Just like any other kind of business, landlords too have to pay taxes on their earnings. In fact, landlords are responsible for paying taxes on the profits that they make from renting out properties, as well as any capital gains they realize when they sell.
Like any other business, there are ways to minimize your rental property taxes so that you don’t pay a penny more than you have to. The IRS isn’t going to wait, so here are five ways to minimize your rental property taxes.
1. Actively Manage Your Properties
When the IRS considers that you are running a business, they allow you to deduct your expenses from your income thereby reducing taxes. The more actively you manage your properties, the more likely it is for the IRS to consider you to carry on a real estate business rather than a passive investor.
The general test for this is the amount of time you spend working on your business. The IRS says you must spend at least 750 hours per year working in the real estate industry for your rental properties to be considered active income.
The level of services you provide may also be a consideration. You are much more likely to be considered an active participant in the business if you are responsible for maintenance and repairs than if you assign those responsibilities to your tenant.
2. Track and Deduct All of Your Expenses
As a landlord, you can deduct almost all of your expenses or from your taxes provided they are both necessary and ordinary. This includes common expenses like the cost of labor and materials for maintenance and repairs, turnaround expenses, like cleaning and advertising, and general expenses like rental property insurance. You can also deduct a variety of other expenses you may not have considered.
For example, you can deduct mileage when you use your car to travel to and from your rental properties. You can also deduct the interest you pay on mortgages and other loans, fees paid to professionals, and even the cost of your home office. Additionally, you can even deduct the amount you spend on property tax and HOA fees.
In order to maximize your deductions at tax time, it’s best to make a habit of continually recording your expenses as they happen throughout the year.
Rental property bookkeeping software can help you manage your receipts and give you a clear picture of what you can deduct on your Schedule E in April.
Learn more about what you can deduct in our article on 10 tax deductions you can claim as a landlord.
3. Depreciate Capital Investments
In addition to your direct expenses, you can also deduct depreciation on capital items. In a nutshell, depreciation is the natural decline in something’s value over time.
While land doesn’t depreciate, the house itself does; you can deduct that depreciation each year on your taxes. You can also claim depreciation on major improvements you make to the home or property. Replacing the roof, installing a new HVAC system, or replacing all of the windows are all examples of investments you can claim depreciation on.
4. Make Borrowing Your Friend
Not only can you greatly improve cash flow by amortizing your expenses, but borrowing can also help you save money on taxes by way of the interest deduction.
The IRS lets you deduct all of the interest you paid on your loans related to your rental business, and not just for mortgages. If you take out an unsecured loan or line of credit, or even if you carry a balance on your business credit card, you can use the interest as a deduction.
For example, if you spent $1,000 in cash on maintenance for your property in a year, you can deduct that $1,000 on your taxes. If you borrow to pay for that expense, you keep the $1,000 in cash and you can also deduct the interest you pay on the loan.
The downside to this strategy is that your debt to income ratio is a determining factor in what kind of financing you can get for your next investment property.
5. Plan to Reduce Capital Gains tax
If you’re planning to sell a rental property, you have to pay a capital gains tax of up to 20% on your profits. However, there are a few strategies you can use to reduce your capital gains and save on tax.
Take advantage of the primary residence exemption
The primary residence exemption lets you exclude up to $250,000 of gains on the sale of a property ($500,000 if you’re married and filing jointly) if you’ve used it as your primary residence. to use the exemption, you must have used the property as your primary residence for at least two of the five years leading up to the sale.
The amount you can exclude depends on how long you lived in the home compared with how long you rented it out. For example, if you lived in the home for two years then rented it out for three years, then sold it, you could claim 2 out of 5 of the exemption or $100,000.
Defer and eliminate capital gains tax with estate planning
If your rental properties have become a family business, careful estate planning can help you avoid paying capital gains tax when you decide to retire.
