In order to better understand the implications of investment property tax deductions, let us briefly discuss the process for determining your tax liability.

 

Tax Preparation Process:

Whoever is preparing your taxes fills out a Form 1040 and submits it to the IRS. This form does two things: 

1. Calculates your taxable income for the year by taking your earnings minus your tax deductions. Earnings consist of all sources of income received throughout the year. Deductions consist of things such as mortgage interest payments, property depreciation, etc. The IRS offers a standard deduction, which you will use unless your itemized deductions exceed that amount.
2. After you determine your taxable income, the Form 1040 is used to reconcile the amount you owe based on your taxable income, minus what you have already paid in through the year. If you paid in more than you end up owing, you get a tax refund. If you end up owing more than you paid in, you get a tax bill.

Owning an investment property will affect your tax liability in two main ways:

1. Rental Income increases your taxable income by the amount received in the tax year.
2. Investment Property Tax Deductions lower your taxable income by deducting certain expenses associated with owning an investment property.

Investment Property Rental Income

The IRS considers rental income to be “any payment that you receive for the use of occupation of property”. When determining your taxable income, it must be included, along with any other income you receive from your investment property.

Timing is important because even if you are paid rent in advance prior to the time period it covers (say, December 31st for January’s rent), you must report the income in the year it is received. That means when the funds were given to you, not when you cash the check.

Something else to consider is that any expense that the tenant pays for the property, such as repairs or replacement of an appliance, must count as rental income received. You must also report as income any non-refundable deposit. If the deposit is to be returned, you should not report it.

Investment Property Tax Deductions

Deductible expenses are things that you are able to write-off on your taxes in order to lower your taxable income. There are a bunch of investment property tax deductions that are available to the property owner. If you are claiming these investment property tax deductions on your tax return, make sure you keep good records in case of an audit.

These are the most common investment property tax deductions:

• Depreciation Deductions

  • This investment property tax deduction is based on the percentage that your asset depreciates each year. Depreciation refers to the value of the property that’s lost over time due to wear, tear, and obsolescence. This can give you a nice tax break in some situations. The depreciation of the rental property and its appliances begins as soon as the property is held out for rent, even if you don’t yet have tenants.
  • Remember that when you sell you will pay tax on the gains you receive as well as the depreciation deductions that you took. You can’t avoid this by not taking the depreciation deductions either. When you sell, the IRS requires you to adjust by your depreciation deductions or the amount of depreciation you could have deducted. What’s the lesson here? Use your depreciation deductions because you have to pay the taxes on them later regardless.

• Interest Deductions

  • Mortgage Interest Deductions: Mortgage interest is another investment property tax deduction that can be very beneficial. This is generally reported to you on a Form 1098.
  • Non-Mortgage Interest Deductions: If you put expenses for your investment property on a credit card that you only use for rental expenses, any interest received is tax deductible.

• Property Tax Deductions

  • Any taxes that you pay for your investment property, whether personal property or sales tax are eligible as investment property tax deductions.

• Maintenance and Management Fee Deductions

  • This includes fees associated with maintaining the investment property such as landscaping, lawn care, cleaning, homeowners associations, condo dues, pest control, and even the cost of light bulbs and smoke detector batteries. If you hire a property manager, that expense is also deductible. If you are a property manager, you can write off any commissions paid to rental agents.

• Repair Deductions

  • This accounts for any property repairs, such as repairing the dishwasher or fixing a leak. You have to tread carefully here and know the difference between repairs and improvements. Repairs are tax deductible, improvements are not tax deductible and they add value to the rental property. Repairs are any fix that is necessary to keep your property in working condition.  

• Office Operating Expense Deductions

  • You can write off expenses associated with running your business, such as office supplies and office space. If you work from home, you can write off your home office based on its square footage percentage of your home. However, you should only use this space for business purposes.

• Advertising Deductions

  • You can deduct the cost of advertising to find tenants for the investment property.

• Traveling Expense Deductions

  • These are expenses associated with traveling to the investment property for maintenance, rent collection, and showings. If you are using your own vehicle you can claim the standard rate per mile as well as any fees associated with tolls or parking.

• Insurance Deductions

  • Insurance premiums are tax deductible. This includes fire insurance, flood insurance, liability insurance and mortgage insurance.

• Legal Fee Deductions

  • Some legal fees associated with your investment property are tax deductible. Tax preparation fees are also tax deductible.

• Utility Deductions

  • You can deduct any investment property utilities that you pay for. However, if the tenant reimburses you later, you must claim that as income

Passive Activity Rules

The IRS’s passive activity rules prevent you from applying net rental losses to offset your other income, such as your salary. In other words, your investment property tax deductions can offset up to the amount of income that comes from your investment property, but no more. You can carry forward disallowed passive losses to the next taxable year.

There are a couple of exceptions to the passive activity rule. If you actively participate in your rental activity, you may qualify to deduct up to $25,000 of loss from the activity to offset nonpassive income. If you are a real estate professional and you meet certain requirements, you may be able to treat it as nonpassive activity and avoid the passive activity rules altogether.

Vacation Home Tax Implications

If you rent out your property for less than 14 days a year, you don’t have to pay taxes on the rental income. This situation normally arises when you have a vacation home that you mostly use personally, but rent out on a very limited basis. The vacation home status also limits the investment property tax deductions that you can claim.

Foreign Investment Property Tax Implications

If your investment property is in another country, you must report the rental income on all of your tax returns. This means that you may be paying the income tax in both countries. However, in the U.S., you can claim the foreign income tax as a deduction against your U.S. tax liability. You report your rental income and deductible expenses at the current exchange rate.

 

Investment property tax implications are complex. It is important to always have a licensed tax professional advise you on your individual tax scenario. Working with a property management company can help ease some of the burden at tax time. At Paradise Care, the property management division of RE/MAX Paradise, we have software to make your 1099 submission easier. Contact us today to get your free property management quote.