I wanted to take the time to write about the top ten tax deductions available for real estate investors. Though some of this may seem relatively elementary, I've included a few gold nuggets for even our most experienced clients.
Real estate investors are always asking what expenses landlords can deduct. Because the answer to that question can quite literally be endless, we often tell our clients to record everything. For those expenses that our clients are unsure about, we ask them to create an “ask my accountant” category or account in their bookkeeping solution which they can discuss during a short call.
Depreciation is an annual deduction that is granted to investment real estate owners or owners of equipment used for business purposes. Things will fall apart and components will become outdated. The point of depreciation is to track the deterioration of the asset over time.
As a new investor, you might be confused about why the asset is depreciated when real estate, historically, appreciates in value.
While it’s true that the value of the land and the building have historically appreciated over time, think about it on more of a micro level. The value of your roof, for instance, decreases over time as it withers away with each passing day. Depreciation tracks the loss in value over time.
The cool thing about depreciation is that you do not have to pay out-of-pocket for it each year. Instead, you pay for it all upfront when you buy the property.
For example, if you buy a $300,000 property, and $25,000 is considered land (we cannot depreciation land), then your depreciation basis is the building with an assigned value of $275,000. Assuming you bought a residential property, you get to write off $10,000 per year – $275,000 / 27.5 years (the standard depreciation length for residential property). This write off is called depreciation. But since you bought the asset and paid for it all upfront with a combination of cash and, if applicable, debt, you don’t have to fork out $10,000 each year to claim depreciation. It’s just something you get to write off each year.
This is hugely beneficial for landlords. Say your net income (rents – expenses) is $8,000 on the above property that you purchased. Your annual depreciation will cause you to show a $2,000 passive loss. This means you pocketed $8,000 cash tax-free and you can potentially write off the $2,000 loss against your other income.
A loss caused by depreciation is called a taxable loss and is definitely not bad. In fact, it’s the best case scenario.
Amortization is a helluva word but an important one none-the-less. Many investors and even CPAs fail to amortize costs appropriately, sometimes missing the costs altogether. Don’t miss deductions that are rightfully yours!
Amortization is similar to depreciation, except that you only amortize intangible expenses, the biggest of which are fees paid in connection to obtaining your loan.
If you are taking out a mortgage on a rental you are buying, you will most likely pay the following loan fees: appraisal, credit check, flood certification, origination fees, and upfront points. You must sum those fees and then amortize them over the life of the loan.
Loan fees are not currently classified as deductions, meaning you cannot deduct them in full in the year you buy the property. Instead, we write off a small portion of these fees over the life of the loan. This is a big mistake I often see folks making.
When you refinance later, any loan fees associated with the old loan, not yet written off via amortization, get to be written off in full. Then you amortize the new loan fees incurred during the refinance.
Any interest expenses that you incur which are associated with capital used to buy rental real estate are classified as deductions. If you are using a mortgage company, they will send you a Form 1098 at the end of the year detailing how much interest you paid them over the course of the year. You will use this to prepare Schedule E.
Note: If your loan is collateralized by your property, then the private lender must issue you a Form 1098 at the end of the year detailing the interest you paid the lender. But, if the loan is not collateralized by the property, then you must issue the lender a Form 1099 detailing the interest you paid the lender over the course of the year. Don’t miss this!
4. Property Taxes and Insurance
Property taxes and insurance expenses associated with rental real estate are classified as deductions. In comparison to your primary residence where your insurance expenses are not deductible.
If you purchased your rental with conventional financing, you are most likely paying property taxes and insurance expenses on a monthly basis into an escrow account. It’s important to understand that the payments into escrow accounts are not actually deductible. Instead, you can only deduct property taxes and insurance when actually paid out of escrow.
Thanks to the De Minimis Safe Harbor, repairs up to $2,500 per item on an invoice are deductible. This is a great thing for you because:
- First, is that you will receive the full tax benefit (savings) from the deductions in the current year.
