Joe Boylan

As the proud owner of rental property, there’s a good chance that you know about and are already using one of the most well-known and popular tax deductions available to landlords:

Repairs are a much-loved deduction, and for many landlords, they represent a significant saving come tax time. They’re popular thanks to their value, as well as the fact that they’re a tangible expense. It’s easy to remember these expenses when you’re doing taxes, and not too difficult to save the receipts throughout the year –especially if you’re organized.

But while this deduction is indeed popular, some landlords aren’t aware that not every repair should be treated the same. While some are able to be fully deducted in the year that they’re incurred, for others, how they’re able to be deducted will vary depending on a few different factors.

The main difference in how these expenditures are treated comes down to one important distinction: is it a repair, or is it an improvement? The IRS also outlines several “safe harbors,” as they call them, under which you can fully deduct many repairs that would otherwise have to be depreciated more slowly over time.

Although making sense of the different distinctions and nuances of the IRS’ guidelines can get a bit complicated, in this guide, we’ll attempt to uncover the main points for classifying and deducting repairs and improvement expenses for your rental.

Repairs Vs. Improvements

While rental repairs and improvements are both able to be deducted, the IRS has different rules regarding how they must be claimed.

Repairs are operating expenses that are deemed ordinary, necessary, and reasonable in amount. As long as they meet these requirements, they’re able to be fully deducted in the year that they’re incurred.

However, certain types of upkeep aren’t considered to be repairs; but instead, need to be classified as capital improvements. Improvements are things that add value to your property or benefit your property for more than one year. Since the benefit to your property will extend beyond one year, they cannot be depreciated in just a single year, but instead must be spread out over the course of a longer period of time and claimed a little at a time on your tax return each year.

In most cases, you’re better off from a tax point of view if you can classify an expense as a repair, rather than an improvement, as you’ll be able to deduct the entire expense all at once instead of having to slowly deduct it over a long period of time. Of course, this doesn’t mean that you should never do improvements on your property, only that from a tax perspective, repairs offer more benefits.

Now, how can you tell the difference between repairs and improvements?

The IRS’ regulations spell out rules for what constitutes a repair and what is considered an improvement. This guide is fairly long, however, and quite complicated as well.

Still, generally speaking, the IRS uses the following categories to define what qualifies as a capital expense.

According to the IRS, expenses that fall under these categories must be depreciated:

• Improvements: You must capitalize any expense you pay to improve your rental property. An expense is for an improvement if it results in a betterment to your property, restores your property, or adapts your property to a new or different use.
• Betterments: Expenses that may result in a betterment to your property include expenses for fixing a pre-existing defect or condition, enlarging or expanding your property, or increasing the capacity, strength, or quality of your property.
• Restoration: Expenses that may be for restoration include expenses for replacing a substantial structural part of your property, repairing damage to your property after you properly adjusted the basis of your property as a result of a casualty loss, or rebuilding your property to a like-new condition.
• Adaptation: Expenses that may be for adaptation include expenses for altering your property to a use that isn’t consistent with the intended ordinary use of your property when you began renting the property.

Here’s a look at some examples of improvements from the IRS:

Additions:

• Bedroom
• Bathroom
• Deck
• Garage
• Porch
• Patio

Lawn & Grounds:

• Driveway
• Walkway
• Fence
• Retaining wall
• Sprinkler system
• Swimming pool

Miscellaneous:

• Storm windows, doors
• New roof
• Central vacuum
• Wiring upgrades
• Satellite dish
• Security system

Heating & Air Conditioning:

• Heating system
• Central air conditioning
• Furnace
• Ductwork
• Central humidifier
• Filtration system

Plumbing:

• Septic system
• Water heater
• Soft water system
• Filtration system

Interior Improvements

• Built-in appliances
• Kitchen modernization
• Flooring
• Wall-to-wall carpeting

Insulation

• Attic
• Walls, floor
• Pipes, ductwork

Three Safe Harbors

For most landlords, being able to deduct expenses all at once in the year that they were incurred is always preferable; and better than having to depreciate them.

Thankfully, the IRS provides what’s known as “safe harbors” –conditions that landlords can use to deduct certain rental-related expenses –in one year.

Here’s a look at these three safe harbors now:

• The small taxpayer safe harbor
• The routine maintenance safe harbor, and
• The de minimus safe harbor

If an expense falls under any of the safe harbors, then it can be treated as a currently deductible expense and deducted entirely in the year that it occurs.

