No landlord would pay more than necessary for utilities or other operating expenses for a rental property. Yet millions of landlords pay more taxes on their rental income than they have to. Why? Rental real estate provides more tax benefits than almost any other investment. Often, these benefits make the difference between losing money and earning a profit on a rental property. Here are the top ten tax deductions for owners of residential rental property.
1.) Operating Expenses
There are many different types of operating expenses which may vary depending on the type of property. Accordingly, the IRS does not attempt to provide an all-inclusive list: rather, the tax code gives the definition of an operating expense, so you can decide for yourself (subject to IRS second-guessing, of course). To be deductible, the expense must be: (1) “ordinary and necessary; (2) current (i.e., less than a year); (3) directly related to your rental activity; and (4) reasonable in amount.” (IRC sec. 162). Therefore, all expenses reasonable and necessary to operate and maintain an income producing property are tax deductible. These include expenses such as property management fees, property taxes, office supplies, leasing commissions, license fees, accounting fees, advertising costs, legal fees and judgments and settlements, insurance premiums, janitorial service, lawn maintenance services, pest control, repair costs, salary and wages, snow removal service, miscellaneous supplies, telephone, trash removal, vehicle mileage expenses, utilities, etc. Operating expenses that are not deductible include federal income taxes paid on rental income, professional examination fees, club dues (country club, social club, airline club, athletic club) charitable donations (unless made by a C Corp.), lobbying expenses beyond a $2,000 limit, illegal bribes or kickbacks, 2/3 of federal antitrust damages, and fines or penal ties paid for law violations.
2.) Start Up Expenses
Closely related to operating expenses are “start up expenses.” The only difference is that operating expenses occur after the business begins; start up expenses occur before the business begins. However, they are usually the same kinds of expenses. These include: make ready repairs, home office expenses, seminars, insurance costs, office expenses (telephone, rent, utilities, etc.), market research costs, permits and fees, professional service fees, hiring expenses, and maintenance expenses. Up to $5,000 in start up expenses can be deducted your first year in business. Amounts over $5,000 are a capital expense and are amortized over 15 years.
Note that the deduction rules refer to a business. Investors (who do not have a business) may not deduct start up expenses. Further, if you have expenses investigating a business but never start one, you may not deduct start up expenses.
Repairs can be some of the most valuable deductions available to a property owner. Yet, the IRS will disallow some repair deductions on the basis that they are “improvements,” which must be depreciated. Knowing the difference between “repairs” and “improvements” can provide valuable deductions in a given year.
A “repair” keeps your rental property in good condition, but it does not (1) materially add value to your property, (2) substantially prolong its useful life, or (3) make it more useful. (Regulation sec. 1.162-4). A repair is a deductible expense in the year that you pay for it.
Repairs include painting, fixing a broken toilet, and replacing a faulty light switch. The cost of repairs to rental property (provided the repairs are ordinary, necessary, and reasonable in amount) are fully deductible in the year in which they are incurred. Good examples of deductible repairs include repainting, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows.
Rental property owners may assume that anything they do on their property is a deducible expense. Not so, according to the IRS. “Improvements” add value to your property and are not deductible when you pay for them. You must recover the cost of improvements by depreciating the expense over your property’s life expectancy. Improvements can include a new roof, patio, or garage. From a tax standpoint, you should make repairs as the problems arise instead of waiting until they multiply and require an improvement.
4.) Property Used In Rental Activities
This requirement mainly distinguishes business property, which is depreciable, from personal property, which is not depreciable. If certain property is used for both business and personal reasons, then it is proper to allocate the business and personal uses and depreciate only that portion of the property that is used in the business.
The Nuts And Bolts Of Depreciation
To depreciate an asset is to deduct a percentage of the asset’s basis each year of its recovery period. This simple statement requires a lot of detailed explanation.
1.) Placed in service
Depreciation begins when an asset is “placed in service.” For rental property, this means when the property is ready to rent. Property is not in service if it is being rehabbed or being made ready to rent. Conversely, depreciation ends when the property is retired from service, destroyed, or sold.
Basis is the amount of your total investment in the property, minus the land value. For a rental property recently purchased, the basis may include the cost of the property, transaction expenses, real estate transfer taxes and fees.
3.) Recovery Period
The recovery period is the length of time the IRS has determined you must use to de preciate an asset. The recovery period varies depending upon the type of asset. Exam ples of recovery periods for certain assets are: software — 3 years; computers, vehicles, appliances, carpet, furniture and draperies – 5 years; Office furniture/equipment – 7 years; landscaping, fences, driveways, swimming pools – 15 years; rental real estate – 27.5 years; commercial real estate – 39 years.
4.) The Amount to Deduct
The amount to deduct is a fixed percentage of the property’s basis each year. However, the percentage will depend upon the depreciation method that is used. Real Property is required to use the straight line method, which means an equal amount each year of the recovery period. Eligible personal business property uses the accelerated depre ciation method, which allows for larger depreciation amounts in the earlier years. For example, for residential rental property, you would be allowed to deduct approximately 3.636% of the basis of the property each year for about 27.5 years (first and last years have special rules).
Additions And Improvements
Changes you make to a building that “substantially add value or increase its useful life are classified as “additions or improvements.” These changes to the building will be depreciated separately from the way you depreciate the building itself. Some examples of additions or improvements are: adding new living areas or square footage; replacing roofs, windows, doors, or balconies; or installing new appliances, countertops, cabinets plumbing or wiring.
By contrast a repair does not substantially add to the value or useful life of a property but merely returns it to its normal condition. Repairs are operating expenses and can be deducted fully in the same year the expense was made.
TAX TIP: Characterize changes to rental property as repairs rather than improvements to the extent allowable by law. You may maximize yearly deductions by carefully planning how you go about making changes to property. That means to keep the property in good condition with timely repairs rather than allowing repairs to mount until a major renovation is required.
Depreciating “Non-Building” Permanent Structures
What does the tax code allow for sprinkler and drainage systems, driveways and parking structures, swimming pools, gazebos, fencing and gates, sidewalks, and outdoor safety lighting at night? These are permanent structures that are associated with and support residential rental property. The tax code provides that these structures may be depreciated over a period of 15 years.
Depreciating “Personal Property”
Capital assets that are used in a rental activity but are not residential rental property are classified as “personal property.” A better term is “personal business property “ because it is clearly used for business, but could be considered of a “personal” nature. It can be deducted using one of three methods (in order of importance): (1) Section 179 expensing; (2) 50% first year bonus depreciation for 2012 only; or (3) regular depreciation.
Personal property includes window treatments, furniture owned by the landlord, temporary partitions or barriers, signage, and tacked-down carpets, landscaping and maintenance equipment, vehicles, and office equipment and furniture in the business office. It also includes equipment in common areas, such as laundry equipment, exercise equipment, and recreational equipment.