So you’re thinking of renting to relatives and want to know the tax implications After all, it’s something that seems to make perfect sense. Your child; or maybe it’s your mother or a cousin needs a place to stay and you have a rental property.
If you were to let them live there rent-free, or maybe for reduced rent, you’d be doing them a tremendous favor, and they’ll be able to look after your property for you; helping to keep it in great condition. It’s the best of both worlds.
But while your plan does make sense, there’s just one problem: if you’re not careful, renting your home out to family could mean that you’re no longer eligible for certain tax deductions.
While tax law allows generous tax deductions that many landlords are eligible for, it also has strict criteria that it insists landlords meet in order to remain eligible for those deductions. There are a number of things that a landlord could do, even unwittingly, that could push the property outside the definition of a rental, and into the criteria of a personal residence; eliminating many of these tax deductions.
Let’s take a look at renting to relatives and the tax implications to ensure that you’re eligible for those valuable deductions.
First up, let’s take a look at what, exactly, the IRS considers to be a rental property.
A property is considered to be a rental if it is rented during the year in question, and used by the owner less than the greater of 14 days – or 10% of the number of days that the unit was rented to others; as long as it was rented at fair rental value.
If, however, you occupy the property yourself for a portion of the year – or rent it out for a reduced rent, then limitations may apply to a number of expenses that you’re able to deduct.
Additionally, if the property is mixed use, then it may be rented and used by yourself for more than 14 days of the year, however, it’s important to note that expenses like insurance, mortgage insurance, taxes, and more will be allocated between rental and personal use.
It’s also important to note that if the property’s rented out for fewer than 14 days during the year, then it’s considered a personal residence, and as such you won’t be able to claim as many tax deductions; only mortgage interest and property taxes. You also won’t be required to report any rental income.
However, complications arise when you are renting to relatives.
These issues usually surround the question of “fair-market-value rent,” and how the IRS classifies rental properties that are rented for less than this amount. Normally people decide to rent out to relatives because they’re looking to give that family member a good deal. But it’s important to realize that for each day that you rent the property for less than its fair market value is considered a personal use day.
Too many personal use days, can quickly push the property into the category of personal use. This could mean that you’d end up having to claim the rent as income, but not being able to claim many of those value tax deductions.
Part of the appeal of rental properties is the myriad of valuable tax breaks that landlords are eligible for. Some available deductions that many landlords are able to take include:
These deductions can add up quickly and make a real impact on the amount of tax that a landlord owes at the end of the year. However, if your rental loses its status as a rental, then most of these deductions will disappear. The exceptions are mortgage interest and property taxes, which you’d be able to claim anyway.
If you’re looking to ensure that your property keeps its rental status –and your rental expense deductions intact, the good news is that you can rent to a family member; there are just certain rules that you should follow.
First of all, in order for the property to be considered a rental, you cannot use the property yourself for more than 14 days –or more than 10% of the total days that you rent it to others at a fair rental price.
If you’re not residing in the property yourself, then you’ll want to ensure that you abide by the following:
For more information on renting to relatives and the tax implications, be sure to see IRS Publication 527, Residential Rental Property. Remember, neglecting to categorize your property properly, and taking deductions that you may not be entitled to could land you in serious trouble should the IRS decide to do an audit. Your best option is to be informed, and talk to a tax professional if you’d like to learn more about the tax implications of renting to family members or using the property yourself.
At the end of the day, renting to relatives and tax implications is something that appeals to many. Just make sure you’re going into the decision fully informed about the implications of renting out your property to a relative –particularly how it will impact which deductions you may no longer be eligible for.
Resources:
Note: This article is intended to inform and to guide; it is not meant to serve in place of tax advice from an attorney or licensed tax professional. Please consult a CPA for help implementing tax strategies, or for more information on how renting out your home to a family member may impact you from a tax perspective.
Capitalization Rate or “Cap Rate” is a ratio used by real estate investors to determine the desirability or profitability of a specific property. This ratio compares the relationship between the property value and the potential income that property may produce as if you had paid cash for the property.
