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June 8, 2021

Which type of investment properties are tax deductible?

If you are on this page, it means you want to know more about which type of properties bought for investment are tax deductible in the United States without having to pay a visit to an accountant. Right?

Fortunately for the property investor, tax legislation doesn’t change with every White House incumbent, and remains fairly predictable throughout. However, these are generalized guidelines, and if you are in doubt after reading this, please visit or set up a video meeting with your local property investment advisor. Investment properties tax issues can be a complex one for beginner investors, because the subject is not straightforward.

Investment property tax deductions:

  • Any tax deductions investment property owners are entitled to are not that complicated to read through at a glance.
  • There are some potential tax implications which are vital to understand before entering the property for investment market.

With that in mind, let’s begin with taxable rental income.

Rental income tax

The first and easiest tax to understand before buying an investment property is that the income from the rental is taxable at your marginal tax rate (tax bracket).
As this is considered to be a passive form of income, it is not subject to Medicare or Security taxes. 

  1. If your tax bracket is 22% – and you earn $1,000 in bonuses (active income) – this will be subject to 22% federal income rate + 1.45% Medicare tax + 6.2% Social Security tax. 
  2. If your tax bracket is 22% – and you earn $1,000 from taxable rentals – it is only subject to 22% federal income tax because it is considered a passive form of income.

Don’t forget that income derived from rentals is sometimes subject to state and local taxes where applicable. This form of tax is most commonly found in areas where the local governments rely on revenue from tourism in popular vacation destinations.

Rental income tax

Just because income derived from rentals is taxable, it doesn’t mean the total amount gets taxed. This is because of two major reductions are taken into account:

  1. Operating expenses
  2. Depreciation

1. Operating expenses

Before taxes can be calculated on income derived from rentals, operating expenses have to be deducted. These are expenses most commonly associated with the property investor’s obligations when it comes to owning, operating, and maintaining the properties in their portfolio. 

To list a few of these operating and maintenance expenses:

  • Paying a property manager whatever fees you have agreed on
  • All advertising and screening costs for new tenants
  • Routine property maintenance costs such as HVAC filter changes and inspection
  • The interest you are charged if you have bought your property with a mortgage
  • Pest control and inspection
  • Hazard insurance 
  • Yard and building structure maintenance
  • Utilities routinely paid by the landlord – water and sewer services, garbage collection, garden upkeep service

As you can see, these kinds of operating expenses will reduce your taxable rental income considerably.

For example, if the rental income from your investment property amounts to $15,000 and your operating expenses total $7,500, it reduces the actual taxable rental income to $7,500.

Is it possible to write off the total cost of an investment property?

It is generally known that the cost of business assets are tax deductible, but can the same hold true for investment property?

If a business purchases a computer, furniture, domain names, or miscellaneous items to be used in running the business, it is tax deductible.

You might be surprised to learn that owning an investment property is also technically a business. Does it follow that the cost of acquiring a property for investment opens a door for a deduction on your next tax return?

When you buy a business asset with a lifespan longer than 1-2 years, it is deductible over a certain number of years. This is called depreciation of business assets. 

Say for example, if a machine you use in business has a recognized lifespan of ten years then 10% of the machine’s cost can be deducted for the next 10 years.

Properties with buildings on them can be deprecated in the same way, although it is a little tricky to determine a building’s life span.

For example, cheap structures might have been built to last for only a couple of decades at the most; some meticulously constructed building such as an historic mansion that is two hundred years old might require professional upkeep to maintain its worth.

Because of these factors, the IRS has set standardized depreciation times: 

  • Any investment property bought for residential use has a depreciation time 27 and half years:
  • Properties bought as an investment for commercial use has a depreciation time of 39 years.

Say you buy an investment property for residential purposes that totals $150,000 after the inclusion of acquisition costs. 150,000 ÷ 27.5 equals $5,455 depreciation deductions per annum. 

This would reduce your taxable income further for every year you own the residential property, and continues until the total $150,000 property price has been deducted.

Breakdown of taxable rental income on a $120,000 residential property generating $12,000 annual rental income with the following expenses for the owner:
  • $500 in utilities
  • $500 in maintenance
  • $1,000 insurance
  • $1,000 property taxes
  • $3,000 interest on mortgage

= $6,000 operating expenses which then = a $6,000 in taxable rental income reductions.

$120,000 ÷ 27.5 = $4,364

$6,000 – $4,364 = $1,636 in taxable rental income. 

Of the $12,000 you took in rental income, only $1,636 of this is considered to be taxable. When many property rentals are combined, it is not uncommon to have a tax loss reported, especially if heavier maintenance costs are paid that year.
If you think this sounds a little too good to be true, you might want to know a bit more about business assets depreciation recapture tax. This, as well as capital gains tax, can be deferred with a 1031 exchange.

A final word on property and real estate investment

Because of the tax benefits of becoming a property rental investor, it is well-know to be one of the most effective ways of gaining financial independence, creating wealth and increasing one’s net worth. 

If you would like to know more information on the fastest way to understanding property tax, please remember that consulting a qualified professional is the straightest line between you and knowing more about rental income tax deductions.

References:

https://www.irs.gov/newsroom/know-the-tax-facts-about-renting-out-residential-property

https://www.irs.gov/businesses/small-businesses-self-employed/tips-on-rental-real-estate-income-deductions-and-recordkeeping

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