Owning rental property can provide significant tax benefits to real estate investors. Not only can rental income help diversify an investment portfolio, but properly managing a rental property allows owners to deduct various expenses and lower their taxable income.
In this article, we will explore how rental property specifically can affect an investor's taxes through common deductions, tax rates, and other strategies.
How is rental income taxed?
In most cases, income received from a rental property is not considered earned income. This means rental income is not subject to self-employment taxes, also known as FICA or payroll taxes that employed individuals pay. Instead, rental income is reported on IRS Form 1040 Schedule E and includes the total revenue, expenses, and depreciation for each rental property.
The net income or loss from Schedule E then flows through to the main Form 1040. Rental income is treated as part of an investor's total taxable income and taxed based on their applicable federal income tax bracket, just like salaries, capital gains, interest, and other sources of earnings.
What expenses can you deduct?
Owning a rental property allows investors to deduct many of the costs associated with operating the property. Common deductible expenses include repairs and maintenance, supplies, property management fees, advertising costs, insurance premiums, utilities paid by the landlord, and more. Additionally, the property's mortgage interest and property taxes are fully deductible.
Depreciation on the property is another significant tax deduction real estate investors can claim that allows them to recover their capital investment over 27.5 years. These deductions help offset rental income and reduce the amount of taxes owed.
Related: Is Rental Property Considered A Business?
Can you deduct personal expenses?
While most operating expenses are deductible, the IRS only allows deductions for expenses with a clear business purpose. However, rental property owners may be able to deduct certain personal costs to some degree. For example, if an owner belongs to a real estate club or takes continuing education classes, those dues and tuition fees can generally be deducted.
Owners may also deduct a portion of vehicle and home office expenses related to the rental business with proper documentation and record-keeping. But luxuries like vacations are nondeductible personal expenses.
How does depreciation work?
One of the most valuable tax deductions is depreciation. With real estate, depreciation essentially allows investors to deduct a portion of the capital costs of the rental property over 27.5 years. This includes the building value but not the land.
If a new roof was installed for $15,000, that amount can be depreciated. Renovations and new appliances also increase the depreciable basis. By claiming this deduction each year, it lowers the tax bill by reducing taxable income.
Even better, depreciation shields investors from full tax liability if the property is ultimately sold at a profit.
What is a 1031 exchange?
Instead of paying capital gains tax when selling a rental property, the IRS allows investors to complete a 1031 exchange to defer those taxes. In a 1031 exchange, the proceeds from the sale must be reinvested in another "like-kind" property within 180 days.
This allows equity to continue compounding tax-deferred. Repeated 1031 exchanges over decades enables significant portfolio growth while kicking the can of capital gains taxes down the road for heirs. To complete an exchange, strict guidelines must be followed to receive these valuable tax savings.
How can you decrease taxes further?
Beyond deductions, real estate pros have additional options. Partnerships, LLCs, and corporations allow income and expenses to pass through to investor tax returns but provide liability protection. Bunching expenses in alternating years via §179 or Bonus Depreciation Deductions also reduces the tax burden.
And careful planning with a CPA allows savvy landlords to maximize tax savings through strategies like cost segregation studies. With smart accounting and an eye on future tax reform, rental real estate investment remains a powerful way to acquire assets and shelter income.
Conclusion
Owning rental real estate provides investors with numerous tax benefits beyond just the revenue it generates. Deducting expenses, taking advantage of tools like depreciation and 1031 exchanges, and utilizing pass-through entities are some of the most effective ways rental property can lower an individual's overall tax burden.
