Most new landlords don’t realize the wealth of expenses linked to rental properties; they assume the expenses are limited to what they can deduct from their own homes. But one of the biggest benefits of owning rental properties is the combination of real-world cash profits and on-paper tax losses.
That means you could end up with positive cash flow every month without having to pay taxes on it. At every stage of the game, you’ll have certain guaranteed expenses, including mortgage interest (if you borrowed money), property taxes, insurance, and property maintenance. Most other expenses will change based on whether or not the property is rented.
1. Expenses to Get the Rental Ready
To attract high-value tenants and get a lease signed as quickly as possible, your property needs to make a good first impression. That means boosting its “curb appeal,” which can include things like planting flowers, trimming trees, painting rooms, and refinishing floors.
It also means making sure all plumbing, wiring, and appliances are in perfect working order, and possibly even updating older equipment before it gives out. In addition to the sprucing-up costs, you’ll also be able to deduct things like insurance, utilities, taxes, and other ongoing expenses even before your property is ready to be rented.
Finally, this category also includes the fees for any permits, licenses, or certifications required before the property can be rented.
2. Expenses Before It’s Rented
Just because you have a tenant-ready apartment doesn’t mean it will be rented as soon as you list it; some properties sit on the market for weeks or months before a tenant moves in. All the money you spend to get a tenant into the property goes into your expense list. That can include things like the cost of:
- Paid listings (in newspapers or online)
- Hiring a property manager
- Researching the local rental market
- Advertising (such as signs or flyers)
- Real estate agents
As long as your property is available for rent, all of those expenses will flow into your financial statements and your tax return.
3. Expenses Once You Have a Tenant
After a tenant has signed a lease and moved in, you’ll have new (or higher) expenses to deal with:
- Wi-Fi (if included with the rent)
- Water bills
- Utility bills (if included with the rent)
- Maintenance (new light bulbs, HVAC filters, etc.)
- Trash and recycling removal
That’s for tenants who don’t cause any issues. Expenses may be higher with problem tenants who consistently clog toilets, leave food out (attracting bugs or rats), or actively cause damage.
Real estate investors have access to a special expense that reduces income on paper without actually costing any money. Depreciation is an accounting expense based on the idea that any kind of physical property (except land) loses value to wear and tear over time. It has nothing to do with changing market values, lousy tenants, or superior handymen; depreciation is all about time.
Here’s the basic idea: instead of taking the entire property as an expense all at once (the same way you’d count an electric bill as an expense), you divide it up over time. That way, you take a portion of the property as an expense every year over its “useful life.”
Rules to Depreciate
As you’d expect, the IRS has pretty strict rules surrounding depreciation deductions, and you have to meet all of them to qualify. In order to legally deduct depreciation:
- You own the property (loans are okay).
- The property is being used to make money (even if it’s not making money now).
- The property has a “measurable” life (which all buildings do).
As long as you meet all three requirements, you can reap the enormous tax benefits of depreciation expense.
To calculate depreciation, you need to know your basis in the property. Basis means the total cost to acquire the rental property, which typically includes the full purchase price (even if you borrowed some of it) and most closing costs.
From that, you have to subtract the value of the land (because land does not depreciate for IRS purposes) to get the basis for the building. If you make any permanent improvements to the property (putting on a new roof, for example, is considered permanent; repainting rooms is not), those get added on to the basis.
The IRS timeframe for depreciating residential rental property is twenty-seven-and-a-half years, but it doesn’t happen evenly over time; it starts high and gets lower every year.
The agency provides depreciation tables that help you figure out what portion of your property can be expensed every year. Even though your accountant will be taking care of this, it’s still important to understand how depreciation works so you’ll know why it looks like your investment is losing money even though you have positive cash flow.