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As we all know, one of the main advantages of investing in real estate is the tax benefits. Many of the investors who I meet for the first time are broadly aware of depreciation, expenses incurred through renovations, and operating costs. However, many don’t know about the steps they need to take to maximize their deductions or about costly mistakes that could attract the unwanted interest of the IRS.
Expenses
When filing your tax return, many investors are confused about what expenses are permissible to be deducted and what are not. Here’s a breakdown:
Permissible expenses
- Advertising: All costs associated with advertising a property. These include the cost of placing an ad online and everything involved with the ad, such as apartment cleaning, staging, rental of lighting equipment, and hiring a photographer for the shoot.
- Auto and travel: Expenses incurred traveling to the property for maintenance and management.
- Cleaning and maintenance: Any maintenance of the rental property, whether daily, weekly, monthly, or between tenants, is a legitimate expense, as is the cost for any cleaning materials used.
- Commissions: If not deducted at source, fees paid to agents or property managers are eligible expenses.
- Depreciation: The IRS allows you to deduct a specific amount (typically 3.636%) from your taxable income every full year you own and rent a property to account for the wear and tear of your investment. You can claim the depreciation of the property every year for 27.5 years. This can lower your taxes and may even drop you into a lower tax bracket.
- Insurance: This is a major expense, especially in a state like Florida, which is prone to extreme weather.
- Legal and professional fees: This covers various expenses, from lease creation and payment to agents or property managers for showings and legal fees for evictions.
- Management fees: When management fees are not deducted at source from the rent and are paid to the management company directly from the landlord, they can be deducted as expenses.
- Mortgage interest: Interest paid on the mortgage from the rental property.
- Other interest: Interest paid on other loans associated with the rental property, such as hard money loans in a BRRRR scenario, or on business credit cards for repairs and other expenses.
- Repairs: All repairs related to your investment, from major renovations to cleanings and paintings between tenants and maintenance of appliances.
- Supplies: This covers a wide variety of possibilities, from cleaning products to stationery, smoke detector batteries, bathroom essentials, and plug-in fragrances for hallways, to name just a few.
- Taxes: Another big expense is property taxes and other taxes related to your property.
- Utilities: All utilities paid by the landlord, such as hallway and exterior lighting, whole apartment water and sewer, and heating (water, sewer, gas, and electric), are legitimate deductible expenses.
Other expenses
Many other expenses do not directly fall into the categories named above but are nonetheless eligible to lessen the taxes you owe. These are typically:
- Bank fees (related to property management account).
- Homeowners Association (HOA) fees.
- IT office expenses, such as telephone and internet, if associated with property management.
- Landscaping.
- Licenses and permits.
- Pest control.
- Security services.
- Snow removal.
Non-permissible expenses
- Capital improvements: These are permanent structural changes to a property that enhances its value and increase its useful life. They can include building a fitness room or replacing kitchens and bathrooms in apartments. These differ from repair and must be capitalized and depreciated.
- Personal expenses: You cannot expense gas for your car if it is used for personal use, even if you also use it to drive to work. Any specific work-related trips—to oversee maintenance or to show a unit to a potential tenant—must be itemized by mileage incurred with appropriate documentation. Similarly, a personal vacation cannot be expensed in its entirety, even if you conducted some real estate business while there.
S-Corps and LLCs
S-Corps and LLCs might be useful asset protection vehicles, but from a bookkeeping perspective, they are unnecessary. In fact, rental property owners should generally avoid S-Corps for their rentals because their assets do not receive a step-up in tax basis upon the death of a shareholder. There are other reasons, which are too lengthy to go into detail here.
If a rental property is held in an LLC or S-Corp, there should be a corresponding bank account that handles the finances of each entity.
Be Careful Using Your Real Estate Professional Status (REPS) for Tax Breaks
REPS can be a powerful instrument for investors who can legitimately document 750 hours of work dedicated to their real estate business and 50% in real property trades or businesses. However, small/part-time landlords often abuse this, and countless audits and tax court cases strongly indicate that attempting to qualify for this while holding a full-time job is virtually impossible. However, you will benefit from REPS if you have a spouse who can qualify and file a joint tax return.
To qualify, investors should maintain detailed logs of their real estate activities, including dates, hours worked, and job descriptions. This documentation is essential for proving eligibility for real estate professional status.
Why Real Estate Investors Get Audited
Real estate investors get audited for many of the same reasons most self-employed people do: They co-mingle personal and business expenses and claim expenses they are not entitled to. A business banking platform like Relay can help tremendously with this, allowing investors to separate their money by property or expense category with multiple free checking accounts.
Other reasons include:
- Double-dipping on opex and capex (both expensing them and depreciating them).
- Erroneously claiming the real estate professional (REPS) status, as mentioned.
- Inaccurate income reporting by not reporting all rental income.
- Misclassifying capex and opex rather than capitalizing and depreciating them.
- Overstating deductions, such as inflating expenses or improperly deducting nonqualifying items.
Note that depreciation is one of the notable benefits of owning real estate investments in the U.S. (many foreign countries do not allow for depreciation or allow far less than the U.S.), and when handled correctly, it can be a huge advantage in owning an investment, irrespective of cash flow and other benefits. However, proper accounting is essential to benefit from this.
Doing Your Own Bookkeeping
Doing your own bookkeeping can be a cost-effective way to start real estate investing until you have four to five doors. At some point, it’s worth delegating to professionals to 1) ensure it is handled correctly and 2) free up time to focus on tasks that grow the business, such as acquiring deals, financing, and making sure the portfolio is being properly managed. With Relay, you can assign bookkeepers or other collaborators secure access to your accounts with different permission levels—like read-only, bill payer, and more—making it easy to hand off these types of tasks without a ton of back and forth.
Common Tax Benefits Some Investors Miss
A qualified tax professional specializing in real estate should know all the tax benefits available to their clients. However, it’s still surprising how many investors I see whose previous tax preparers missed some glaring expenses. These often include:
- Missing out on all available depreciation.
- Not using a cost segregation study.
- Not claiming REPS when investors legitimately qualify.
- Not using tax-efficient exit strategies to minimize taxes on sales, such as the 1031 exchange.
- Not claiming other potential deductions such as the home office, business vehicles, or miles driven for business.
Tax Strategies to Boost Cash Flow and Help Investors Scale Faster
When implemented, all available tax strategies help increase profit and thus allow investors to scale their portfolios. However, some are particularly useful:
- Cost segregation: This has recently become a buzzword. It accelerates depreciation on items such as appliances, which depreciate faster than other areas of a property, improving cash flow.
- 1031 exchanges: This tax code greatly benefits real estate investors who want to defer capital gains taxes when reinvesting in like-kind properties.
- Tax credits: Multiple tax credits, such as those for energy-efficient improvements, are often overlooked and can amount to considerable savings.
Final Thoughts
The U.S. tax code is designed to help generate business revenue, and it is particularly favorable for real estate with 1031 exchanges, depreciation, and REPS, which are noticeably absent from other countries. You require a nuanced and meticulous, customized approach to enjoy the most significant tax benefits from your investment.
Abusing expenses, misstating important information, or taking bad advice can cost investors dearly.
This article is presented by Relay
Relay is an all-in-one business banking and money management platform for complete cash flow clarity.
This article was written by Tax Strategist and investor Thomas Castelli in collaboration with Relay, an all-in-one business banking and money management platform for complete cash flow clarity. Thomas is dedicated to helping real estate investors keep more of their hard-earned dollars in their pockets.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.
