section 1031 Advantage
As per Section 1031 of the Internal Revenue Code, landlords can swap their rental for another similar unit with little to no tax obligations. The 1031 exchange allows owners or investors to pass on their capital gains from one property to another to skip paying taxes. However, there are a few 1031 exchange rules to follow:
- Both properties should be equal or of more value compared to the one you are selling
- You must identify a new real estate within 45 days
- You must use the new property for business purposes
- You must buy the replacement unit within 180 days
9. Other Expenses You Can Deduct
Apart from the deductions mentioned above, you can also deduct the cost of personal property used for rental purposes. Such things include appliances, gardening equipment or furniture in the units. Additionally, if you hire anyone to perform your services, you can cut their wages as a rental business expense.
It applies when the worker is a resident manager or an independent contractor. You can also write off fees that you pay to accountants, attorneys, real estate management companies, real estate investment, and operating expenses if you have already paid the costs for work related to your business activity.
By now, you must have understood the rental property tax benefit you qualify for and how you can cut them to improve your bottom line. However, if you need adequate information and taxation knowledge, you can seek professional help from an experienced company like Portola Property Management.
We make it easy for landlords to track the house’s performance, organize real estate documents and export tax-ready financials at tax time to make maximum profit. For information, contact us at Portola Property Management.