- Second, is that since the expense is a repair, we aren’t capitalizing the expense as an improvement and depreciating it over a number of years.
- Third, since you do not depreciate the repair, you don’t have to pay depreciation recapture taxes (Un-recaptured Section 1250 Gain).
So by deducting items as repairs, rather than capitalizing them as improvements and then depreciating, you are able to recognize the tax savings this year, make your accounting easier, and save yourself from incurring depreciation recapture taxes when you sell.
Any property repairs done with a certain level of frequency can be classified as maintenance expenses. You have a very relaxed safe harbor from the IRS if you expect that maintenance expense to be incurred again within the next ten years.
Maintenance items are generally smaller in nature, however the major one I want to point out is painting. You almost always classify painting a maintenance expense. Especially if you paint when the property is not advertised for rent prior to incurring the painting expense.
7. Home Office
The home office deduction is a low hanging fruit that everyone should take advantage of if allowable. In order to claim a home office as a business expense, you must either be running a business or own rental properties. You must also use the home office exclusively and regularly for business and it must be your business’ principal place of business. Your office space can be either a stand alone, designated, room or a corner of an otherwise non-business room.
If you think that matches your situation, get a home office in place as soon as you can. The home office deduction no longer raises audit flags, contrary to popular belief. The working world is moving toward virtual work-spaces and the IRS recognizes that. Here are two ways to start deducting:
- The first is the standard method of deducting. Here, you pro-rate a portion of your common expenses (interest, insurance, tax, maintenance, etc) and deduct it per the square footage of your office compared to the square footage of your home. You may also deduct repairs made directly to the home office (i.e. new windows).
- The second, new(er), method is the Simplified Method. This allows you to deduct $5 per square foot of office space. If you are bad at record retention, try this method.
- The home office deduction is a great ancillary benefit, but the real value is the deductions from travel expenses. With this in place, the transportation expenses between your home office and rental becomes a deductible business expense. Without the home office, the IRS deems you to be traveling from your home to a business location, thus a personal commute and non-deductible.
8. Transportation and Travel
As I alluded to above, transportation and travel deductions come with a whole slew of interesting rules.
Transportation expenses are those that occur within your tax home (geographic location in which you reside/do business). So things like mileage, metro costs, bus costs, etc. are transportation expenses. In order for transportation expenses to be deductible, you must be traveling between business locations (i.e. office-to-office).
Any expenses that you incur while traveling outside of your tax home are ‘travel costs’. In order for travel costs to be deductible, you must be able to demonstrate that it was more feasible to stay overnight than to return home. Additionally, your trip must include more business days than it does personal days. So a seven day trip requires four days of business.
To qualify a day as a ‘business day’ you must have conducted at least four hours of work. We have our clients book meetings/appointments and their business tasks in their calendar application of choice. Doing so will help provide for audit protection should that arise.
Four hours per day with more business days than person makes it a business trip. Meaning that you can deduct your travel costs as well as your lodging for business days but not for personal days.
Everyone must eat, but can you really deduct food?
Yes! Discussing business immediately before, during, or after your meal, technically makes it a business meal, allowing it to be deductible. The limitation is that you can only deduct 50% of your meal’s cost.
Fun fact – if you and your spouse are partners in your real estate ventures, you likely talk real estate at every meal. Thus, you could make the argument that you are talking business, with your partner, at every meal. Don’t try this without help from a competent advisor!
Education is imperative to further the growth of your real estate venture. Any form of education expense related to growing your real estate portfolio or your real estate business, is deductible. I’m talking books, seminars, classes, meetup events, etc.
BUT (this is a BIG but) if you incur those education expenses prior to closing a real estate deal, the education expenses are not counted as deductions. The IRS argues (and will win) that the expense was incurred before your venture was “in service,” the education qualified you for the venture. Education that qualifies you for a new venture is non-deductible. Education expenses are only classified as deductions when it enhances your current skill set in your respective field or venture.
So to all those folks who spent $40,000 on those sleezy education programs, tough luck – you can’t deduct it.