It’s almost the end of 2022 already! Which means that Tax Season will quickly be upon us. Our team at Keyrenter wanted to provide some support and FAQs around how you can best prepare yourself to file your taxes and to identify some common mistakes landlords will make so you can avoid them yourself. Our CEO, Brandon Scholten, got on the phone Jason Garcia, a CPA of twenty years, seven of which have been spent at Mile High Tax and Accounting, to get his takeaways on the subject. You can check out the video of their discussion here, or read on for the summarized topics.
What Expenses Related to Rental Properties Are Tax Deductible?
Most are familiar with the standard expenses and deductions, such as mortgage interest, utilities covered by the landlord (water, trash, etc), taxes, insurance, or management fees from the management company.
However, many miss the cost of contractors and professional service firms, such as the invoices associated with hiring a CPA to handle the property accounting, or an attorney to establish an LLC or navigating eviction proceedings. Also, many forget that while tax prep fees aren’t typically deductible, in this case they qualify as business expenses and can be counted as a deduction. Other factors to keep track of and can be deducted are the travel costs associated with visiting rental properties (gas or hotel costs, etc), or the depreciation on the rental property which everyone is eligible for.
How Can Landlords Set Themselves Up to Have a More Favorable Tax Position?
One great way to prepare yourself that many CPAs recommend and many landlords don’t often do, is to have a cost segregation study done for the property, or prepare one yourself if you know how. For income tax purposes, property owners and real estate investors generally depreciate residential rental property over 27.5 years and commercial property over 39 years (excluding the land). A cost segregation study is a process that looks at each element of a property, splits them into different categories, and allows you to benefit from an accelerated depreciation timeline for some of those building components. This study will allow other items that you bought along with the property like appliances (which can often be depreciated over five years), a hot tub or pool, or furniture included with the purchase which can affect the first year of depreciation and accelerate that deduction and give you more things to write off in the first few years instead of having to spread it out over the standard 27.5 years.
What Is an Overview of Regular Expenses vs. Capital Improvements/Expenditures?
Regular expenses that you would deduct each year include things like mowing the lawn, and other minor repairs (that do not increase the value of the property), but that are required to operate and run the “business” of the rental property.
Capital Expenditures improve the property and increase the value, such as replacing the roof, plumbing, electricity or floors that will typically last more than a year (which is often a good gauge to determine the difference) and are part of the house itself.
For example, a repair to an appliance like a fridge might be classified as a regular expense, whereas replacing the appliance entirely would be a capital expenditure.
How Can You Determine the Difference between Regular and Capital Expenses for Filing Taxes?
If you’re not sure of the difference, the best suggestion is to compile all the property’s maintenance and repair information for the year and then consult a tax expert like a CPA or accountant to help determine the difference and file appropriately.
What Are Some Tax Strategies around the Timing of Buying Rental Property?
Long-term capital gain is taxed more favorably to more of short-term. Long-term is often taxed closer to 15%, where marginal tax rate can be taxed closer to 22-32%. So if you’re going to buy a rental property, it is in your best interest to maintain possession of the property for over a year which would qualify it as a long-term capital gain when sold. That will make a big difference in your tax rate.
Also if you are considering purchasing an additional property, but don’t plan on selling your former primary residence, it’s important to note that your original property will still qualify as primary residence (even if rented) provided that you resided there for 2 out of the last 5 years. That means, should you ultimately decide you no longer want to be a landlord and would prefer to sell the original property, and it qualifies as within that timeline (perhaps you lived there for 2 years and then rented it for another 2-2.5 years), the property will qualify as a primary residence meaning there is no gain on the sale, resulting exclusion of up to $500,000 (for married couples) that you might not otherwise be protected from.
What Is a 1031 Exchange and How Does It Work?
With a 1031 Exchange, a taxpayer may defer recognition of capital gains and related federal income tax liability on the exchange of certain types of property. If a business owner/property investor has property they currently own, they can sell that property, and if they reinvest the proceeds (which must be held by a qualified intermediary from the sale of the original property) into a replacement property, there’s no immediate tax consequence to that particular transaction. These can be unusual as often it can be challenging to find a property to exchange that the owner may find of equal value. It’s also worth noting that this exchange cannot be done with personal property, only investment opportunities and require a strict timeline to be followed. The replacement property must be identified within 45 days, and the sale must close within 180 days. Check out our interview with Jason Garcia,CPA for some great examples of how the 1031 exchange can work in action!
What’s a Common Mistake Related to Filing Taxes That You Often See from Rental Owners?
One of the most common mistakes, especially when property owners file their own taxes, is neglecting to take the depreciation deduction. Some rental property owners may have been filing taxes on their property for five or more years but never taken a depreciation deduction. Often this is because the property owner will believe that they were barely breaking even as it was, so the depreciation deduction wasn’t necessarily going to help them in the moment. And, with the hopes of eventually selling the property, they didn’t want the deduction to decrease their basis and have to pay gain later down the road.
However, that’s not actually how it works. When the owner eventually goes to sell the property, the owner will be required to decrease the basis by the amount of depreciation you have taken, or the amount that you should have taken. So if the owner has waited five years, without ever taking the depreciation deduction, when you sell the property you will have to decrease the basis by the depreciation you didn’t take. That means you will have lost out on five years of potential depreciation deductions that you could have been filing the entire time. There are ways to go back and amend the return or a change of accounting method, but it is no small feat, especially if you already sold the property.
Overall, taxes are an important and complicated aspect of owning rental property, so it’s really good practice to consult an attorney or accountant to discuss all your best options to protect yourself and your business!
If you have questions and want support, don’t hesitate to contact Mile High Tax and Accounting (milehightax.net, 303-657-1040, [email protected]) or contact us at the Keyrenter Team!