The short answer is yes, but there’s much more to it. I’ve described the tax code as labyrinthine on more than a few occasions. I’m not fond of using big words, but the sheer mass of tax law on the books cannot be overstated. Fortunately for property owners, where there is complexity, there is opportunity. So, can you deduct real estate taxes on investment property? The answer is yes—with caveats.
Today, we’ll take a look at the different methods for maximizing the tax efficiency of property ownership. By the end of this article, you’ll know the current deductions available and what steps you need to take as a property owner to qualify.
There’s no shortage of tax deductions for rental income. Which applies to you? How do you qualify?
1. Deduct up to $10,000 in property taxes.
If you’re heavily invested in managing¹ your property, you may be able to deduct all your property taxes, including state, local, and federal taxes. This privilege is a boon for investors in areas with steep property taxes, as it is our very own fine state of Texas.
Here’s where it gets interesting. I said, “heavily invested in managing” your property. That means you are the primary caretaker, to borrow a medical term. You handle maintenance, property care and upkeep, and code and compliance issues.
What if you are not responsible for your investment property? Or, perhaps, have never seen it? If this applies to you, see point number four below.
2. Deduct depreciation on your income-producing rental property.
The depreciation deduction is an incredible tax benefit that lets you offset the cost of purchasing² and renovating your property over time. It’s Uncle Sam giving you a tax break to compensate for the wear and tear your property suffers in the process of generating value and encouraging
3. Deduct mortgage interest.
In addition to the depreciation deduction, you can deduct interest³ paid on a loan used to purchase or improve an income-producing property.
4. Are you a passive investor? Then, you’re excluded from deducting losses.
Suppose you’re a real estate professional or investor with qualified business income and are actively involved in maintaining and managing your properties.⁴
In that case, you can use these losses to lower your taxable income and avoid the net investment income tax.⁵ However, deductions do not extend to passive investors⁶ who are not actively involved in property management.
5. You get to deduct a real estate business’s ordinary and necessary expenses.
These expenses include but aren’t limited to:
- Repairs and Maintenance: Essential for preserving or improving the property’s condition.
- Operating Expenses: Day-to-day costs of running the property.
- Utilities: Water, electricity, and other necessary services.
- Mortgage Interest: Interest on loans for purchasing or improving rental properties.
- Depreciation: The purchase and improvement costs over the property’s useful life.
6. Some taxes are nondeductible.
It’s important to note that you can’t deduct all taxes and fees associated with real estate. These ineligible charges include but aren’t limited to the following:
- Federal income taxes
- Social security taxes
- Transfer taxes, such as taxes imposed on the sale of property
- Stamp taxes
- Homeowner’s association fees
- Estate and inheritance taxes
- Service charges for water, sewer, or trash collection
7. You can minimize capital gains tax liability with careful tax planning.
Capital gains are profits from the sale of an investment. Your tax treatment depends on how long you’ve held the asset. Short-term capital gains are subject to ordinary income tax, while long-term capital gains enjoy more favorable tax rates.
The tax code offers real estate investors several paths to defer taxes.
Smart investors have several tools to reduce and manage their tax burden:
- Investing through tax-deferred retirement accounts can shield your gains from immediate taxation.
- The 1031 Exchange rule lets investors delay paying taxes on their profits by using the money to buy other properties of the same or higher value.
- Pass-through deductions, introduced by the Tax Cuts and Jobs Act, offer tax relief for eligible real estate investors.
I highly recommend familiarizing yourself with 1031 exchanges and tax-deferred retirement accounts, as they are both integral to tax planning.
A Real Estate Investment Trust (REIT) offers an alternative route to investing in real estate.
Now, can you deduct real estate taxes on investment property without direct property management? Yes, it’s possible with a Real Estate Investment Trust (REIT).
For serious investors, REITs are the simpler and more tax-efficient choice for purchasing property when compared to partnerships. Here are the details.
- How shareholders are paid: REITs pay out at least 90% of their taxable income to shareholders in the form of dividends.
- What’s subject to taxes under REITs: As a shareholder, you will have to pay income taxes when you receive these dividends and document your ordinary income, sales gains, and proportional share of the fund on a 1099 form.
- Federal tax-saving opportunities with REITs: RIET dividends are often classified as qualified business income (QBI) for shareholders (individual investors), offering a hefty 20% deduction.
- State-level tax savings with REITs: If you live in a state like Texas, a zero-income tax state, then no matter what state your REIT’s properties are located in, your dividends will be taxed as income in your state of residence. For Texans, that means zero state taxation on investment property income.
Investing as part of a REIT is going to introduce complexity to your tax situation, but the savings are lucrative. If you’re interested, give me a call, and I’ll guide you through the process.
Get every tax deduction available for real estate investments.
Schedule a discovery call today, and we’ll start by evaluating your current properties.
Talk soon,
Jeremy A. Johnson, CPA
References
- W:CAR:MP:FP. 2015 Publication 925 [Internet]. 2016. Available from: https://www.irs.gov/pub/irs-pdf/p925.pdf
- Publication 946 [Internet]. Available from: https://www.irs.gov/pub/irs-pdf/p946.pdf
- Department of the Treasury Internal Revenue Service Get forms and other information faster and easier at: Tax Guide for Small Business For use in preparing 2016 Returns [Internet]. 2017. Available from: https://www.irs.gov/pub/irs-pdf/p334.pdf
- W:CAR:MP:FP. 2015 Publication 925 [Internet]. 2016. Available from: https://www.irs.gov/pub/irs-pdf/p925.pdf
- Net Investment Income Tax | Internal Revenue Service [Internet]. Irs.gov. 2013. Available from: https://www.irs.gov/individuals/net-investment-income-tax
- W:CAR:MP:FP. 2015 Publication 925 [Internet]. 2016. Available from: https://www.irs.gov/pub/irs-pdf/p925.pdf