This article has been updated to reflect the new tax laws that went into affect. Rental properties are a great investment thanks to the cash flow they produce. Not only does a great rental property provide plenty of cash flow, but rental properties have incredible tax advantages. The IRS allows most expenses associated with rental properties to be deductible or depreciated, and you can depreciate the property as well. It is very common for a rental property to produce a profit, but thanks to depreciation, show a loss on your taxes. You can also deduct the interest portion of a loan on a rental property, which is another huge advantage. I would not buy rental properties just to save money on taxes, but they can be an awesome investment when the cash flow as well.
Please consult an accountant for specific tax questions
This article is meant to offer a broad overview of the tax advantages of rental properties, not specific advice. I am not an accountant or an attorney and if you are looking for tax advice please talk to a tax professional. There are also a number of tax calculators and estimators online that can assist you as well. This article gets much of its information from the IRS tax code on rental properties.
Can interest on a mortgage be tax deductible on rental properties?
The interest you pay on a rental property can be a deduction on your tax return. Your entire payment cannot be deducted, because part of your payment is equity pay down which is not deductible. Paying down equity is not considered a business expense, since the money is not spent on repairs or maintenance, but used to reduce debt.
There is talk of the IRS eliminating the interest on mortgages as a deduction for primary home owners. However, that probably will not affect rental property owners because the interest is thought of as a business expense, not a special deduction. There is always talk of the tax code changing, but rarely do huge changes actually occur. I would not worry about rumors until they actually take place.
How does the IRS treat depreciation on rental properties?
The IRS treats rental property as an asset that can be depreciated. They assume the rental property will slowly degrade over time until it falls down and is worthless. Most properties are not going to fall into a pile of rubble unless they are not maintained, but the IRS does, which is very good for rental property owners.
The IRS says a house will last 27.5 years, which means an investor can deduct the cost basis of the rental property in equal increments over 27.5 years. To calculate the amount that can be depreciated divide the cost basis by 27.5 and that is your deduction for the next 27.5 years. For example:
- A property is bought for $150,000, but the structure is worth $120,000.
- The structure can be depreciated over 27.5 years.
- $4,364 can be deducted from your income, which can result in thousands of dollars in tax savings a year.
For commercial properties the property is depreciated over 39 years. There was talk that the new tax law would reduce both residential and commercial depreciation to 25 years, but this clause did not make it into the final bill.
What does the IRS consider the cost basis on a rental property?
The cost basis is the cost of the rental property and only includes the structure of a rental property, not the land. If you buy a rental property for $100,000 that is on its own lot, the entire $100,000 is not the cost basis. You have to deduct the value of the land from the purchase price and then you have the starting point for your cost basis. You can also add many of the closing costs like abstract, title, recording and other fees to the cost basis. The entire list can be found on the IRS website.
Depreciation is what allows a rental property to show a loss, even though it may have made you money
If I am bringing $3,000 of rental income on a property after all expenses, I get to use that $3,000 however I want. However it most likely will not show up as $3,000 in taxable income because of depreciation. If the cost basis of my rental property is $100,000 then the depreciation would be $3,636 a year for 27.5 years. The $3,636 would counteract all the income I made, plus show a loss of $636! Even though I have $3,000 more in my pocket due to my rental property, I pay no taxes on that money and may even be able to counter other income with that loss.
For more information on the best ways to buy rentals, check out my book: Build a Rental Property Empire: the no-nonsense book on finding deals, financing the right way, and managing wisely. The book is available on Amazon as a paperback, audio book, and eBook.
What is the disadvantage of depreciating a rental property?
If you depreciate a rental property over 20 years and sell the home; you will have a large tax bill from the IRS. The depreciation on rental properties can be recaptured, which means you have to pay back all those taxes you saved with the depreciation deduction. The depreciation is only recaptured if you sell the asset and for at least the amount of your cost basis minus the depreciation.
Even though you have to pay back those tax savings, it is still better to pay those taxes 20 years down the road instead of now. With inflation, money is worth less in the future and you can also invest that money for 20 years until you have to give it back to Uncle Sam. Think if it as a no interest loan from our government! You also may be paying a lower tax rate on depreciation recapture than you would on ordinary income depending on your tax rate. The depreciation recapture rate is 25 percent, where ordinary income rates can be much higher. There are also many ways to avoid depreciation recapture.
How do you avoid depreciation recapture on rental properties?
- The easiest way to avoid paying back the tax savings is to keep the rental property and never sell it. After 27.5 years you won’t be able to use the depreciation tax break anymore, but you also won’t have to pay back any of the previous tax savings.
- Another way to avoid the depreciation recapture is to use a 1031 exchange. If you sell your rental property, the IRS allows you to exchange that property for a similar property without having to recapture any depreciation. Here is much more information on 1031 exchanges.
- If you happen to pass away while you own your rental properties; the properties will pass on to your heirs. When your heirs inherit the properties the cost basis becomes the current value of the properties, not what the original owners cost basis was. That means there will be no depreciation recapture. Planning to hold your rental properties until you die is not a bad strategy tax wise.
What other expenses can be deductible on rental properties?
Not every expense on rental properties is deductible, but many are. Since rental properties are considered a business; travel expenses, accounting fees, management and many more expenses are debatable.
If you make repairs on your rental properties they are deductible as well, but improvements are not. If you repair a leaky faucet that is deductible, but if you add-on a second story it is considered an improvement and not deductible.
How are improvements calculated on tax returns?
Even though improvements are not deductible, that does not mean you can’t count them on your taxes. Improvements can be depreciated like the rental property itself. There are different amounts of time that improvements are depreciated over, ranging from 3 to 20 years. You won’t have to wait 27.5 years to see the full tax benefit of most improvements.
Are there maximum amounts that can be deducted?
The IRS has different rules for those considered in the real estate business and those that are not. If you spend more than half your time on rental properties, you are considered in the rental property business. If you are in the business, there is no limit to the deduction or losses you can take on your rental properties.
If you are not in the rental property business, you can take a maximum $25,000 loss depending on how much money you make. The more money you make, the less of a loss you can count towards your other income. The deductions and depreciation will still counteract the money you make on the rental properties, but it might not help reduce your regular income taxes.
What are some of the new tax laws that help real estate investors?
A new tax bill was passed since I first wrote this article. The bill is very friendly to real estate investors. The big change is that pass through entities can deduct 20 percent from the taxes with some restrictions. If you own a rental property in an LLC, you may be able to deduct 20 percent from your taxes. The tax rates also were lowered for most tax brackets. You can find more information on the changes in this article.
Rental properties are an awesome investment and a great way to retire thanks to the cash flow they produce. The tax savings are an amazing benefit that make rental properties an even better investment. I would always consult a tax professional for any specific tax questions or when trying to figure out what can and cannot be deducted or depreciated.