Ryan Barone is cofounder and CEO of RentRedi, a property management software that simplifies the renting process for landlords and renters.
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If you own a rental property, it can be beneficial to plan for tax season throughout the year. This can help ensure you’re making the most of the tax benefits and deductions available to you as a landlord. An important determinant is whether the Internal Revenue Service will consider your rental property a business or an investment, as this distinction can affect your taxation and reporting.
With an educational background in economics, and as the co-founder of a company that provides property management software to help with rental property accounting, making renting easier for both landlords and tenants is always top of mind for me. Based on this experience, here are some of the potential tax advantages and concepts I encourage landlords to familiarize themselves with.
Real Estate Professional Status
Generally, rental property activities are considered passive by the IRS unless you qualify as a real estate professional, according to Publication 527 by the IRS. Real estate professional status is an official designation for substantially engaged real estate professionals. According to the IRS, you qualify as a real estate professional for the given tax year if you meet both of the following requirements:
1. "More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate."
2. "You perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate."
For landlords, performing 750 hours of property management services per tax year translates to a little over 14 hours per week of work. Activities that might qualify as services toward this requirement include property management or approving new tenants, for example.
Be sure to keep logs such as calendar entries, appointment books, receipts and detailed notes to help verify the hours you spent on your property. If you use a property management app, particularly one with accounting features, you may be able to store this information in one place. This could make it easier to track the hours you spent servicing your rental property when trying to qualify for real estate professional status.
Passive Activity Losses
Qualifying for real estate professional status may provide tax advantages. One important distinction is that the real estate professional designation means the rental activities you materially participated in are no longer considered “passive,” which removes limitations on claiming passive activity losses, per Publication 527.
That publication also said, “If you or your spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income.” This is an exception to the rule, as you generally can't claim losses in excess income from passive activities.
Expensing Deductions
Real estate professionals may also be able to deduct various expenses related to the rental property's maintenance, operation and management. These expenses may include mortgage interest, property taxes, insurance, utilities, maintenance, repairs, advertising, property management fees and depreciation, Publication 527 also said.
Having dedicated office space in their home might also qualify some professionals for additional tax deductions if the space is their primary place of doing business. They may be eligible to claim home office deductions for a portion of home-related expenses, such as utilities and insurance. The IRS website lists two methods to calculate home office expense deductions for those who are qualified.
Capital Gains Deferrals
Managing your own rental property may also help optimize your tax situation when you decide to sell it. Section 1031 of the U.S. Internal Revenue Code, often referred to as a 1031 exchange, allows you to defer paying capital gains taxes on sold properties if you reinvest those proceeds in a qualifying similar, or "like-kind," property within 180 days.
The IRS defines “like-kind” property as “property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate.” There are certain requirements that must be met to qualify for a 1031 exchange, including that the property being sold and the replacement property being acquired "must be held for use in a trade or business or for investment." Therefore, if you manage your own rental property for investment or business purposes, educate yourself on the rules of a 1031 exchange and the types of properties that qualify.
Accelerated Depreciation
The IRS allows property owners to depreciate their property over time as it wears out. Publication 946 by the IRS explains that improvements to a depreciable property, such as replacing a roof, can affect the value of the property as well as your depreciation deduction. Accelerated depreciation allows for more depreciation to be deducted in the earlier years of property ownership, whereas straight-line depreciation deducts the same amount every year. However, there are requirements a rental property must meet for the owner to be able to depreciate it, according to Publication 527.
You can record an annual depreciation expense for all the properties and other fixed assets owned by your business. Then, perform a cost segregation study to identify components of the rental property with a shorter useful lifetime than the property itself.
Keep in mind that rules and regulations involving the tax code are constantly evolving, and they also vary from state to state. You should always consult an attorney, CPA, accountant or qualified tax professional to ensure you’re complying with the most up-to-date tax laws.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.
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