By Zina Kumok | December 14, 2015
With the Federal Reserve likely to raise interest rates soon, many people are pulling the trigger on purchasing a rental property. It can be a great way to earn passive income and diversify your portfolio. But don’t jump in with your eyes closed. Even if you’re a homeowner, owning rental property is a different beast. Real estate tax law is not the same for rental properties as it is for residences. Here are some ways to save yourself from the tax man and get the most from your real estate investment.
If you’re used to paying taxes on your home, there are some differences in property tax for landlords. Here’s what you need to be aware of when it comes to real estate rental taxes: (For more, see: Tax Deductions for Rental Property Owners.)
Record your deductions. Like any small business, you can deduct the costs of running your real estate property from your taxes. These might include advertising, maintenance, utilities, insurance premiums, management fees, repairs and more. You can also deduct any mileage related to maintaining the rental property. Keep a small notebook in your car to log your mileage.
Know the difference between a repair and an improvement. According to the Internal Revenue Service (IRS), there are two types of changes you can make to a rental property. One is a repair, which can be deducted from your taxes. A repair implies a fix to something that is broken, such as a water heater or faulty wiring. An improvement is when you make a change that increases the value of the home, such as finishing the basement or adding energy efficient insulation. Improvements must be depreciated over a period of time. (For more, see: How Rental Property Depreciation Works.)
You may not be eligible to deduct anything. The IRS limits deductions to married couples filing jointly earning $150,000 or more. Deductions begin phasing out starting at $100,000. If you earn $100,000 you can deduct up to $25,000. However, any losses that exceed that amount can be carried over to future years. If your salary exceeds this amount, make sure to set aside money for your rental taxes.
Count your time. According to certified financial planner (CFP) Chris Hardy, if you spend more than 750 hours a year working on your real estate business, you can deduct expenses even if you exceed the income threshold. This could be a huge boon for high-earning professionals. Track the time you spend working on your rental property. This way, you’ll have a record in case the IRS comes calling. (For more, see: Tips for the Prospective Landlord.)
Live there first. Hardy says that another way to save on taxes is to live in your rental property for at least two years before renting it out. Single people can receive $250,000 in capital gains without paying taxes (or $500,000 for married couples filing jointly). When you sell your home, you’ll be able to deduct up to that amount from any profit you earn. This is great for people looking to buy houses and flip them later.
Vacation homes have special rules. If you own a vacation home that you rent out, you don’t have to pay any taxes if it’s rented for less than two weeks a year. This can be a great way to make some extra money on your property without paying extra taxes on it.
The Bottom Line
Real estate tax law can get hairy, but don’t let that stop you from buying a rental home if you’re in a suitable position to do so. The above tips will help. If you have more questions, consult a tax professional who can guide you. (For more, see: The Pros & Cons of Owning Rental Property.)
Refine Your Financial Vocabulary
Gain the Financial Knowledge You Need to Succeed. Investopedia’s FREE Term of the Day helps you gain a better understanding of all things financial with technical and easy-to-understand explanations. Click here to begin developing your financial language with this daily newsletter.