While there are certainly more sophisticated analytical tools we can use when evaluating rental properties, cap rate is a good quick reference tool used to assess whether or not a property is even worth considering.
We use this formula when we are working with our investor clients. Knowing property values and rental rates along with a good sense of average repair and maintenance costs and potential vacancy rates allow us to calculate a rough cap rate on the fly.
As we narrow down the properties our client is interested in, we can do a more precise calculation prior to making an offer on any properties.
Cap Rate is established by dividing the Net Operating Income (NOI) of a property by the value of that property. The cap rate essentially shows the relationship between the property value and the potential income that particular property could produce. The higher the cap rate the more attractive the property is.
Let’s look at the Net Operating Income half of the cap rate equation. NOI consists of all revenue from the property, minus any reasonable operating expenses. NOI is a pre-tax figure, appearing on a property’s income and cash flow statement, that excludes principal and interest payments on loans, any capital expenditures, depreciation, and amortization.
In order to establish Net Operating Income, you total the annual rents collected for a property, this is the Gross Income. Once this figure is established you would subtract the following expenses.
The other half of the equation is “value”, this is the price you paid for the property or the current value of the property. If you are looking at properties and have questions about value, your agent should be able to give you a reasonably good idea of what the property’s true value is.
Cap Rate can also be a helpful tool to use in order to determine your bottom line when evaluating a property you are interested in purchasing.
Let’s say you are interested in a property that is listed for $300,000. Your goal is a 10% cap rate on any property you purchase. Let’s say the NOI for this property is $27,000, which gives us a 9% cap rate, not bad but you want 10%. This means you would need to acquire this property for $270,000 in order to get your 10% cap rate.
Each situation and market are different but knowing that $270,000 is your bottom line helps you decide if you want to even pursue this property or if the price is too high for the return you’d see. In some markets, an offer that is 10% below asking price is a common practice while in other markets it would be a slap in the seller’s face. Each market is different and these are decisions investors need to make.
It’s important to note that cap rate looks at potential financial performance, not actual returns. In order to get a better idea of how a given property will perform, there are other methods of evaluating a property that will give you better results. Methods like cash flow analysis and cash-on-cash returns are potentially better metrics to use, assuming you know your numbers.
The vacancy rate, maintenance, and repairs all affect an investor’s bottom line and all three are fairly unpredictable. Controlling these costs without compromising the health and safety of your tenants is the key to long term profitability from rental properties.
There are a number of methods investors can use to analyze an investment or rental property. Cap Rate should be just one tool in an investor's arsenal but it is an important one. Remember to use cap rate in the early stages of new property acquisition.
The key to successful investing in the residential real estate rental market is buying the property at a great price. This one key detail makes all of the other factors easier to work with and cap rate does a great job when you are looking for deals.
When it comes to investments, real estate can offer some solid benefits. Property appreciation, tax breaks such as rental property depreciation, and recurring cash flow can turn your property into a money generating investment. You can take advantage of these benefits whether you use a Property Management company or self-manage your own rentals.
In many ways, the law seems to favor real estate investors and rewards those who make this type of investment with a number of opportunities for different tax breaks.
One tax break that many landlords benefit from is depreciation; which allows you to recover some of the cost of income-producing property through yearly tax deductions. You can do this by depreciating the building, and in some cases, the personal property inside by deducting some of the cost each year on your tax return.
Generally speaking, depreciation results in more money in a landlord’s pocket. Since the single largest expense that most landlords have is the cost of the rental property, being able to depreciate it allows you to claim a significant portion of that expense by spreading it out over the course of a number of years, thereby reducing the amount of tax that you owe.
If you’re currently a landlord or are thinking about buying an investment property, having a basic understanding of the deductions that you may be eligible for can help you to save significantly on your tax bill. In the case of depreciation, it can also help you to prepare for unexpected costs down the road, allowing you to manage your portfolio and structure your deals in a way that will benefit you the most.
With this in mind, let’s take a look at depreciation for rental property, and see how you can use this deduction to reduce your tax bill.
