Understanding Tax Deductions & Depreciation for Investors

Understanding Tax Deductions & Depreciation for Investors

July 20, 2022

Why are tax deductions important for real estate investors?

Owning rental property is a good way to put your money to work earning passive income, and to grow your money through property appreciation. Did you know that there are also several tax advantages that come with owing investment properties? These advantages add up and understanding how to prepare for filing your taxes will help you reduce your tax burden and increase your returns. This article covers the high-level concepts of tax deductions and depreciation but remember to always consult with a tax professional to get specific advice for your investments.

What are Common Tax Deductions for Rental Property Owners?

When doing your taxes, taking deductions will reduce the amount of income you’ll be required to pay taxes against. There are several tax deductions owners of rental properties can take when filing their annual taxes.  Understanding these options and how to track your finances will make it easy at tax time to document the deductions that you may be eligible to take.

Operating Expense Deductions

Operating expenses for a rental property, according to the IRS, include “ordinary and necessary” expenses that are incurred operating the property. These are things like repairs and maintenance, advertising a vacancy, property management fees, landscaping, etc. Material improvements to the property aren’t deducted as operating expenses – the cost of improvements can be recovered through the deprecation deduction covered below.

Interest Deductions

Interest paid on a mortgage may be tax deductible. Additionally, interest paid to a credit card for operating expenses could also be deductible. Some investors use a specific credit card for these expenses so tracking the interest paid is isolated, and easier to document. If you are operating your rental property as an LLC, any interest paid to a member of the LLC that has loaned the business money may also be deductible.

Owner Expense Deductions

Reasonable expenses related to owning rental property may also qualify for a deduction. These include business travel, continuing education, and home office expenses.

Depreciation Deductions

Depreciation deductions are very important for investors because they can reduce your tax burden, but they don’t reduce your property’s cash flow. Depreciation allows you to deduct a portion of the property value each year. For residential property investments, the IRS allows depreciation of the property over 27.5 years.  This provision accounts for the wear and tear on the building itself. The value of the land must be subtracted, because there is no wear and tear on the land – only on the building itself. Let’s look at an example:

Depreciations deductions can only be claimed against properties that are actively rented – or in service, according to the IRS. For each year your property is in service, the depreciation deduction is equal to the property value, minus the land value, divided by 27.5. For example, if you purchase a rental property for $400,000, and the land value is $100,000 each year you can deduct depreciation of $300,000 / 27.5 or $10,909.  

Improving your property in a way that adds to the property value, or making a capital improvement, can be capitalized and depreciated over time. If these improvements are made before the property is rented, you can adjust the property value right away for year one. If you make a repair after the building has been rented, you can recapitalize the property and adjust the depreciation.

For example, if your property needs a new kitchen before you rent it, you can immediately claim the improvement as part of the property’s value. If in year 5 you replace the roof of your property, you can adjust the property value based on the cost of the roof and recalculate the amount of deprecation you claim in subsequent years.

Claiming depreciation deductions is complicated and requires keeping good records of your expenses & usage. There are rules for when the property enters and exits service, what happens if it is idle, if you reside on the property, handling partial years of service, etc. You can do more research on the IRS website, and you should consider working with a tax professional to get the details right when you file.

You’ll want to keep close track of the total deprecation, because it will be essential to calculate deprecation recapture, which is required at the point of sale.  Depreciation recapture will be covered in a future article.

Calculating Annual Deductions for a Rental Property

Here is an example of how to calculate annual deductions for a property. First, here are the variables used for the example:
- purchase price $415,000
- land value: $83,000
- initial improvement (new kitchen): $25,000
- annual operating expenses: $4,200
- mortgage interest: $15,000

To calculate the annual depreciation deduction for a rental property, start by calculating the building value, by removing the value of the land and adding the initial improvement. The initial improvement increases the building value.  In this example, that’s $415,000 + $25,000 - $83,000 = building value of $357,000. Next, divide the building value by 27.5 to calculate the amount of the property eligible for depreciation each year, which will be: $12,982.  

To get the total deductions for the first year, add up the deductions including initial repairs, the annual operating expense, mortgage interest, and the deprecation, which means the first year’s deductions would be $5,000 + $4,200 + $15,000 + $12,982 totaling $37,182. The taxable income for the rental property amount would be reduced by this amount.     

Estimate the Tax Benefits of a Property Using Padvest

The tax benefits of real estate investing are important to savvy investors, and it’s important to get specific guidance about your taxes from a tax professional. To make it easier to do tax analysis, the Income Statement section of Padvest’s property evaluation report provides an estimate of the total tax benefits for each year of ownership. You can enter the estimated land value of a property, see the estimated annual depreciation, and the total tax benefits including interest and expense deductions based on the parameters in the property evaluation report.

To simplify sharing this information with your tax professional, or to dig into the details yourself, you can export the Income Statement as a PDF or an Excel document.

Try it for free today and get a comprehensive financial outlook for a rental property you’re considering.