Introduction
It is nearly tax time again. Owning a profitable investment property is great unless it is April 15th and Uncle Sam has his hand out for his share of the profits. If you want to keep more of your hard-earned cash, then pay particular attention to the following couple of pages. We are going to share some tips on how to maximize your investment property deductions and we will share a secret on how to use your second home as a rental tax-free.
Passive and Non-Passive Investors
What Kind of Investor are you?
Before we start getting into the nitty-gritty of how to pay fewer taxes and earn more income, Uncle Sam wants to know what kind of investor you are – Passive or Non-Passive. If you are a full-time property investor or spend the majority of your time in real estate, you are considered a non-passive investor. Everyone else is considered Passive.
Tax Breaks for Passive Investors
Passive investors are only allowed to deduct losses up to $25,000 against your rental income. You can however carry over those losses to the following year. This deduction is reduced when your modified adjusted gross income exceeds $100,000.
The Benefits of Non-Passive Investors
If you spend more than one-half of your time working in the rental business, property development, construction, acquisition or management and spend more than 750 hours per year working on your rental properties, you are classified as a non-passive investor and all losses are fully deductible against all income.
Income
What All is Considered as Income?
If you want to avoid an audit, make sure you include all your sources of income. Sources of income, besides rent, also include tenant-paid expenses, trades-for-services, and portions of the security deposits that were kept by the landlord. In these three cases, you can deduct the expenses associated with the income to knock them out.
For example, if you kept $250 of your tenant’s security deposit to clean the carpet, you must declare the $250 as income (but not the rest of the returned security deposit). You can also write off the $250 as an expense that was paid to the carpet cleaner.
Remember, however, that you must report the income in the year you received it. If a tenant pays you rent on December 31st that is due in January. You need to report that income as received in December.
DID YOU KNOW?
If you received the first and last month’s rent, you need to report all of it the year you received it. If you want to reduce your income taxes, skip the last month’s rent and collect a security deposit instead.
How to Maximize Your Deductions?
Here is the low down on what you can count as a deduction against your rental income:
Mortgage Expenses
You can deduct the interest, but not the principle. The total amount of interest you paid will be found on Form 1098 that your lender will send you.
If you paid closing costs (commissions, appraisals, mortgage points, loan application etc.), you cannot deduct the full amount the year you paid them, but you can amortize these costs over the life of the mortgage.
DID YOU KNOW?
You can deduct credit card interest that you paid on goods or services used in a rental activity. To keep your records straight, only use one credit card for all investment property purchases and then keep that one separate from personal charges.
Travel Expenses
Keep track of the miles every time you have to drive to your rental to collect the rent or plunge the toilet. It is considered travel expenses. The IRS allows you to deduct either the mileage or the actual expenses. You will need to make this decision the first year you claim your vehicle.
There are some travel expenses that are not deductible – even if they have to do with your investment property. For example, if you are going there to work on replacing the roof, well guess what, you can’t deduct those miles. It all has to do with whether or not you are making a repair or a capital improvement. Keep reading to find out why.
DID YOU KNOW?
You can mix business travel with pleasure, but you must break out the expenses related to your personal activities. For example, if you own a seaside vacation rental and plan to spend 3 days getting the property ready for a new tenant and 2 days relaxing on the beach; you can deduct all the travel costs to reach there and 60% of the costs while there.
On the other hand, if you spent 3 days on the beach and only 2 days working, the trip is classified as personal and only the direct expenses related to the repairs would be deductible. So, plan your trip carefully to maximize your expenses.
Taxes and Insurance – You can deduct property taxes and insurance costs. If your insurance did not cover the full amount of a loss from a causality (hurricane, earthquake, flood, or theft), you can deduct the excess loss as well.
Home Owner Association Fees – As long as the fee is being used for repairs and maintenance, then it is deductible. If it includes a capital improvement assessment (building a clubhouse, repaving the streets or something similar), then that amount must be handled differently. We will discuss that a little later.
Maintenance and Independent Contractors – If you call a plumber to fix the shower in your rental, that expense is deductible. If you have a maintenance man that you pay an hourly wage, that too is deductible, whether they are an employee or an independent contractor.
Legal and Professional Services – The fees you pay for your attorney to draft a lease agreement are deductible. So are the costs of hiring a property management company. The bill from your accountant is also deductible as long as it relates to your investment properties and not your personal return.
Other Expenses – Other expenses related to your investment property that are deductible include advertising, cleaning, pest control, equipment rental, supplies, trash removal, and owner-paid yard maintenance.
Depreciation – Unlike other expenses, depreciation is a bonus from the IRS. While you do not physically pay money out of pocket for depreciation, you can deduct annual depreciation on your taxes. Consult with your accountant or tax planner to make sure you set up your depreciation schedule correctly the year you purchased the property.
DID YOU KNOW?
Landlords can greatly increase their depreciation deduction during the first few years of ownership by using segmented depreciation.