In short, these safe harbors make life easier and allow you to deduct expenses that otherwise would have to be depreciated.

In order to determine whether an expense qualifies as a deduction, first, determine whether it falls under one of the safe harbor provisions. Secondly, if no safe harbors apply, you’ll then want to determine whether the expense is a deductible repair or an improvement.

With this in mind, here’s a look at the three safe harbors now:

1. Safe Harbor for Small Taxpayers (SHST):The safe harbor for small taxpayers (SHST) could easily rank as one of the most important safe harbors for small landlords. Under this safe harbor, you can deduct all of your annual expenses for your rental –including repairs, maintenance, and improvements –without having to worry about whether or not they qualify as repairs as opposed to improvements

   However, it’s important to note that there are some important restrictions when it comes to using this safe harbor, and of course, you’ll also need to keep track of all of your expenses throughout the year as well.

   In order to qualify, the total amount of maintenance, repairs, and improvements that you’ve paid out during the year must total less than $10,000 or 2% of the unadjusted basis of the building –whichever’s less.

   Additionally, the SHST can only be used for buildings with an unadjusted basis of $1 million or less. Although if you own more than one rental unit or building, the $1 million limit is applied to each separately.

   Finally, in order to qualify, you must have average annual gross receipts of no more than $10 million during the three preceding tax years.

   You can learn more about the Safe Harbor for Small Taxpayers in Nolo’s article: Small Taxpayer Safe Harbor For Repairs and Improvements.

2. Routine Maintenance Safe Harbor:Under the routine maintenance safe harbor, expenses that qualify as routine maintenance are deductible in a single year. With this safe harbor, there are no dollar limits and any landlord can use it, regardless of the amount spent on maintenance. However, there are a few limits on when this safe harbor can be used

   Take a look:

   Routine maintenance is recurring work done to keep a building in operating condition, and includes two activities:

   • Inspection, cleaning, and testing of the building structure and/or each building system, and
   • Replacement of damaged or worn parts with comparable and commercially available replacement parts.

   There are two main limitations to routine maintenance: the ten-year rule and the no betterments rule.

   • The Ten-Year RuleMaintenance qualifies for the routine maintenance safe harbor only if, when you placed the building or building system into service, you expected to perform this maintenance more frequently than once every ten years.
   • No Betterments or RestorationsThis safe harbor is intended for expenses incurred to keep the property in operating condition, but it does not apply to major remodeling projects. Additionally, you can’t use this safe harbor when you’ve taken a casualty loss.
3. De Minimis Safe HarborFinally, there’s also the de minimis safe harbor. With this option, landlords can deduct any low-cost personal property items used in their rental business. In most cases, the maximum amount is $2,500 per item.

   All expenses you deduct using the de minimis safe harbor must be counted toward the annual limit; the lesser of 2% of the rental’s cost or $10,000.

Repair Versus Improvements

If your expenses don’t fall under a safe harbor, then you’ll need to determine whether they are improvements or repairs. While repairs can be deducted in one year, improvements must be depreciated and deducted over several years.

In order to determine whether it’s a repair or improvement, you’ll need to delve into the IRS’ repair regulations and determine what the unit of property (UOP) in question is. You’ll then want to decide whether the expense resulted in an improvement.

Under IRS regulations, buildings must be divided up into nine different UOPs.

Here’s a look at them now:

1. Building Structure
2. Heating, ventilation, and air conditioning (HVAC) systems
3. Plumbing systems
4. Electrical systems
5. Escalators
6. Elevators
7. Fire-protection and alarm systems.
8. Security systems
9. Gas distribution system

Generally speaking, the larger the UOP, the more likely the work will be considered a repair, rather than an improvement.

Joseph Lewis, CPA, and Partner at Isler CPA explains this concept well in his article: Rental Property Repairs: to Expense or to Capitalize? That Is the Question. “Work on an engine of a vehicle is more likely to be classified as an expense that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.”

Any work done to any of the above building systems that improves that system in some way must be depreciated.

Deducting Repairs and Maintenance

Repairs and maintenance are different things, but you’ll want to deduct both of them on IRS Schedule E. You’re required to list each type of expense separately, so try to keep track of them throughout the year as well.

At the end of the day, landlords benefit more from a tax perspective by taking advantage of the safe harbors or making repairs; rather than upgrades. While upgrades can be a necessary part of owning a rental, it’s always a good idea to consider the long-term tax implications when deciding whether to repair or replace an item.

