The Top 5 Tax Benefits Of Owning Rental Property
You might be contemplating investing in real estate and your primary concern might be the tax consequences. The tax authority has been very generous to real estate investors as there are several tax benefits of rental property. In this article, you will find out the top 5 tax benefits of owning rental property.
What Are The Tax Advantages Of Owning A Rental Property
Does owning rental property help with taxes? The answer is a big Yes. Rental property owners get to write off ordinary and necessary business expenses incurred in its maintenance.
These operating expenses may include repairs, supplies, pest control, marketing costs, property taxes, Utilities paid by you, fees paid to your real estate agent or any other professionals, etc.
Below is the list of the top 5 tax benefits of owning rental property.
1. Defer Capital Gain By Using Section 1031 Exchange
Section 1031 exchange allows you to defer capital gains tax if you reinvest the proceeds from the sales into the like-kind property. This exchange can take place either by
- Simultaneous swap where you sell & buy property simultaneously.
- The deferred exchange happens when you sell your property first and buy a replacement property later.
- Reversed exchange is where the replacement property is bought first and within a specified time period you sell your property.
It is important to note that the replacement property must be
- Equal or more than the property you hold in terms of price.
- Identified within 45 days.
- Purchased within 6 months.
Note that it is not a tax-free option, meaning you will be paying taxes on it at some point in the future when the gain is realized. How long you have held the property will determine the applicable tax rates.
2. Tax Break On Interest
Tax deductible interest expenses for rental property include
- Mortgage interest you pay on the loan taken out for the purchase of the rental property.
- Credit card interest you pay on the purchase of items such as appliances. Etc. Consider having a business credit card if you make a significant purchase to get a tax break.
3. Depreciation
Depreciation is a non-cash deductible expense. You can depreciate a rental property at 27.5 years except for land because land doesn’t wear out.
Additionally, any improvements you make to your home such as installing a new roof are considered capital expenditure. This means, Unlike revenue expenditures which are ongoing operating expenses, capital expenditure is a one-off expense that increases the cost basis of your fixed asset.
For e.g. every year you spend around $400 on repair & maintenance this is an ongoing revenue expenditure and will be deducted from your income for financial & tax purposes.
However, if you have bought a single-family rental property for $300,000 and installed a roof for $40,000. The cost basis of your property will be 340,000 instead of $300,000. And this will be depreciated at 27.5 years.
If you bought appliances for about $5000 they will be recorded as a separate fixed asset and will be depreciated at 5 years.
For this scenario this is how we compute the depreciation expense;
Depreciation of Property=Cost/27.5 years = $300000/27.5years=$10909
Depreciation of Appliances=Cost/5years=$5000/5=$1000
Total depreciation charge = $10909+$1000= $11909
4. There Is No Social Security And Medicare Tax
One of the tax benefits of owning rental property is you can avoid social security and medicare taxes. Self-employed individuals are liable to pay these taxes which is 15.3%. Salaried individual pays half of this tax which their employers withheld from their pay cheque.
But rental income is not subject to this tax. For e.g. if you are making $150,000 per year as a self-employed individual you owe $22,950 in payroll taxes. But if this was your income from a rental property you wouldn’t have to pay this tax.
5. Deductible Landlord Expenses
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The Home Office Deduction.
If you use a portion of your home exclusively for business purpose then the IRS allows you to deduct the expenses. You can use one of the two ways to calculate your home office deduction.
The Regular method: where you compute your deduction on the basis of your actual home office expenses.
The simplified option: where you compute home office deduction by multiplying the IRS determined rate by the home office square footage used. Note that- The IRS determined rate is $5 per square feet
- Home office square cannot exceed 300 squares
- The maximum deduction you can claim when using the simplified option is $1,500.
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Travel Expenses.
As a rental property owner you are allowed to write off travel expenses like airfare provided that your travel is for business purposes, you spent most of your time on business activities & the expenses are ordinary and necessary and nothing luxurious.
You are allowed to deduct business car expenses using two ways. One way is to keep track of the actual expenses by extensive record keeping. Another simple alternative to computing your car expenses is to multiply the standard mileage rate by the business mileage you drove during the tax year.
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The Qualified Business Income Deduction.
Suppose you are a member of a pass-through or flow-through entity where the business income is taxed as the investor’s personal income. This might make you eligible to claim a qualified business deduction of up to 20% of your qualified business income.
You can get more tax write-offs for your rental property such as continuing educational development, communication expenses, etc.
How Does Rental Property Affect Taxes?
Your level of participation will determine how rental income & losses from your rental property will affect taxes.
IRS distinguishes between material and active participation.
Material
You are materially participating in your rental business activities if you do most of the tasks & work
- 500 hours or more during tax years & the activity is significant participation activity
- 100 hours and no one else matches your level of involvement
Your regular, continuous & substantial participation also counts when establishing whether or not your participation is material. You satisfy the material participation test if you have participated in any activity for any
- 5 of the prior 10 years
- 3 prior years and the activity is a personal service
If you materially participated as a real estate professional your rental income will be non-passive and you will be allowed to deduct your losses in full. Your real estate activities might include
- Property development
- Construction
- Acquisition Mangement.
Active
Unlike material participation, active participation is less strict. You are considered an active real estate investor if you participate in making management decisions such as approving expenditures & new tenants.
Apart from making management decisions if you also hold at least 10% interest in the investment you will be allowed to deduct up to $25000 of the passive losses.
Passive
If you neither actively nor materially participate in your rental activities then you are considered a passive real estate investor. In this case, you can only use your passive losses to offset passive income.
Which one of these tax benefits of owning rental property you can enjoy and how much tax break you can get will be accurately determined by a tax professional so don’t forget to consult one.
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