Depreciation, in a nutshell, is based on the concept that some assets are depreciating in value.
While real estate in most areas is an appreciating asset increasing in value, the truth is that the building itself along with some of the property inside the building, like appliances, are things that’ll wear out over time. As the years go by, property wears out, decays, or becomes otherwise unusable.
Depreciation is an annual tax deduction that landlords can take that reflects this cost.
With depreciation, landlords can depreciate the value of the building, land improvements, such as landscaping, as well as personal property items that are inside the building, but not physically part of it; for example, refrigerators, stoves, and carpet.
One thing that makes depreciation so valuable for landlords is the fact that you get to take it year after year. In the case of most rental properties, the cost of depreciation is spread out over the course of 27.5 years, making it a long-term benefit. Additionally, unlike many deductions, landlords don’t have to pay anything in order to claim depreciation, aside from the cost of the original asset, and owners are entitled to depreciation even if their property goes up in value over time, as is often the case.
Here’s a practical example of how depreciation works:
Example: Denise purchases a rental property with a depreciable value of $100,000. Because of this, she is entitled to a yearly depreciation deduction of $3,636 for the next 27.5 years (excluding the first and last year, when it will be somewhat less). The only thing Denise has to do to get these annual deductions is to keep the property as a rental, file a tax return, and do some simple bookkeeping. She doesn’t need to spend an additional penny on this property.
Now, there’s a downside to depreciation that most people tend to overlook, that is, depreciation recapture.
Depreciation recapture is a small “Gotcha!” from your friends at the IRS, which requires you to pay 25% tax on any gain realized through depreciation.
So if you were to sell your rental property down the road, you’ll have to pay 25% tax on the total amount of depreciation deductions that you took over the years.
Of course, there are a few alternatives to this tax.
One alternative is using what’s known as a 1031 deferred exchange, or a “like-kind exchange”, which allows you to defer this payment. With an 1031 exchange, when you sell your property you can roll the depreciation into the next property that you purchase. The downside to this option, though, is that you’re simply deferring the tax. You’ll still have to pay recapture taxes when you sell the exchanged property in the future.
Another option is not selling the property at all, but instead keeping it as a rental and then passing it on to your heirs. When they inherit the property, they won’t have to pay your depreciation recapture taxes.
A third option is to sell the property at a loss, but of course, this is a far less popular option.
In most cases, the longer you wait before you sell, the less of an impact the depreciation recapture taxes will have. This is because you’ll have had many years to make use of the additional tax savings that accrued from using depreciation. Additionally, you may not be in the same tax bracket that you would have been in had you made the sale earlier on.
Keep in mind that there are a number of different ways that you can structure your investment properties and use tax deferral strategies to avoid depreciation recapture taxes. It’s a good idea to speak with an accountant to see what your options are and to find out how you can best take advantage of depreciation.
At this point, you may be thinking, “Ok, I’ll just skip depreciation, and not claim it”.
Unfortunately, depreciation is not optional. You must take a depreciation deduction if you qualify for it. If you don’t, the IRS will still treat you as though you had. This means that if you sell your property, you’re still going to be taxed on depreciation deductions, even if you didn’t claim them.
If you have unclaimed depreciation currently, you can deduct the entire amount in one year. To do so, you’ll want to make what is known as an I.R.C. Section 481(a) adjustment and file IRS Form 3115 to request a change in accounting method. Generally, this type of change is granted automatically by the IRS, and you won’t need to file any amended tax returns. You may need to seek out an accountant, though, as it’s a confusing form.
First, there’s depreciation on the rental building itself. This usually accounts for the largest depreciation deduction that you can take.
With this deduction, the rental building itself (the structure) can be depreciated. The land that it’s sitting on, however, cannot. This makes sense when you think about it. While the house may be slowly wearing down with time, land doesn’t wear out or “depreciate” in the same way.
Secondly, personal property that’s a part of your rental business, can also be depreciated. This includes things like appliances or furniture in the house, as well as office or construction equipment, cars, and other vehicles that you own, and use for the rental properties.