Additional Resources

Here are some additional resources on deducting rental property repairs and improvements.

• IRS – Form 1040 Schedule E Instructions
• IRS – Form 1040 Schedule E Instructions
• IRS – A Brief Overview of Depreciation
• IRS Publication 946 – How to Depreciate a Property
• Nolo: Every Landlord’s Tax Deduction Guide

Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.

The end of a lease is an important event for landlords and tenants alike.

It can also be a time of conflicting expectations.

The landlord will usually expect their property to be returned to them in the exact condition that it was in when the tenants moved in –and if this doesn’t happen, are often happy to use the tenant’s security deposit to make it this way. Tenants, on the other hand, more often than not will expect their full security deposit back, even if there has been some damage to the rental.

In order to help manage expectations, and make the move-out process as simple and straightforward as possible, it’s important for both landlords and tenants to be on the same page. This includes having a good understanding of security deposits, and what they can and cannot be used for.

At the Time of Move-Out

At the time of move-out, the landlord or property manager is responsible for repairing any damages to the property, as well as assessing and documenting normal wear and tear. A good Property Manager will have a move-out routine that includes items like:

• Making sure the property is clean
• Replace all furnace filters
• Check smoke and CO detectors are in good working order
• Replace burnt-out lightbulbs
• etc…

They’re also responsible for deciding who will pay for any repairs, maintenance, and cleaning that’s required to bring the property back into rentable condition.

This is the part of the process that’s often full of contention. When it comes to assessing damages, the landlord’s job is to assess the property and determine what falls under the category of damages, and what should be considered simply normal wear and tear. While damages are the tenant’s responsibility, things that fall under the category of normal wear, should not be taken out of the security deposit.

It’s important that landlords not use the security deposit to pay for things that go above and beyond the scope of normal wear. They may attempt to use it for things like worn carpeting or faded paint on the walls, things that aren’t damages, but instead are just the result of normal usage. In most cases, landlords know to use the security deposit as intended, to repair damages to the property, only for the tenant to contest this, and seek to get it back. One important exception to this rule pertains to items spelled out in the lease. Examples might be cleaning or carpet cleaning. If these items are stipulated as tenant responsibility in the lease, the landlord is within their rights to use security deposit funds to pay for them, if the tenant left these items undone.

When it comes to repairs, though, the law stipulates that the security deposit should only be used for repairs to damage that goes beyond what’s considered to be ordinary wear and tear.

Colorado Law (C.R.S. 38-12-102) defines “normal wear and tear as “Deterioration which occurs, based upon the use for which the rental unit is intended, without negligence, carelessness, accident, or abuse of the premises or equipment or chattels by the tenant or members of his household, or their invitees or guests.”

That’s a bit confusing for landlords and tenants alike. To help clear things up, here’s a list of examples of both normal wear and tear and damage.

When determining costs, the landlord will also make decisions about repairing versus actual replacement. In some cases, repair is the best choice. A good example of this would be a recent experience we had. A tenant had backed a car into the side of a home damaging a section of masonite siding. The siding was already in rough shape and the product was failing and the particular pattern was no longer available. The owner was planning to reclad the home in stucco in a couple of years anyway, so we just applied a patch using every the favorite body putty of every motorhead, “Bondo”.

This repair worked out well because the owner already had a plan in place for new exterior stucco and was willing to kick the can down the road. Had this not been the case, the repair could have cost the tenant a lot more money. It’s important to note that in some cases, a landlord may charge a replacement cost for an item that could be repaired with a short-term fix. So, for example, suppose a tenant punches a large hole in a wall. The landlord may choose to repair it in the short-term by simply patching it. While this temporary fix is fine for the short-term, the underlying fact is the wallboard is not the same, and the owner may choose to go back at some point and replace the entire wallboard so they are within their rights to charge for replacement.

Calculating Repairs Cost

If the item can be repaired, though, in most cases the landlord will choose to go that route. In this case, the landlord will deduct for labor, materials, and travel.

• Calculating Average Repair Costs-It’s also important for the landlord to determine material and labor costs based off of averages. This will help to avoid conflicts, and in the event of litigation, the courts will also require a list of repairs, and having average costs will make it easier to prove your case.
• Factoring in Depreciation-Depreciation also factors into how much the tenant ends up being charged for damages. Depreciation takes into account the fact that things have a life expectancy. This includes carpet, appliances, paint, tile, and more. This life expectancy needs to be factored into the cost of repairs or replacement.

