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Tax Implications to Know if You Own a Rental Property

Tax Implications to Know if You Own a Rental Property

You've probably heard somewhere that buying multiple properties is a surefire way to become a millionaire. While owning a rental property is indeed a way to start the process of building wealth, it is imperative that you fully understand the costs involved, what expenses are deductible, and the best advice on how to manage what will be considered a new business. Let's examine these four key implications.


Understand the expenses that offset rental income

Rental expenses and income are listed in Schedule E of the tax return and are considered "passive income" and not "earned income."

This distinction is crucial, especially when assessing the losses on your rented property. Passive losses can only offset passive income and cannot affect income from non-passive activities, such as a daily job or side business. Moreover, passive losses cannot be offset by investments or dividends.

However, many common deductible expenses can work in your favor, including:

  • Administrative expenses: rental companies and property managers

  • Advertising: e.g., online service listing to promote your rental property

  • Cars and Travel: e.g., local expenses and overnight travel to manage the rental

  • Cleaning and maintenance/repair: costs of maintaining your rental in good condition.

  • Insurance (do not include PMI): insurance that protects your property, such as home and tenants insurance, when paid on behalf of the tenant

  • Legal and other fees: CPA fees, lawyers, realtor fees paid to find a tenant

  • Mortgage interest: Use your 1098 for total interest paid in this fiscal year

  • Property taxes: a continuous expense of ownership


Factor in Depreciation, Basis, and Home Improvements

The basis is the purchase cost of any property (excluding closing costs/taxes). This is important when calculating the lease sale's annual depreciation and capital gains.

It helps to understand that certain events can increase or decrease your basis. Usually, your basis will increase when you do home improvement projects, renovations, or major electrical or plumbing work (also called capital expenditures).

Capital expenditures are generally not deducted over one year but amortized over several years.

Instead of taking a large deduction in the year you buy and/or make improvements to the property, depreciation distributes a deduction for the life of the property, which is 27.5 years for residential properties. Consider:

  • Appliances such as stoves, refrigerators, or furniture used in rented property can be depreciated before 5 years instead of 27.5 years. Your CPA will know which items fall under the various depreciation schedules.

  • Only the cost of the building and certain leased movables can be depreciated, not the land since it never gets used up.

  • When selling a leased property, a real estate investor must "recover" the depreciation incurred in previous years.


Determine eligibility for a Qualifying Business Income Deduction

The Qualifying Business Income (QBI) deduction is a tax deduction that allows small business owners and qualifying self-employed individuals to deduct up to 20% of their qualifying business income.

Landlords can assume that their rental income qualifies for this deduction. Still, passive rental companies are not considered a business or company unless they are RREE (rental real estate enterprise). Be sure to check with a CPA that the QBI will be a deduction you can count on.


Invest in Bookkeeping 

You might wonder how you can keep track of all these expenses, incomes, and home improvements. The answer is proper bookkeeping, the holy grail of a regular tax season.

To show that you are eligible for the tax benefits mentioned above, you must keep track of everything, including invoices, receipts, and rent collection. A good way to do this is to invest in accounting software. 

Pro Tip: Keep a separate account where all your income and expenses come from, which helps avoid "asset confusion."

If you treat your business money as your own, you risk exposing your belongings to a lawsuit (even if you have an LLC). The IRS may also try to treat certain business expenses as personal in a future audit if you're not careful.


Plan Ahead

If owning a rental property is your dream, consider the tips before starting. As with any other asset, being aware of the tax implications, obligations, and benefits before purchasing will ensure you have a tax-free trip.


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