Rental property tax deductions

What qualifies as rental income?

According to the IRS, you must include all amounts you receive from your rental property as gross income in your tax report. The income is taxed based on your tax bracket.

Contrary to what you may expect, what the IRS considers “rental income” is more than the monthly rent from a tenant.

Here is everything the IRS categorizes as rental income:

• Any payment received for a property occupation
• Advance rent (the amount you receive before the period it covers)
• Security deposit (rent for the last year's lease) unless you plan to refund it at the end of the lease
• Payment for canceling a lease
• Expenses paid by the tenant and deducted from the rent, such as water or sewage bills if tenants don't have to pay utility bills under the lease agreement
• Products or services received in exchange for rent payment (for example, a painter painting the building for two months’ rent)
• If your tenant has a lease-to-own agreement, the payment you receive as their down payment
• Partial interest in rental property

In addition to rental income, landlords should also track their expenses. In your rental property deductions, the rental taxable income is calculated as:

The value you get should then be reported on your Form 1040, Schedule E, Part 1.

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Common tax deductions for rental properties

As a rental property owner, you can save money by deducting mortgage interest, depreciation, property taxes and the cost of operation and maintenance.

This can help reduce your taxable income and subsequently your tax debt.

Mortgage interest

Mortgage interest on a rental property can be deducted as an expense, and it's reported on Schedule E.

Your mortgage lender provides you with Form 1098, which shows the total interest you contributed that year.

Property taxes

Property taxes are levied on real estate or property you own; the tax varies from one state to another and depends on the property's worth.

Homeowners can deduct up to $10,000 (or $5,000 if married and filing separately) for property taxes and either state and local expenses or sales taxes.

This limit doesn't apply to business activity, so depending on your level of involvement in your rental property, you can deduct the total amount as a business expense.

Operating expenses

Operating expenses are ordinary and necessary expenses landlords use to manage, conserve and maintain a rental property. They include:

• Interest
• Taxes
• Advertising
• Maintenance
• Utilities
• Insurance premiums
• Home office expenses

Deductible repair costs

Repairs are activities that keep a rental property in good condition without upgrading it or adding value to the property. Deductible repair costs include:

• Fixing a broken toilet
• Replacing a faulty light switch
• Repairing a broken staircase
• Repairing a damaged garage door
• Painting

Capital improvements

Capital improvements are different from repairs and aren't deductible. A capital improvement is a restoration or addition of a structure on a rental property that enhances its value, prolongs its life or creates new uses.

Although these improvements aren't tax deductible, they can be capitalized and become a part of how much you paid for the house, increasing the depreciation write-off.

For example, if you buy a house at $750,000 and renovate the kitchen with $50,000, you can't deduct $50,000 that year. However, the taxable income of the capital gain changes when you sell the house because the IRS considers the buying price as $800,000 instead of $750,000.

Capital improvements include:

• Water heaters
• Security systems
• Additions like an extra bedroom
• Landscaping
• Flooring

Professional services

Landlords can also deduct any fees they pay professionals, such as wages and salaries paid to individuals in association with the rental property. They can also deduct fees paid to independent contractors, such as:

• Carpenters
• Architects
• Gardeners
• Electricians
• Plumbers

Before working with any professional, ensure they provide you with a completed W-9 form, especially if they're unincorporated, and submit their payment on IRS Form 1099-MISC. The form isn't required if you pay a contractor less than $600 in a year. However, you can still deduct the expense.

» MORE: What home improvements are tax deductible?

Depreciation deductions for rental properties

According to the IRS, assets have a useful life. As a property owner, you can deduct depreciation from your taxes to compensate for the wear and tear of your property.

Rental property depreciation is also reported on Schedule E of a standard 1040 tax form. However, this can change depending on the situation. For example, if you claim the depreciation deduction the same year you put your rental into service, you'll use Form 4562.

Rental estate depreciation is calculated as follows:

Cost basis of the property / useful life of the residential property

• The cost basis is the total amount you paid for the property and other costs you used to obtain the property. For example, if you purchased your property at $500,000 and paid $10,000 closing costs, your cost basis is $510,000.
• The useful life is the years a property is considered usable, which is 27.5 years for residential property.

In our case, the depreciation of the rental property is $510,000/27.5 = $18,545.45 per year.

Brian Mollo, owner and CEO of Trusted House Buyers in San Diego, Calfornia, says depreciation can help lower the tax burden.

“You can also claim your depreciation, which can help significantly reduce your tax burden. One thing to keep in mind is if you have several assets on one property, you can assign different depreciation schedules to them,” he said. “For example, if you own a small apartment complex, you can depreciate each individual building as they all have their own unique addresses.”

Bottom line

Renting out property is a great way to earn passive income. To maximize the revenue, you must take every opportunity to reduce running costs. One way to do this is by taking advantage of the rental property tax deductions to reduce the tax liability on your rental income. Understanding all the rental deductions ensures you do it right and avoid penalties from the IRS.