Rental Property Tax Benefits
As experienced professional property managers in the Minnesota area, one of the first things we help people who are considering renting out their property to understand is how a properly managed residential rental property can have significant tax advantages for them. We are not CPAs or tax attorneys, but we are experienced investors who understand the many tax advantages of owning rental properties. We encourage our clients to seek professional advice from their own tax advisors, but we can help you to understand how these tax savings can benefit you.
To get an idea how this all works, let’s look at a typical Minnesota metro area rental home. Valued at $300,000, this typical home represents, roughly, a land value of $25,000 and a value of $275,000 for the structure. If it rents for $1,500 per month, it would be typical for this rental market. That adds up to $18,000 a year of rental income. During the year, you may pay about $10,000 per year in mortgage interest and $2000 in property taxes. In addition, you’ll spend about $700-$800 per year in insurance for the home. Your actual numbers will vary, of course, but we’ll use these numbers for our examples.
As a homeowner living in that home, you’d be able to deduct the mortgage interest and property taxes as itemized deductions in Schedule A when you file your IRS forms each year. But, when that home is a rental property, you’ll find a number of other deductions that may surprise you. As a rental property owner, you’re a small business, and IRS tax codes are very favorable for rental properties. Instead of just entering deductions for mortgage interest and property taxes on Schedule A, you’ll now be completing Schedule E, which covers gains and losses from residential rental properties.
IRS Schedule E Is The Key to Tax Savings for Minnesota Landlords
As explained in IRS Publication 527, Schedule E includes deductions not only for mortgage interest and property taxes, but also a number of other expenses and depreciation you can deduct for being in the residential property rental business. The rows and columns for Schedule E include entries for all of the following:
- Rental Income – For our sample home, you’ll enter $18,000 as the income from this rental home. If you own multiple rental properties, the total of collected rents will be entered as rental income.
- Expenses – All of the expenses you incur for your rental property get listed in Schedule E, and the list is much longer than in Schedule A, and includes:
- Mortgage Interest– For our sample home, you’ll enter $10,000.
- Property Taxes – Here, you’ll enter $2000 for the sample home.
- Insurance – The insurance on your rental property is now an expense.
- HOA Fees – For condominium properties, these are a business expense.
- Property Management Fees – Why manage your own rental property if you can use professional management fees as a business expense?
- Maintenance Costs – Repairs, upgrades, and improvements are business expenses for rental properties.
- Other Expenses – As a business, you can potentially deduct things like home office expenses, a portion of cell phone and Internet costs associated with the rental property, and more.
- Travel Expenses – If you live far from your rental property, you can deduct the entire cost to visit the property to inspect it.
If you add up all of the deductible costs connected with your home, as in this sample, you may find that the expenses you can include on Schedule E may equal the rental income. If you own more than one property, this may mean that, despite the cash flow from your rentals, you end up producing a very low or zero actual income you’d have to pay taxes on. So, where’s the benefit to the rental property owner?
Depreciation Is the Key to Wealth Building through Residential Rental Property
The last part of IRS Schedule E lets you deduct depreciation on your home, much as you would for any business asset, like cars, trucks, or computer equipment. IRS tax laws allow you to depreciate the value of the structure, but not the land it sits on. IRS Publication 527 sets the depreciation period of a typical home at 27.5 years. For our example home, then, dividing the value of the structure, $275,000, by 27.5, lets you enter $10,000 per year as a depreciation expense. When you do that, assuming your net income is zero after deducting other expenses described above; you now show a $10,000 loss.
That’s not a real loss, though. It’s a depreciation loss. The actual value of the property does not go down over time. It is a non-cash accounting loss, all the same, and can reduce the IRS taxes you owe. As an Active Investor, you’ll enter that deduction on line 17 of your IRS Form 1040, and it will reduce your taxable income by the amount of the depreciation loss. That will reduce the amount of taxes you have to pay, in an amount that depends on the details of your particular situation and your tax bracket. In most cases this results in an actual positive cash flow from the rental property.
Despite the Depreciation Expense, Your Property Continues to Gain Value
Even though you can use depreciation as an expense, as a rental property owner, the actual value of your property doesn’t go down. Historically, residential properties have appreciated in value over the long term, the recent economic downturn notwithstanding. If you hold your home as that appreciation occurs, you’ll have to pay capital gains and recapture taxes on the accumulated depreciation when you sell the property, but most rental property owners realize a positive actual benefit from the year to year income tax savings, compared to the depreciation recapture tax.
Capital gains taxes are another issue. Through several methods, you can minimize or even eliminate these, as well. Reestablishing primary residence in the home, 1031 tax deferred exchanges, and careful estate planning can help you to avoid both the depreciation recapture taxes and capital gains for rental properties. Consult your CPA, tax advisor, or estate planner on details about these possibilities, which can be complex, but feasible for most investors.
Investing in Professionally Managed Home Rental Properties – Minnesota
Building genuine wealth is one of the primary benefits of owning rental properties. Whether you own just a single rental home or a portfolio of residential rental properties, you’re on your way to a tried-and-true wealth building strategy. Professional property management services are crucial to maintaining your cash flow and keeping your rental properties in great condition without taking up your valuable time. At our Minnesota property management company, we’re eager to help you with all aspects of property management, and can help you realize your goals. Contact us today for more information about how home rental property ownership in Missouri and Kansas can help you build wealth while providing regular cash flow.