Of course, only property that you own is able to be depreciated. You can’t depreciate property that you lease for your rental activity such as office space. Additionally, you aren’t able to depreciate property that’s solely for personal use. So no depreciation for your personal residence, and should you convert a rental property to a personal residence, you must stop taking the depreciation for the property. If a property serves as both a rental and for personal use, you may depreciate only part of its value; the percentage of the property used for rental purposes.
Finally, the amount of your depreciation is based on the cost of the property itself. The amount that you borrowed to purchase –i.e. the interest rate on the loan is irrelevant. You can, however, deduct interest on the mortgage, or for HELOCs that are used for the property.
Practically speaking, how do you go about claiming it on your tax return?
First, you must determine what’s known as your property basis, that is, how much the property’s worth for tax purposes.
Usually, your basis is the cost of the property, and any expenses of the sale such as real estate transfer taxes.
Land cannot be depreciated, so it must be deducted from the cost of the property.
Next, you must determine the depreciation period, or “recovery period" of the property or aspects in question, that is –how long the IRS says you must depreciate it for.
Real property placed into service after 1986 is depreciated under what’s known as the Modified Accelerated Cost Recovery System (MACRS). Under this system, the depreciation period for residential real property placed in service after 1986 is 27.5 years. Prior to 1987, different depreciation methods with different depreciation periods were in effect.
The periods are the same whether the property being depreciated is old or new. When you buy property, you start a new depreciation period beginning with year one, even if the prior owner previously depreciated the property as well. This makes no difference to you, though, your depreciation period starts when you purchase the property.
You then deduct a certain percentage of its basis each year during its recovery period.
Next, you’ll want to calculate your deduction amount. Your depreciation deduction is a set percentage of the basis of your property each year.
This percentage varies, depending on the depreciation method you use. All real property must be depreciated using the straight-line method. Under this method, you deduct an equal amount each year over the depreciation period, generally 27.5 years.
At the end of the day, rental property depreciation can be a useful and often-necessary deduction that landlords can take. Just make sure you work with a good accountant, who can fill you in on depreciation, as well as depreciation recapture if you’re planning to sell the property down the road. This will allow you to structure your purchases in a way that will benefit you the most and will help to keep you from being hit with any unexpected taxes in the future.
To learn more about depreciation, be sure to check out the IRS Publication 946 (2017), How To Depreciate Property.
Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.
For most landlords, being able to deduct operating expenses can make a big difference on the amount of tax that they owe. Understanding the rental property tax deductions can be complicated, but well worth the time.
But when it comes to fully utilizing those rental property tax deductions, 
that’s where many landlords struggle. After all, there are so many different expenses that you can claim! Additionally, the IRS doesn’t have an exhaustive list of all the eligible expenses, just that they must meet their requirements to qualify as deductible. This means that they must be ordinary and necessary, current, directly related to your rental activity, and reasonable in amount.
Here’s a look at what you should know about operating expenses, and how you can claim them on your taxes.
Deductions fall into one of two different categories: current and capital.
Now that we’ve got that out of the way, let’s take a look at some of the deductions that you may be eligible for. Make sure you’re not forgetting anything this year!
Some valuable rental property tax deductions that landlords can claim include:
If you purchase something or subscribe to a service that you use for both business and personal use, you can deduct only the portion that you use for business-related purposes. To determine this, you’ll need to pinpoint how much time you use your item for rental-related purposes, and how much for personal use. Then, divide the cost between the two purposes and deduct the rental-related portion. So, say for example that you use your internet connection for official business purposes 60 percent of the time. In this case, you can only deduct 60 percent of the cost of service.
The IRS has created specific rules for certain operating expenses, that spell out which expenses are tax deductible, how much is able to be deducted, and in some cases, even stipulate specific record-keeping requirements.
Here’s a look at the main areas that include special rules and requirements.
For more information on these rental property tax deductions, and the rules surrounding them, visit the IRS Publication 463: Travel, Entertainment, Gift, and Car Expenses.
