6 Tax Benefits of Investing in Rental Properties

Real estate is one of the best ways to build wealth. It allows you to generate cash flow whilst increasing equity in an appreciating asset. On top of this, there are numerous tax benefits of an investment property, more so in fact than any other income-producing assets.

The US tax code is relatively friendly to real estate investors (who know what they're doing), with numerous legislations designed to help investors operate a profitable business. This includes tax deductibles such as depreciation, loan interest, maintenance expenses, and more. As well as, things like the pass-through tax deduction and strategies for deferring capital gains tax indefinitely.

In this article, we take a closer look at 6 major tax benefits of rental property investing, and what you need to know to maximize your portfolio ROI and achieve your financial goals.

Key takeaways

• As a landlord, you can deduct operating, owner and property management expenses against your income to effectively reduce your end-of-year tax bill.
• Using a 1031 exchange, you can defer capital gains tax allowing you to reinvest funds and scale your portfolio.
• Depreciation is a sizeable deduction allowed to landlords that can significantly reduce taxes.
• Real estate inventors can deduct the interest on investment loans.

6 Tax Benefits of Rental Property Investing

Tax law around rental property management and accounting can be complex. However, as long as you follow and understand key bookkeeping rules you should be able to minimize your end of year tax bill and increase overall profitability.

A few bookkeeping tips include, employing a quality property accounting software to track your income and expenses throughout the year, set up individual bank accounts for each property, and digitizing your receipts and supporting documents for better organization and referencing.

By following these basic rules, you can streamline your accounting and management you'll ensure you can make the most of the rental property tax advantages explored below and save $1000's each year on your end of year tax bill.

1. Deduct Operating Expenses

Operating expenses incurred during the normal management and maintenance of your rental properties are almost all tax-deductible. This is a key rental property tax advantage. However, as the IRS explains, these expenses must be ordinary and necessary. This means unrelated expenses or expenses that improve the property or business may not be immediately deductible.

A few key deductible expenses include:

• Advertising costs
• Leasing commissions
• Property management fees
• Repairs and maintenance
• Supplies
• Landscaping
• Pest control
• Property taxes
• Homeowner and landlord liability insurance
• Utilities paid directly by the landlord
• Professional service fees, such as an accountant or real estate attorney

Find out more about deductible expenses and how to track them.

2. Deduct Owner Expenses

Owner expenses differ from operating expenses in that they aren’t necessarily related to an individual property. Rather, they're additional expenses related to the improvement, management, and growth of your rental business. For example:

Education

Expenses related to educational services, such as real estate magazines, courses, and real estate books can normally be deducted from rental property income.

Travel

As a rental owner, you’ll probably be familiar with the importance of tracking your mileage when travelling to and from your rentals.  The standard mileage deduction rate was 62..5 cents per mile for the second half of 2022. The easiest way to track your mileage is to use Landlord Studio’s automatic GPS mileage tracker.

If you own rentals out of state you may even find yourself flying to and staying in these locations - in which case these expenses may also be deductible.

Travel expenses are deductible if it meets the following criteria described in IRS Publication 463:

• Travel must be mainly for business and have a clear business purpose
• The majority of the time must be spent on business activities and not leisure activities
• Travel expenses must be ordinary and necessary for the real estate business but not be overdone, such as staying a reasonably-priced hotel versus a five-star resort

Home office

Rental property owners are also often eligible for the home office deduction if they use a portion of their residence as an office. It is important to note this space must be used exclusively and on a regular basis for business purposes.

The IRS has a simplified option for home office deduction that allows taxpayers to claim a standard deduction of $5 per square foot, up to a maximum of 300 square feet.

3. Deduct Loan Interest

As a landlord, one key deductible expense is the interest on your loans. This loan interest includes both the interest on your mortgage as well as loans for things like property maintenance or credit cards.

Taking advantage of these real estate tax benefits will allow you to reduce your tax bill and optimize your leveraging.

4. Take Advantage of the Depreciation Deduction

Depreciation is a major rental property tax advantage and a main reason many landlords remain able to report profits in increasingly competitive markets.

Depreciation is the process of deducting the value of the asset (in the case of real estate this means the building only, not the land) and any improvements against your taxes. Depreciation of a rental property is spread out over what is deemed its useful lifetime by the IRS. For residential property, this is 27.5 years, and for commercial property is 39.5 years.

For example, you buy a property for $350,000 where the land value is $75,000. You would then be able to deduct the asset value of $275,000 over the useful life time which would equate to a $10,000 annual deduction.

The IRS has very specific rules regarding depreciation and depreciation recapture (the IRS reclaims a percentage of the depreciated amount upon the sale of the asset). If you own rental properties, it’s worth discussing these laws with a qualified CPA or financial advisor as the IRS will reclaim depreciation even if you don't claim it.

