There are several expenses that are associated with your rental property that can be considered a deduction. There are obvious deductions such as advertising costs, mortgage interest, utilities, depreciation, etc.
The IRS uses two rules for determining if your expense is deductible; in general you may deduct ordinary and necessary expenses in conducting trade or business. An ordinary expense is a common and accepted expense in the rental industry. A necessary expense is one that is appropriate for rentals.
One tricky deduction is that of repairs versus improvements. Repairs are expensed and deducted in the current tax year. However, improvements are capitalized and depreciated over time. The quandary for rental owners is that they want to expense as much as they possibly can to gain the immediate tax relief that comes with a deduction. In IRS Publication 527 (Residential Rental Property), the IRS defines improvements as something that “adds to the value of property, prolongs its useful life, or adapts it to new uses.” Some examples of this are wall to wall carpeting, a new roof, additions, and kitchen updates; just to name a few.
It is important to point out, and you should be made aware that in the same list of examples, the IRS is quick to point out that work you do or have done to your rental property that does not add much to either the value or the life of the property, but rather keeps the property in good condition is considered a repair and not an improvement. A common example of such a repair would be the painting of the property.
Your biggest deduction when it comes to rental properties is depreciation. Depreciation is how you recover the cost of capital expenditures. Generally, in the case of a rental property, capital expenditures would be the basis of the property less the cost of the land plus any improvements made to the property. Land does not depreciate.
There are three basic factors of determining how much depreciation that you can deduct:
- The basis of your property (see Chapter 1)
- The recovery period of the property
- The depreciation method used
You cannot simply deduct your mortgage principle payments or the cost of furniture, fixtures, and equipment as an expense. You cannot deduct depreciation only on the part of your property used for rental purposes. Depreciation that is used reduces your basis for figuring gain or loss on the sale or exchange of the property. We will discuss that in a later chapter.
There is a special provision in the tax code called IRC §179, that allows a taxpayer to accelerate the cost of depreciation in the first year an asset is put into service. However, you may not use this deduction on rental property.
It is important to point out that using a method of accelerated depreciation may affect your being subject to alternative minimum tax (AMT). Accelerated depreciation allows you to deduct more depreciation earlier in the recovery period than you could deduct using a straight line method (same deduction each year). The prescribed depreciation methods for rental real estate are not accelerated, so the depreciation deduction is not adjusted for the purposes of AMT. However, accelerated methods are generally used for other property connected with rental activities (i.e. appliances, furniture, fixtures, etc.)
You can depreciate your property if it meets the following requirements:
- You own the property
- You use the property in your business or income-producing activity
- The property has a determinable useful life
- The property is expected to last more than one year
The most obvious requirement of depreciation is that you own the property. It is important to note that you are considered to own the property even if it is subject to debt. Generally, if you pay rent for the property, you cannot depreciate that property. Usually, only the owner can depreciate it. However, if you make permanent improvements to leased property, you may be able to depreciate the improvements.
Something that is common with rental properties is that a person will own a home that they use as their personal residence. They will move into a new home and rent out the old home. If you place in service property that was used for personal use, and the property is converted to business property (you began renting it out), you can begin depreciating the property at the time of conversion. If your rental property is idle due to it not being rented out, you would continue to claim depreciation on the property during the time that it is idle.
As mentioned before, you stop depreciating the property when you retire it from service, even if you have not fully recovered its cost or basis. You retire property from service when you permanently withdraw it from personal use in the trade or business, or from use in the production of income because of any of the following events
- You sell or exchange the property
- You convert the property to personal use
- You abandon the property
- The property is destroyed