Your best option when it comes to claiming them is to be diligent with your record-keeping. This means keeping track of all of your receipts, invoices, and bills as expenses arise. Likewise, be sure to use a separate checking account for your expenses, and try to obtain documentation for every transaction that occurs.
As a landlord, there are a lot of deductions that you’re most likely eligible for.
Since taxes can easily eat into a significant portion of your rental income (up to 50 percent according to some estimates!) experienced investors know that taking advantage of the available deductions is key to maximizing their profits. Don’t miss out! Make this year the year that you save.
And don’t forget, if you’re stuck, it’s always a good idea to work with an experienced CPA –ideally someone who’s experienced in preparing taxes for landlords. A good accountant will be able to inform you of tax deductions that you may be eligible for and can keep you from making many common pitfalls that landlords often make when filing, helping you to save when tax time rolls around.
Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.
Taxes aren’t exactly something that we look forward to, but for landlords and real estate investors, at least, there may be some reason to rejoice. If you own rental property, there are landlord tax deductions that can help you out.
The tax code tends to favor real estate investors and having rental property can open the door to a tremendous number of tax deductions and credits that you could be eligible for, all of which can make a significant dent in your tax bill.
The key to maximizing your income with rental property is taking advantage of all of the tax benefits that are offered to you. Yet many landlords are unaware of just how many there are!
Some deductions are more valuable than others, but overall, these write-offs can help you to increase your rental revenue considerably. Of course, how much you stand to benefit will vary widely depending on a range of factors including your filing status (married, single, joint-filing-separately?), tax status (business, investment?), tax bracket, the number of properties that you own, and how you structure your investments (LLC, sole proprietorship?).
If you’re a first-time landlord, or even an experienced investor, having a firm grasp of the tax code –as it applies to you will prove to be a tremendous advantage. It’ll help you to know how you should structure your investments, allow you to accurately calculate your taxes for prospective investments to see if a property’s worth investing in, and if you have an accountant, can help you to ensure that you both are on the same page.
With this in mind, let’s take a look at the basics of the tax code, as it applies to landlords. Read on for an overview of the tenets of taxes, and to see which deductions that you may be able to claim.
First, let’s take a look at the different types of taxes that you’re required to pay as a landlord:
Here’s a look at each type of tax now.
Rental income that you receive is taxable and subject to federal income tax. When you file your annual tax return, you’ll add your net rental income to your other income for the year, such as income from your job or investment income.
Additionally, you may be subject to state income tax as well. Forty-three states also have income taxes, with the exceptions being Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. For more information on your state’s income tax law, visit Tax Sites, or your state tax agency’s website.
If you sell a rental property, the profit on the sale is added to your income for the year and is also subject to tax. If you’ve owned the rental for more than one year, this income will be taxed at capital gains rates, which in most cases, are lower than income tax rates. However, if you sell your property and use the proceeds to purchase a similar property, using what’s known as a like-kind exchange, or a Section 1031, you can defer the tax on your profits.
Many landlords are also required to pay Social Security and Medicare payroll taxes, or Federal Insurance Contributions Act (FICA). While employees pay half of these taxes and employers pay the other half, self-employed people must pay them all themselves.
These are two separate taxes. Let’s look at each now:
Combined Social Security and Medicare tax is 15.3%, up to the Social Security tax ceiling –whether you’re self-employed or an employee.
If you hire employees to work in your rental property business, you may have to pay and withhold Social Security and Medicare taxes. Your share of these taxes, though, as an employer is deductible.
However, income you earn from a rental property is not subject to Social Security and Medicare taxes, even if your rental activities constitute a business for tax purposes. The exception to this is if you’re a landlord who provides “substantial services” to your tenants, such as the services provided by hotels or bed and breakfasts.
Net investment income tax is a 3.8% tax that affects many higher-income landlords. This is a tax on unearned income including rental income and gains from selling property. If your adjusted gross income exceeds $200,000 if you’re single, or $250,000 if you’re married filing jointly, you will be subject to this tax.
