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Tax Benefits of Rental Property Ownership

Tax Benefits of Rental Property Ownership

By Nathan A. Bozung, CPA, MST (719) 633-3002

Positive Cash Flow and a Tax Asset 

When  structured  properly  first‐time  landlords  will  ideally  find  themselves  in  a  situation  where  they  are receiving a positive cash flow, while generating a tax deduction that offsets some of their other sources of income (W‐2 wages, for example).  The primary variable that helps to accomplish this state is having the  property subject to a mortgage.   

Now, this is not a position one wants to be in forever.  Having a rental property throw off income that taxes  must be paid upon is a good problem to have.  The more taxes owed the more money you are making.  But  having a “tax loss” with a positive cash flow in the early years certainly helps get the ball rolling. 

What is deductible? 

Just about anything ordinary and necessary for you to spend on a rental property is deductible.  The most common  deductions  seen  are:  insurance,  property  taxes,  and  mortgage  interest.    Utilities,  property management fees, HOA dues, and any repairs and maintenance paid are also deductible.  Travel/mileage costs can also be deductible, but extra care should be taken to document these types of expenses.  There are special rules about the timing of deductions when it comes to “major” improvements, such as buying a new furnace or redoing a master bathroom, but ultimately everything spent will be deducted eventually. 

Something  I  always  tell  my  clients  is  you  do  not  want  to  generate  an  expense  solely  for  the  purpose  of generating a tax deduction.  This is because deductions only save you money to the extent of your marginal tax bracket.  It never makes sense to spend a dollar on something to save 30 cents of tax, for example.  But if you know you will be spending the money sometime in the next six months, maybe it makes sense to accelerate that deduction to this December instead of waiting until next year. 

One of the most confusing deductions that almost every rental property should have is depreciation expense.  Depreciation is the way a landlord is permitted to expense a portion of the cost of the rental building itself.  Residential real estate is depreciated over 27.5 years, so on a $275,000 home the annual deduction would be $10K.  This depreciation deduction is a timing difference – You get a deduction today, but someday when you sell the property you will likely have to pay back depreciation recapture for the amounts you previously expensed.  I have encountered many taxpayers who prepare their own tax returns who think they can choose to  not  claim  depreciation  expense in order to avoid the recapture  when  they  sell  the  property.      This  is incorrect, as the IRS rules clearly state that you must recapture  the  greater  of  the  depreciation  actually claimed or the depreciation that you were eligible to claim.  Bottom line: deduct what you can now because you will have to pay it back regardless when you sell the property. (Exception: Section 1031 exchange) 

It’s Complicated 

In addition to what I’ve described above there are many other important considerations when it comes to taxes and rental properties ‐ passive activity loss rules, Real Estate Professional rules, Net Investment Income Tax, Active Participation $25K deduction rules along with income‐based phase‐out.  Always consult your tax advisor when it comes to these rules as everyone’s personal tax  situation  is  unique  and  the  laws  are constantly changing.  Case in point, the day of my typing this the House of Representatives passed legislation that would revoke the Net Investment Income Tax completely – it still has to get through the Senate and the President’s desk before it becomes law, but this could have an effect on your decision to be a landlord or not.