For example: if a five-year-old carpet is destroyed and that particular type of carpeting had a 10-year life expectancy, the landlord may only charge the tenant 50% of the replacement cost. This is a good practice, and extremely important as it helps to prevent landlords from using deposit funds in order to upgrade their properties.

These are estimates are produced by HUD. Manufacturer estimates will vary.

Assessing the Condition of the Property

Assessing the condition of the property is the responsibility of the landlord or property manager.

This will allow the landlord to determine whether there are any damages that are the tenant’s responsibility, and therefore should be paid for out of the security deposit. It also allows them to set the condition baseline before a new tenant moves in.

The challenge is determining and documenting the condition of the property before the damage occurred. This is important in the event that the tenant disputes the damages, or if the case goes to court, as having proof that the affected or damaged area was in good condition before will generally resolve the issue.

Documentation Methods Include:

• Written Reports: Written reports are an old method, but one that’s still in use today. With a written report, the landlord or property manager does a walk-through of the property and takes notes on its condition. Relying solely on written reports isn’t the best option, since it can be subjective, and doesn’t really provide much proof of the condition one way or the other. In most cases, property managers and landlords would be better served by using another form of documentation in addition to, or instead of a written report.
• Apps: Some landlords prefer to use an app that prompts them for pictures and notes. Although this certainly is a step above the old-fashioned written report, in that it makes it easy to capture images and notes to go along with your report, in some cases, they just aren’t thorough enough.
• Video: Video footage is an especially good method of documentation. To capture video footage, the landlord or property manager will perform a walk-through inspection of the home with a video recorder or phone, compiling a detailed video of the condition of the unit. However, this method can be problematic. When it comes to finding the affected item in question, having video footage means that the landlord will have to fast forward and rewind through quite a bit of footage. This can be time-consuming and uncomfortable in court. Just imagine fast forwarding and rewinding while the judge waits! Of course, you could capture image stills before you go to court, but again, this could be a time-consuming process.
• Pictures: Taking photos is one of the best ways to document the condition of a property. And it’s especially affordable since the advent of digital photography and affordable storage options. You can take hundreds of pictures of a property and if there’s damage, it’s fairly easy to go back and find the photograph that references the newly-damaged area. If you choose this method, just make sure you use your digital camera’s time and date stamp feature.
• 3D Imagery: Another new method for documenting the condition of a property, using 3D photography like the Matterport 3D camera allows landlords to do realistic virtual walkthroughs on properties. Since the footage is stored in the cloud, you can use the mouse to walk right up to the area that’s damaged and check to see what the condition was prior to their move-in. You can also take additional pictures inside cabinets, closets, and other places the camera can’t see. A secondary benefit from these tours is showing prospective tenants –especially out-of-state applicants, the property before they agree to lease it.

Tenant Should Protect Themselves

Of course, there’s a lot that tenants can do to help ensure that they’ll get their deposit back at the end of their lease.

First, of course, tenants should ensure that they keep the property in good condition while they live there, and avoid anything that might cause damage to it.

Secondly, if a tenant would like to contest the landlord’s decision to apply the security deposit to damage, they can do so. The best way to do this is by being able to furnish proof of the condition of the property. In most cases, tenants should consider taking their own photos. Generally speaking, the more documentation, the better. Photos that are taken at the time of move-in could provide proof of the condition of the property, and images that are obtained, say; a month into the lease could be used as proof of damage caused by movers. It’s also a good idea to use a camera with a time and date stamp feature and to show any pictures of post-move-in damage to the landlord.

It’s also worth noting that if a landlord fails to follow Colorado security deposit laws, the tenant could be awarded up to three times the amount that was wrongfully withheld, plus attorney’s fees and court costs, so it’s important for landlords to ensure that they remain in compliance with the law, and handle the security deposit properly.

Being Clear on the Terms of the Lease

For tenants, it’s important to remember that normal wear and tear versus damage are broad definitions, and much of the detail about the condition that you’re required to leave the property in at move-out will be specified out in your lease.

It’s important to read the lease before signing it and to make sure you ask questions to ensure that you’re clear on what’s expected of you. For instance, in some cases a landlord may state that the carpets are to be professionally cleaned at the time of move-out, others will require you to perform regular, outdoor grounds keeping maintenance, so make sure you fully understand your responsibilities and requirements before you move in.