Finally, if you own property, you’ll have to pay property tax. These are taxes imposed by cities, counties, or other jurisdictions, and are a tax on the value of your rental.
Of course, your rental income includes the rent that your tenants pay, but it can also include other payments as well.
One of the great things about owning investment property is the wealth of tax deductions that are available for landlords.
The law allows you to subtract operating expenses for your rental –including repairs and maintenance, as well as other expenses including mortgage interest and depreciation from your gross rental income, to determine your taxable income.
Here’s a look at some of the deductions that landlords are able to take:
In many cases, landlords end up with so many deductions that they show a net loss when calculating their gross rental income. In these cases, you’ll owe no tax on your rental income. This tends to be more common during the first few years of owning rental property, when the rents may be lower, and you may be claiming more for depreciation.
In fact, in some cases, you may show a loss for tax purposes, even if you’ve actually earned more income than you’ve paid in expenses –due to the often-significant deductions of mortgage interest and depreciation.
Rental properties can be considered a business, an investment, or in rare cases, a not-for-profit activity.
If your rental activities qualify as a business, you’re entitled to all the landlord tax deductions listed above, however, if your rentals are considered an investment, you’ll lose certain deductions. Of course, landlord tax deductions for not-for-profits are extremely limited.
Your tax status will be determined by how much time and effort you put into your rental activities, and whether you earn profits each year.
Keep in mind that how you structure your rental property purchases will affect the type of tax returns that you must file.
The main ownership options for most landlords are:
These different types of ownership can be divided into two main categories; individual ownership and ownership through a business entity.
Small landlords, those who own one to ten residential rentals, generally own their properties as individuals. In fact, according to one government survey, individuals owned 83% of the 15.7 million rental housing properties with fewer than 50 units. (Department of Housing and Urban Development and Department of Commerce, U.S. Census Bureau, Residential Finance Survey: 2001 (Washington, DC: 2005).)
Partnerships, limited partnerships, LLCs, and S corporations, on the other hand, are all “pass-through” entities. This means that the entity itself doesn’t pay taxes, but the profits or losses are passed through to the owners who include them on their tax returns.
Because pass-through taxation permits property owners to deduct losses from their personal taxes, it’s generally considered the best form of taxation for real estate ownership. And with the new Tax Cuts and Jobs Act, there may be even more incentive for investors to structure their purchases this way. Pass through entities with “qualified business income” are now eligible for a 20% deduction.
Sure, it’s not our favorite topic, but since taxes are often one of the single biggest outgoing expenses that we have each year, aside from the mortgage itself, looking for ways to reduce your tax bill can often result in significant savings.
If you’re a landlord, it’s worth spending some time familiarizing yourself with the tax code, to find out if you’re saving as much in tax as you could be. It’s also a good idea to consult with a qualified CPA, to ensure that you’re structuring your purchases in a way that’ll be most beneficial for your tax situation, and to make sure you’re not missing out on any valuable tax deductions that could make a big difference in the amount of tax that you owe.
Many thanks to Stephen Fishman's Every Landlord's Tax Deduction Guide, for providing clear, concise information on taxes as they pertain to landlords. See Every Landlord’s Tax Guide to learn more about taxes for landlords.
Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not legal or tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.
As the proud owner of rental property, there’s a good chance that you know about and are already using one of the most well-known and popular tax deductions available to landlords:
Repairs are a much-loved deduction, and for many landlords, they represent a significant saving come tax time. They’re popular thanks to their value, as well as the fact that they’re a tangible expense. It’s easy to remember these expenses when you’re doing taxes, and not too difficult to save the receipts throughout the year –especially if you’re organized.
But while this deduction is indeed popular, some landlords aren’t aware that not every repair should be treated the same. While some are able to be fully deducted in the year that they’re incurred, for others, how they’re able to be deducted will vary depending on a few different factors.
The main difference in how these expenditures are treated comes down to one important distinction: is it a repair, or is it an improvement? The IRS also outlines several “safe harbors,” as they call them, under which you can fully deduct many repairs that would otherwise have to be depreciated more slowly over time.
