Owning investment property offers a number of tax advantages that enhance your profit potential. While these tax benefits by themselves would not be a reason to own an investment property, understanding them ensures that you maximize your profits and cash flow from owning the property.
Just as with any other type of business venture, the costs related to the property are often tax-deductible. Here are a few of these deductions that might apply to your situation.
Mortgage Interest and Property Taxes
As homeowners know, your ability to deduct your mortgage interest and property taxes on your personal residence has been limited by the SALT (state and local taxes) cap and the increased levels for a standard deduction. Both of these rule changes limit the ability of homeowners to itemize deductions.
When it comes to an investment property, the owner can deduct the interest on a mortgage or any loan taken out to finance the purchase of the property against any rental income they earn. The same applies to any property taxes they pay on the property. These are considered business expenses, just like the expenses of running a retail store or a manufacturing business.
Depreciation is an expense where an asset’s cost is expensed over its useful life, as defined by the IRS. Investment real estate is considered a depreciable asset, and owners of investment property can depreciate the cost of their investment over time.
Depreciation is a non-cash expense. In other words, there is no annual outlay for it each year. Owners of investment property can still deduct depreciation from any rental income earned from the property, just like other expenses they may incur in the operation and management of the property.
Note that if you eventually sell the property for a gain, some or all of the depreciation that you’ve expensed over the years could be subject to recapture upon the sale.
Expenses Related to Ongoing Upkeep and Maintenance
Owning an investment property, either residential or commercial, that is rented to tenants requires the owner to perform varying levels of upkeep and maintenance. Whether this is ensuring the lawn is mowed, repairs are made for things like a broken furnace or air conditioning unit, or any number of other items, the expenses associated with these tasks would generally be considered a deductible expense to be offset against rental income from the property.
General maintenance expenses, as well as those related to readying the property for tenants, are tax-deductible. Examples include, but are not limited to; cleaning of common areas, plowing or shoveling snow in the winter, lawn mowing and related yard maintenance, plumbing and electrical repairs and painting.
Expenses to Improve the Property Prior to Renting to Tenants
Perhaps the rental unit or commercial space needs to be painted, needs new carpeting or just in need of general cleaning. These types of expenses would be considered operating expenses and can be deducted in the year they occurred.
Any repairs or maintenance costs that are more permanent improvements to the property are treated a bit differently. These expenses need to be capitalized, rather than expensed in the year completed. These expenses could be things like expanding the property, rebuilding or restoring some or all of the property to its original condition or converting the property to a different type, such as converting a manufacturing facility to a retail store.
When an expense is capitalized, it is depreciated, and a portion is then expensed annually over the useful life of the improvements, as defined by the IRS. In some cases, these types of capital improvements can be expensed in the year of the expenditure, if a certain election is made with the IRS. This is a very complex area, and it's wise to consult with a knowledgeable tax professional for guidance.
Property Management Expenses
Being a landlord can entail having to make repairs to your investment property at odd hours. There are countless horror stories of the 3 a.m. call from a tenant with a toilet that needs to be fixed. In addition to not wanting to get calls about repairs that need to be made, some folks can’t or don’t want to do this type of work.
For these and other reasons, it might make sense to hire a property manager to manage your investment property. This might become a real necessity if one or more of your properties are located in a different city from where you live, or if you own several investment properties.
Property managers take responsibility for collecting rent, overseeing the rental process for new tenants, ensuring that all repairs and maintenance are performed and a host of other related tasks. They charge a fee for their services and will also bill the property owner for any costs incurred to hire people to do some or all of the related work. These expenses would be considered to be deductible against any rental income received.
Overall, it’s perhaps easiest to think of owning investment property like owning a business, which it essentially is. Most expenses incurred in operating that business is deductible against revenues earned by the business, with the net result being what is taxed. Some types of expenses with an estimated life of a number of years are considered capital expenditures and are expensed as depreciation over a number of years, and the same holds true with investment property.
Often, the one added feature of investment property is the opportunity to sell it at a profit at some point in the future. To the extent that you can use the ability to deduct certain expenses along the way, this can help minimize the cost of ownership and maximize your return on your investment in the property.