Successful and straightforward move-outs are always the result of good documentation and communication, from both parties. It’s important for landlords to spell out their expectations in the lease document, and for tenants to ensure that they’ve read the lease –and are clear on their responsibilities both in terms of maintenance, and the condition that they’re expected to leave the property in at the time of move-out.

 Additional Resources:

• Wendy Weir-Renting vs Buying, Weigh Your Options
• Michelle Gibson-Why Should a Wellington Landlord Pick You?
• Anita Clark-Should I Sell or Rent My Home?

For most landlords, being able to deduct operating expenses can make a big difference on the amount of tax that they owe.

But when it comes to fully utilizing those deductions, that’s where many landlords struggle. After all, there are so many different expenses that you can claim! Additionally, the IRS doesn’t have an exhaustive list of all the eligible expenses, just that they must meet their requirements to qualify as deductible. This means that they must be ordinary and necessary, current, directly related to your rental activity, and reasonable in amount.

Here’s a look at what you should know about operating expenses, and how you can claim them on your taxes.

Deductions: Current Vs. Capital

Deductions fall into one of two different categories: current and capital.

Let’s look at both now.

• Current Expenses:: These are generally for one-off purchases or expenses to keep the property in good working condition or to help you run your rental business. Current expenses can be claimed in whole on your tax return and deducted entirely in the year that they occurred.

  In order to qualify as a current expense, the purchase or repair must be considered “ordinary and necessary,” which means that it is an ordinary expense that’s considered common in the business. This includes interest, taxes, advertising, and more. It must also be “current,” which means that it must have more short-term value than long-term. A repair to a roof has a short-term value and can be claimed as a current expense. A new roof, on the other hand, has a long-term value. Finally, your current expenses must be reasonable in amount, so be realistic when claiming your expenses. A $400.00 door handle, for example, is likely to raise some eyebrows at the IRS.

• Capital Expenses: These, on the other hand, are improvements or purchases that are made to the property, that enhance its value –or, that will benefit your rental activity for more than one year. So, for example, a complete kitchen remodel, which would add value to your rental and benefit your property for more than one year, would be considered a capital expense.

  Unlike current expenses that can be claimed in the year that they were incurred, capital expenses must be depreciated, and can only be deducted a little bit at a time over the course of many years. The exact timeframe for depreciation varies depending on the item in question but it will be somewhere between 5 and 27.5 years.

Operating Expenses: What Are They?

Now that we’ve got that out of the way, let’s take a look at some of the deductions that you may be eligible for. Make sure you’re not forgetting anything this year!

Some valuable deductions that landlords can claim include:

• Mortgage Interest – Interest from mortgage payments and even interest on credit cards that are used for the rental can be deducted. If you have a mortgage on your property, this expense could easily represent one of your largest and most valuable deductions.
• Depreciation of the Property Depreciation is another significant deduction. Depreciation of the property itself is considered a capital expense, and can’t be claimed all at once. Instead, it must be spread out over the course of 27.5 years.Just note that depreciation that you claim must be recaptured and paid should you sell the property at some point down the road. The IRS also doesn’t give you an option to opt out of claiming depreciation on the property, it’s a deduction that you’re required to claim. If you don’t, you could still be held liable for paying depreciation recapture tax when you sell your property.
• Mortgage Insurance (PMI/MIP): If you have a mortgage on your property, you can deduct mortgage insurance from your rental income.
• Taxes – Taxes, including property tax, city tax, and even taxes for any employees that you hire for your rental properties can all be claimed on your tax return. If you have a mortgage, your taxes will often be paid through this. You can find amounts on your 1098 form. If you’ve paid off your mortgage, you’ll have to keep receipts yourself, or look up your tax records online.
• Advertising: The cost of advertising your property, including online listings or ads that you take out, can also be claimed on your tax return.
• Insurance: Insurance for the rental or rental property business can also be deducted. This includes fire, theft, liability, and more.
• Utilities: If you pay the utilities for your rental, you can deduct them as well.
• Repairs and Maintenance: Repairs and maintenance for your rentals can also be deducted. Just remember that improvements must be treated as depreciation, and will have to be paid back at the time of sale in depreciation recapture.
• Professional Services: If you hire an accountant, attorney, property manager, or other professional –their fees can also be deducted.
• Travel Expenses: Whether your rentals are local or long-distance, your cost of travel to and from the property; including gas and airfare, can be deducted.
• Losses From Theft or Other Casualties: If your property was damaged in a fire or flood, or if valuables were stolen or the property vandalized, you may be able to deduct a portion of the loss.
• Tenant Screening: When it comes to tenant screening, all of the expenses associated with that can also be claimed. Credit reports, criminal background checks, identity verifications, employment and income verification, and more can all be claimed if you paid for them.
• Commissions: Commissions can also be deducted. This includes incentives that are paid to managers and salespeople, or any commissions that you pay for tenant referrals –say you offer outgoing tenants a bonus if they find a replacement tenant for you.
• Equipment, Supplies, and ExpensesNew equipment and supplies including a phone, laptop, camera, tablet, and even internet service, printer toner, paper, and more –as long as they’re used specifically for your rental business, can also be deducted. Just make sure you keep good records and are able to demonstrate that your purchases and expenses are for business purposes.
• Home Office Deduction: If you use a room in your home for conducting business, you can deduct this expense as well. You can use the IRS’ simple method for calculating this deduction and deduct $5 per square foot up to 300 square feet.