Although making sense of the different distinctions and nuances of the IRS’ guidelines can get a bit complicated, in this guide, we’ll attempt to uncover the main points for classifying and deducting repairs and improvement expenses for your rental.
While rental repairs and improvements are both able to be deducted, the IRS has different rules regarding how they must be claimed.
Repairs are operating expenses that are deemed ordinary, necessary, and reasonable in amount. As long as they meet these requirements, they’re able to be fully deducted in the year that they’re incurred.
However, certain types of upkeep aren’t considered to be repairs; but instead, need to be classified as capital improvements. Improvements are things that add value to your property or benefit your property for more than one year.
Since the benefit to your property will extend beyond one year, they cannot be depreciated in just a single year, but instead must be spread out over the course of a longer period of time and claimed a little at a time on your tax return each year.
In most cases, you’re better off from a tax point of view if you can classify an expense as a repair, rather than an improvement, as you’ll be able to deduct the entire expense all at once instead of having to slowly deduct it over a long period of time. Of course, this doesn’t mean that you should never do improvements on your property, only that from a tax perspective, repairs offer more benefits.
Now, how can you tell the difference between repairs and improvements?
The IRS’ regulations spell out rules for what constitutes a repair and what is considered an improvement. This guide is fairly long, however, and quite complicated as well.
Still, generally speaking, the IRS uses the following categories to define what qualifies as a capital expense.
According to the IRS, expenses that fall under these categories must be depreciated as a rental property tax deduction.
Here’s a look at some examples of improvements from the IRS:
Additions:
Lawn & Grounds:
Miscellaneous:
Heating & Air Conditioning:
Plumbing:
Interior Improvements
Insulation
For most landlords, being able to deduct expenses all at once in the year that they were incurred is always preferable; and better than having to depreciate them.
Thankfully, the IRS provides what’s known as “safe harbors” –conditions that landlords can use to deduct certain rental-related expenses –in one year.
Here’s a look at these three safe harbors now:
If an expense falls under any of the safe harbors, then it can be treated as a currently deductible expense and deducted entirely in the year that it occurs.
In short, these safe harbors make life easier and allow you to deduct expenses that otherwise would have to be depreciated.
In order to determine whether an expense qualifies as a deduction, first, determine whether it falls under one of the safe harbor provisions. Secondly, if no safe harbors apply, you’ll then want to determine whether the expense is a deductible repair or an improvement.
With this in mind, here’s a look at the three safe harbors now:
There are two main limitations on routine maintenance: the ten-year rule and the no betterments rule.
If your expenses don’t fall under a safe harbor, then you’ll need to determine whether they are improvements or repairs. While repairs can be deducted in one year, improvements must be depreciated and deducted over several years.
In order to determine whether it’s a repair or improvement, you’ll need to delve into the IRS’ repair regulations and determine what the unit of property (UOP) in question is. You’ll then want to decide whether the expense resulted in an improvement.
Under IRS regulations, buildings must be divided up into nine different UOPs.
Here’s a look at them now:
Generally speaking, the larger the UOP, the more likely the work will be considered a repair, rather than an improvement.
Joseph Lewis, CPA and Partner at Isler CPA explains this concept well in his article: Rental Property Repairs: to Expense or to Capitalize? That Is the Question. “Work on an engine of a vehicle is more likely to be classified as an expense that must be capitalized if the engine is classified a separate UOP. By contrast, if the UOP is the vehicle, the engine work has a better chance of passing muster as a repair.”
Any work done to any of the above building systems that improves that system in some way must be depreciated.
Repairs and maintenance are different things, but you’ll want to deduct both of them on IRS Schedule E. You’re required to list each type of expense separately, so try to keep track of them throughout the year as well.
At the end of the day, landlords benefit more from a tax perspective by taking advantage of the safe harbors, or making repairs; rather than upgrades. While upgrades can be a necessary part of owning a rental, it’s always a good idea to consider the long-term tax implications when deciding whether to repair or replace an item.
Here are some additional resources on rental property tax deductions and repairs and improvements.
Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.