Tips to Keep Your Cash
While most property owners have a basic understanding of what they can count as a deduction, we want to take our discussion a little further. Here are some tips, pointers, and suggestions that can maximize your deductions and keep more of your rental income in your pocket.
Opt to Repair not Improve
Just because you spend money on your rental does not mean that it is automatically deductible. The IRS allows you to deduct repairs but not improvements. What is the difference?
Repairs are Deductible
A repair is fixing something that keeps the property in good condition, but that does not add value to the property. Replacing a faucet, painting the living room, and fixing a broken toilet are all repairs. These are deductible.
Improvements are Not…
Improvements, on the other hand, increase the value of the property and last longer. Replacing the roof, converting the garage into a recreation room, remodeling the kitchen are all improvements. These are not deductible in the year you do the work. You can depreciate the improvements and they count against capital gains.
So, if you want to maximize your deductions, make sure you keep on your repairs rather than waiting until the item needs replacement or renovation.
Set-Up a Home Office
Would you like to deduct some of the interest, taxes, insurance, utilities and repairs paid on your personal residence from your investment income? Then consider setting up a home office. The IRS does have some pretty tight qualification guidelines, but the benefits are that you can write-off more of your expenses and keep more cash.
Create a Paper Trail
The IRS allows plenty of deductions, but if you are every audited, you are going to have to be able to prove each one of them. This means that you need to keep good records. If you want to keep your stress down and your office organized, skip the shoebox and accordion files and opt to use some sort of bookkeeping software – or better yet have your property manager keep track of them for you.
How to Rent Out Your Vacation Home Tax-Free
So, you have bought a beautiful little bungalow on the North Carolina coastline. Since you are not there all the time, you have decided to earn a little extra cash to put towards the mortgage, taxes and property insurance. What a great idea!
But, before you list it with your property manager, you should consider how it will affect your Federal income taxes. How Uncle Sam will tax the income generated off your rental is based on how much time you actually live in the property.
If you yourself spend 14 days or less (or 10 percent of the time it’s rented, whichever is greater) at the property, then essentially you own an income or investment property and not a second home. This means that you are eligible for all the deductions which are granted to income producing properties, but you will also have to pay income tax on the excess.
If you don’t want to pay any income taxes at all, then only rent out your property for 14 days or less per year. Any money received for a two week rental per year is tax-free.
Most vacation property owners will be somewhere in the middle. How can you reduce your income taxes? You must keep meticulous records. The reason is that you can allocate a percentage of all your expenses against the income that was earned.
Here’s an example. Say you spend 2 months during the winter at your vacation home. You then rented it out for 180 days. This means that the property was occupied for a total of 240 days. You rented it out 75% of the time (180 rental days ÷ 240 days of use).
This means that you can deduct 75% of your qualifying expenses such as mortgage interest, repairs, advertising, management, property taxes and insurance etc.
What is even better is that the rest of the allowable expenses get reported on your personal tax return.
If you think you will rent out your house for only a couple of months per year, then consider renting it at below-market rates except for the two weeks during the peak high season. This will put all the below-market rent as “personal use” according to the IRS. As long as you do not rent out the property for “a fair rental price” for more than 14 days, all of the income is tax-free.
Keep in mind that if you “rent” out your house to family members – whether they pay you or not, it is considered personal use. If you rent out your property to a friend for less than market rent, that is also considered personal use.
DID YOU KNOW?
Want free money? Then only rent out your property for 14 days or less a year. Any money received for a two-week rental or less per year is tax-free!
If you want to maximize all of your deductions and have the ability to report a loss, then you need to only vacation there less than 10% of the total days you rent it out to others or no more than 14 days, whichever is greater.
The choice is yours but either way, make sure you keep good records in order to prove your deductions.
Why You Should Be Happy to Pay Income Taxes on Your Investment Property
Happy to pay taxes? No, we are not out of our minds.
But consider this, at least you are not paying the dreaded 15.3% self-employment tax which applies to other self-employment ventures. And if you are a self-employed weekend warrior, consider becoming a landlord to keep more of your income.
Additionally, if you are paying taxes on your rental property, that means that your investment is creating a positive cash flow. A positive cash flow means that your rentals are profitable. Its better to pay taxes on a property that is earning you income than to deduct losses from a money pit.
Let’s assume that you end up paying $2,550 in income taxes from your vacation rental. If you are in the 30% bracket, that means that your rental property had an NOI of $8,500. Though you hate the idea of giving Uncle Sam $2,550 of it, you have still pocketed $5,950!
If you have an investment property that is always declaring a loss, you should stop and honestly examine the cash flow. At times, it is the allowable IRS deductions that can make an actually profitable property look like a money pit but at other times the reality is that it is a money pit. If that is the case, perhaps it is time to contact your real estate agent to exchange this investment for a more profitable one.
Here at Victory Real Estate, Inc. not only are we passionate about property management, but we can help you to maximize your deductions and capitalize on profit centers all while helping to ensure that your rental property is meeting your investment goals.
Also check out! Who Doesn’t Like a Tax Deduction?