Learn more about available deductions for landlords here.

Business Vs. Personal Use

If you purchase something or subscribe to a service that you use for both business and personal use, you can deduct only the portion that you use for business-related purposes. To determine this, you’ll need to pinpoint how much time you use your item for rental-related purposes, and how much for personal use. Then, divide the cost between the two purposes and deduct the rental-related portion. So, say for example that you use your internet connection for official business purposes 60 percent of the time. In this case, you can only deduct 60 percent of the cost of service.

Special Rules for Certain Expenses

The IRS has created specific rules for certain operating expenses, that spell out which expenses are deductible, how much is able to be deducted, and in some cases, even stipulate specific record-keeping requirements.

Here’s a look at the main areas that include special rules and requirements.

• Home Office Expenses: There are strict requirements for taking this deduction. Learn more here.
• Meals and Entertainment: There are some IRS requirements for meals and expenses. Including the requirement that someone who can benefit from your rental activity must be present. These expenses are usually 50 percent deductible.
• Travel: Travel expenses can be deducted from the IRS guidelines. The amount you can deduct will vary depending on the length of your trip and the time you spend on business while away. See this page for more information.
• Vehicle Expenses: The standard mileage rate for the cost of operating your car changes from year to year. For 2017, standard mileage is 53.5 cents (0.535) per mile.
• Business Gifts: The IRS limits business gifts to $25 per person.
• Bad Debts: Some bad debts are deductible, but unpaid rent is generally not one.
• Interest Payments: In most cases, you can deduct interest on money that you borrow for a business or investment activity –however, rules and restrictions apply for other types of interest.
• Casualty Losses: For losses due to a casualty, like theft, vandalism, or fire –you usually won’t be able to deduct the entire cost of the property destroyed. Instead, how much you’ll be able to deduct will depend on whether the property was stolen, completely destroyed, and whether the loss was covered by insurance.
• Taxes: While you can fully deduct your current year state and local property taxes on real property as an operating expense, any prepaid taxes must be deducted the following year.
• Education Expenses: In order to qualify for an education deduction, you must be able to show that they education maintains or improves skills that are required to be a successful landlord, or is required by law or regulation to maintain your professional status.

For more information on these deductions, and the rules surrounding them, visit the IRS Publication 463: Travel, Entertainment, Gift, and Car Expenses.

Get Organized

Okay –so you have a lot of deductions that you can work with now. Your best option when it comes to claiming them is to be diligent with your record-keeping. This means keeping track of all of your receipts, invoices, and bills as expenses arise. Likewise, be sure to use a separate checking account for your expenses, and try to obtain documentation for every transaction that occurs.

So there you have it! As a landlord, there are a lot of deductions that you’re most likely eligible for.

Since taxes can easily eat into a significant portion of your rental income (up to 50 percent according to some estimates!) experienced investors know that taking advantage of the available deductions is key to maximizing their profits. Don’t miss out! Make this year the year that you save.

And don’t forget, if you’re stuck, it’s always a good idea to work with an experienced CPA –ideally someone who’s experienced in preparing taxes for landlords. A good accountant will be able to inform you of tax deductions that you may be eligible for and can keep you from making many common pitfalls that landlords often make when filing, helping you to save when tax time rolls around.

Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.