While you’re alive, selling your properties triggers a capital gain. Giving property to a family member will trigger the gift tax, which ranges from 18% to 40% of the property’s fair market value, with only a small exclusion permitted.
However, tax rules are far more forgiving when a gift comes in the form of an estate. Not only are there no federal estate taxes on an estate’s first $12.06 million, each property’s cost basis is “stepped up” on inheritance, effectively resetting the clock on capital gains.
That means if the person who inherits a property decides to sell it, they will only pay tax on the change in value from the day they inherited it.
6. How to review your property tax Assessment
Property tax assessments are critical to rental property ownership, as they determine the property taxes owed. Ensuring the accuracy of your property tax assessment is essential in minimizing your tax burden.
Here is a detailed explanation of reviewing your rental property tax assessment and taking necessary actions if needed:
Obtain your property tax assessment
Property tax assessments are typically mailed to property owners annually by the local tax assessor’s office. Sometimes, the assessment information may also be available online through the county or municipal website. Ensure you obtain a copy of your most recent property tax assessment to review its accuracy.
Review the assessment details
Carefully examine the rental property tax assessment for errors or inconsistencies. Key factors to check include the assessed property value, classification, exemptions, and any recent property improvements or changes that may affect the assessment. Comparing your property’s assessed value to similar properties in your neighborhood can also help determine if your property is fairly assessed.
Ensure the accuracy of assessed value
If you believe your property’s assessed value is incorrect, gather supporting documentation to justify your claim. This documentation may include recent appraisals, comparable sales data, or information on property improvements that could affect the property’s value. If you are unsure about the accuracy of your property’s assessed value, consider consulting with a real estate professional or property tax consultant for guidance.
Appeal assessment if necessary
If you find discrepancies in your property tax assessment or believe the assessed value is too high, you can appeal the assessment. The process for appealing a property tax assessment varies by jurisdiction, so it’s essential to research the specific procedures and deadlines for your area. Generally, the appeal process involves submitting a formal appeal to the local tax assessor’s office, providing supporting documentation to justify your claim, and attending a hearing if required.
Stay informed about local property tax laws
Property tax laws and assessment procedures can vary between jurisdictions and may change over time. Staying informed about local property tax laws can help ensure you are aware of any changes that may affect your property tax assessment or the available deductions, exemptions, and tax relief programs. You can stay informed by regularly checking your local tax assessor’s website, attending community meetings, or subscribing to local news sources.
Reviewing your rental property tax assessment involves the following:
- Obtaining the assessment.
- Examining the details for accuracy.
- Appealing the assessment if necessary.
- Staying informed about local property tax laws.
By actively engaging in this process, rental property owners can help ensure they pay a fair amount of property taxes and minimize their tax burden.
Our Final Thoughts: Minimizing Your Rental Property Taxes
Paying tax is a part of doing business, no matter what line of work you’re in. But there’s nothing wrong with making sure you pay only your fair share and no more.
Take advantage of all the deductions you can and plan ahead before selling your properties to minimize the amount of your hard-earned money that goes to the IRS.
FAQs
The IRS receives reports from a variety of sources they use to look for tax returns that don't look quite right. Reports from your bank, municipal licensing, property tax records and even whistleblower reports from a disgruntled tenant can all be used as grounds for an audit. It’s best to keep your bookkeeping in order and save all your receipts. You can use Baselane’s platform to stay organized and ahead of the IRS.
Landlords pay tax only on their rental property profits at their marginal rate.
For example, if you received $25,000 in rent payments and had expenses of $20,000 in a year, you would pay tax on the $5,000 profit.
If that profit was in addition to a salary of $75,000 from your full-time job, it would be taxed at a marginal rate of 22% meaning you would owe $1,100 in tax for the year.
It’s best to check with your local CPA or accountant for specifics on how much taxes you have on your rental income.
There is no tax exemption for a rental property income. However, your income is reduced at a 1:1 rate by your expenses including depreciation. Any profit you make in your rental business will be taxed at your marginal rate.