This expense is designed to counter the wear and tear of the property. It’s important to note that the land value must be excluded from the depreciable value of the property.

In addition to the property, appliances, furnishings, and improvements may also be depreciated. Calculating your annual depreciation can quickly become complicated so it’s advisable to discuss this with your accountant.

Learn more about depreciation and depreciation recapture →

5. Deferring Capital Gains Tax

When investors sell a rental property, they're liable to pay long-term capital gains tax of 0 percent, 15 percent, or 20 percent on any profit from the sale. This means, should you purchase a property for $200,000, and then sell for $300,000 ten years later you would be required to pay capital gains tax of up to $20,000.

Additionally, the depreciation expense is recaptured upon the sale. To work out the depreciation recapture amount, the total depreciated amount is treated as gains and taxed as ordinary income up to a maximum rate of 25 percent (depending on the investor’s federal income tax bracket).

However, by using a 1031 exchange real estate investors can defer the payment of capital gains tax on the sale of a property.

With a 1031 exchange, the investor doesn’t extract the fund but puts it back to work by investing in another rental property. The rules and restrictions relating to a Section 1031 exchange are complex, so an investor will want to consult a licensed professional to better understand how one is carried out.

There are three main 1031 exchange rules to follow:

• Replacement property must be of equal or greater value to the one being sold.
• Replacement property must be identified within 45 days.
• Replacement property must be purchased within 180 days.

Rental property owners can conduct 1031 exchanges indefinitely to defer paying capital gains and depreciation recapture taxes. When or if an investor eventually decides to sell the property, any accumulated capital gains tax owed will need to be paid at this time.

6. The Pass-Through Tax Deduction

The pass-through tax deduction allows qualifying real estate investors to deduct up to 20% of their net business income from their income taxes (with certain restrictions). To qualify, investors must own a pass-through business and have a qualifying business income (QBI).

A pass-through business includes LLCs (limited liability companies), S corporations, partnerships, and even sole proprietorships. QBI includes the net income or profit from a qualifying business, but does not include short or long-term capital gains, dividends or interest income.

How Is Rental Income Taxed?

Rental income is reported on form 1040, Schedule E. This lists the revenue, expenses, and depreciation for each of your rental properties.

To make filing your taxes as easy as possible, Landlord Studio has created default expense categories that align with the Schedule E tax form. You can use the app to instantly generate a Schedule E report with all the data you entered over the tax year and simply copy the information when filing your end-of-year taxes.

Rental income is taxed as ordinary income and you pay according to your marginal tax bracket, which is between 10% and 37%.

Generally speaking, income from a rental property is not classified as earned income, which means that an investor does not need to pay FICA or payroll tax.

Learn more about tax on rental income →

Tracking Income and Expenses to Maximize Your Deductibles

In order to file an accurate end-of-year tax return and make the most of the tax benefits of investing real estate, you will need to keep excellent records of all your income and expenses throughout the year. The best way to track and record your income and expenses is with purpose built software such as Landlord Studio.

With Landlord Studio you can:

• Track income and expenses in real-time so you never miss a tax deduction.
• Connect your bank accounts to reconcile transactions.
• Instantly generate professional reports perfect for tax time.
• Gain insights into your property’s performance and create accurate forecasts and budgets.
• Track your mileage to make the most of your travel expense allowance.
• Prepare financial statements for your accounts, business partners and for your taxes.
• Easily digitize receipts and store them securely in our cloud server for future reference.

If your tax return is selected for an audit, you will need to provide all the required supporting documents. Having a system where you can keep everything well organized and easily accessible will help you avoid any potential additional taxes, penalties, and interest.

Additionally, Landlord Studio pairs these essential financial tracking features with a suite of property management tools designed to save you time and money, such as:

• Online rent collection for faster, more efficient and more secure rent collection.
• Create a rental listing
• Pre-screen and manage tenant applications
• Run comprehensive tenant screening reports
• Manage and track leases, store documents
• And more…

Final Words

The variety of tax benefits that come with investing in real estate make it a wise investment choice. However, landlords and investors have to stay on top of their accounts throughout the tax year. Not doing so can lead to costly accounting errors, missed deductions, and potentially even an audit.

The best way to make the most of the tax benefits of real estate investing is to use a tool like Landlord Studio. Automate rent collection and income tracking and streamline your expense accounting to save time, reduce errors and keep more detailed, organized accounts with all of the required supporting documents at your fingertips.

You Might Like

• 9 Best Property Management and Accounting Software 2023‍
• What Is a T12 in Real Estate and Why Do You Need One?‍
• The Complete Rental Property Deductions Checklist‍
• Rental Property Bookkeeping Tips For DIY Landlords