Taxes aren’t exactly something that we look forward to, but for landlords and real estate investors, at least, there may be some reason to rejoice.

The tax code tends to favor real estate investors and having rental property can open the door to a tremendous number of tax deductions and credits that you could be eligible for, all of which can make a significant dent in your tax bill.

The key to maximizing your income with rental property is taking advantage of all of the tax benefits that are offered to you. Yet many landlords are unaware of just how many there are! Some deductions are more valuable than others, but overall, these write-offs can help you to increase your rental revenue considerably. Of course, how much you stand to benefit will vary widely depending on a range of factors including your filing status (married, single, joint-filing-separately?), tax status (business, investment?), tax bracket, the number of properties that you own, and how you structure your investments (LLC, sole proprietorship?).

If you’re a first-time landlord, or even an experienced investor, having a firm grasp of the tax code –as it applies to you will prove to be a tremendous advantage. It’ll help you to know how you should structure your investments, allow you to accurately calculate your taxes for prospective investments to see if a property’s worth investing in, and if you have an accountant, can help you to ensure that you both are on the same page. With this in mind, let’s take a look at the basics of the tax code, as it applies to landlords. Read on for an overview of the tenets of taxes, and to see which deductions that you may be able to claim.

Taxes Landlords Are Required to Pay

First, let’s take a look at the different types of taxes that you’re required to pay as a landlord:

• Income tax on rental income and property sales
• Social Security and Medicare taxes (some landlords)
• Net investment income taxes (some landlords)
• Property taxes

Here’s a look at each type of tax now.

Income Tax on Rental Income

Rental income that you receive is taxable and subject to federal income tax. When you file your annual tax return, you’ll add your net rental income to your other income for the year, such as income from your job or investment income.

Additionally, you may be subject to state income tax as well. Forty-three states also have income taxes, with the exceptions being Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. For more information on your state’s income tax law, visit Tax Sites, or your state tax agency’s website.

Income Tax on Property Sales

If you sell a rental property, the profit on the sale is added to your income for the year and is also subject to tax. If you’ve owned the rental for more than one year, this income will be taxed at capital gains rates, which in most cases, are lower than income tax rates. However, if you sell your property and use the proceeds to purchase a similar property, using what’s known as a like-kind exchange, or a Section 1031, you can defer the tax on your profits.

Social Security and Medicare Taxes

Many landlords are also required to pay Social Security and Medicare payroll taxes, or the Federal Insurance Contributions Act (FICA). While employees pay half of these taxes and employers pay the other half, self-employed people must pay them all themselves.

These are two separate taxes. Let’s look at each now:

• Social Security TaxSocial Security tax is a flat tax of 12.4% on net self-employment income or, if you have employees, on their wages up to an annual ceiling –that’s adjusted for inflation each year. In 2017, this ceiling was $127,200.
• Medicare Payroll TaxThere are two different Medicare tax rates –2.9% tax up to an annual ceiling of $200,000 for single taxpayers and up to $250,000 for married couples filing jointly. All income above this amount is subject to tax at a 3.8% rate.

Combined Social Security and Medicare tax is 15.3%, up to the Social Security tax ceiling –whether you’re self-employed or an employee.

If you hire employees to work in your rental property business, you may have to pay and withhold Social Security and Medicare taxes. Your share of these taxes, though, as an employer is deductible.

However, the income you earn from a rental property is not subject to Social Security and Medicare taxes, even if your rental activities constitute a business for tax purposes. The exception to this is if you’re a landlord who provides “substantial services” to your tenants, such as the services provided by hotels or bed and breakfasts.

Net Investment Income Taxes

Net investment income tax is a 3.8% tax that affects many higher-income landlords. This is a tax on unearned income including rental income and gains from selling property. If your adjusted gross income exceeds $200,000 if you’re single, or $250,000 if you’re married filing jointly, you will be subject to this tax.

Property Taxes

Finally, if you own property, you’ll have to pay property tax. These are taxes imposed by cities, counties, or other jurisdictions, and are a tax on the value of your rental.

What Is Considered Rental Income?

Of course, your rental income includes the rent that your tenants pay, but it can also include other payments as well.

• Security DepositsSecurity deposits that you plan to apply to the tenant’s final rent payment must be claimed as income in the year that you receive them. However, if you plan to return the deposit to your tenant at the end of their rental term, then do not include it as income. If you end up keeping some of the money because your tenant doesn’t live up to the terms of the rental agreement, you should include the amount that you keep in your income for the year.
• Interest on Security DepositsAny interest earned on security deposits should also be included in your income unless your state requires landlords to credit that interest to tenants.
• Advance Rent PaymentsAny rent that you receive in advance, before the period that it covers should be included in your rental income for the year that it was received.
• Property or Services Paid in Lieu of RentProperty or services that you receive from a tenant as rent must also be included as rental income.
• Rental Expenses Paid for by TenantAny rental expenses that a tenant pays to you are also considered rental income. This includes utilities, repairs, and more. These expenses can then be deducted by you.
• Fees or Charges Paid by TenantAny fees that tenants pay are also considered rental income. This includes charges for paying late rent, parking fees, storage facility fees, or even laundry income.
• Lease CancellationsPayments for lease cancellations are also considered rental income.
• Leases With an Option to BuyIf your rental agreement gives your tenant the right to buy your rental property, the payments you receive under the agreement are usually considered rental income.

Tax Deductions

One of the great things about owning investment property is the wealth of tax deductions that are available for landlords.

The law allows you to subtract operating expenses for your rental –including repairs and maintenance, as well as other expenses including mortgage interest and depreciation from your gross rental income, to determine your taxable income.

Here’s a look at some of the deductions that landlords are able to take:

• Mortgage Interest
• Interest on Other Loans
• Depreciation
• Repairs and Maintenance
• Professional Services
• Insurance
• Advertising
• City and State Taxes
• Utilities
• Travel Costs
• Losses
• Operating Expenses

In many cases, landlords end up with so many deductions that they show a net loss when calculating their gross rental income. In these cases, you’ll owe no tax on your rental income. This tends to be more common during the first few years of owning rental property, when your rents that you’re charging may be lower, and you may be claiming more for depreciation.

In fact, in some cases, you may show a loss for tax purposes, even if you’ve actually earned more income than you’ve paid in expenses –due to the often-significant deductions of mortgage interest and depreciation.

Your Tax Status Affects Your Deductions

Rental properties can be considered a business, an investment –or in rare cases, a not-for-profit activity.

If your rental activities qualify as a business, you’re entitled to all the tax deductions listed above, however, if your rentals are considered an investment –you’ll lose certain deductions. Of course, tax deductions for not-for-profits are extremely limited.

Your tax status will be determined by how much time and effort you put into your rental activities, and whether you earn profits each year.

Property Ownership Affects Taxes

Keep in mind that how you structure your rental property purchases will affect the type of tax returns that you must file.

The main ownership options for most landlords are:

• Sole proprietorship
• General partnership
• Limited partnership
• Limited liability company (LLC)
• Corporation
• Tenancy in common
• Joint tenancy

These different types of ownership can be divided into two main categories; individual ownership and ownership through a business entity.

Small landlords, those who own one to ten residential rentals, generally own their properties as individuals. In fact, according to one government survey, individuals owned 83% of the 15.7 million rental housing properties with fewer than 50 units. (Department of Housing and Urban Development and Department of Commerce, U.S. Census Bureau, Residential Finance Survey: 2001 (Washington, DC: 2005).)

Partnerships, limited partnerships, LLCs, and S corporations, on the other hand, are all “pass-through” entities. This means that the entity itself doesn’t pay taxes, but the profits or losses are passed through to the owners who include them on their tax returns. Because pass-through taxation permits property owners to deduct losses from their personal taxes, it’s generally considered the best form of taxation for real estate ownership. And with the new Tax Cuts and Jobs Act, there may be even more incentive for investors to structure their purchases this way. Pass through entities with “qualified business income” are now eligible for a 20% deduction.

Sure, it’s not our favorite topic, but since taxes often one of the single biggest outgoing expenses that we have each year, aside from the mortgage itself, looking for ways to reduce your tax bill can often result in significant savings.

If you’re a landlord, it’s worth spending some time familiarizing yourself with the tax code, to find out if you’re saving as much in tax as you could be. It’s also a good idea to consult with a qualified CPA, to ensure that you’re structuring your purchases in a way that’ll be most beneficial for your tax situation, and to make sure you’re not missing out on any valuable tax deductions that could make a big difference in the amount of tax that you owe.

Many thanks to Stephen Fishman’s Every Landlord’s Tax Deduction Guide, for providing clear, concise information on taxes as they pertain to landlords. See Every Landlord’s Tax Guide to learn more about taxes for landlords.

Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.