Real Estate Tax Deductions Guide

It’s that time of year again… taxes. 

But let’s make it more interesting and focus on tax reduction, and more specifically, real estate deductions.

As a real estate professional, I have to know about this subject. But that doesn’t make me a tax professional. So here is my disclaimer.

I’m not a CPA or a tax attorney. This article is for informational purposes and should not be construed as tax advice. Learning how to use real estate to reduce your tax burden legally can be liberating, but only implement these ideas in consultation with your trusted tax professional.

Now, let’s get down to business.

What are Real Estate Deductions?

In the past, I’ve written several articles on how investors can benefit from the numerous real estate tax advantages available. You can find some of those articles below.

Today I want to show you how real estate deductions can cut your taxes at the property level, thus generating more potential cash flow each and every month.

Tax Write-Offs for Real Estate and Rental Income

Monthly rents and rental fees generate property revenue. But you also have offsetting operating costs and other expenses. 

Here’s a quick  example. Let’s say a property makes $100,000 in gross revenue.  For the same period the property also has $40,000 in qualified expenses. $100,000 in revenue minus $40,000 in expenses is $60,000 in net income, which could be taxable in some way.. 

This is a high level example. So let’s break down the components of revenue and expense to see where we can improve the tax profile of the investment property.

Want to learn how you can get stable tax-advantaged income and equity growth in today’s market?
Get access to our newest investment platform:
What is Considered Rental Income?

Rental income is the income you receive in exchange for allowing one or more individuals to occupy your real estate property.

The gross revenue one receives from multifamily apartments is typically rental income and other income. Other income is a broad category that can include some of these items.

  • Laundry machines
  • Pet fees
  • Covered parking fees
  • Storage fees
  • Vending machines
  • Application fees
  • Amenity fees
  • Valet trash
  • Etc.

When you combine rental income with other income, you arrive at the gross income for the property. 

Active Participation vs. Passive Activity

Passive activity is when an investor doesn’t materially participate in the business or management of the rental property. Instead, someone else typically manages the rental property for them.

In contrast, active participation is when you materially participate in the real estate business and property management. Be aware that by default, the IRS considers the rental activity passive even if you materially participate. For them to know you have active participation, you must qualify as a real estate professional and document it.

Which Rental Property Expenses Are Not Tax-Deductible?

All ordinary and necessary expenses to run an apartment building are deductible. But, anything that increases the investment property’s value or extends its life is not considered a business expense. Instead, it is treated as a capital improvement and, as such, must be capitalized and depreciated over a specified period of years.

The Tax Benefits of Investing in Real Estate

As discussed earlier and in the articles linked above, the tax benefits of investing in real estate can be substantial. Whether it’s depreciation, accelerated depreciation, bonus depreciation, 1031 exchanges, the basis reset at death and legacy transfer on a stepped-up basis, or the deductions allowed by the tax code, real estate provides ample tax benefits.

In the upcoming sections, we’ll dive further into some permitted deductions that can lower your tax bill.

Common Real Estate and Rental Property Tax Deductions

Regarding real estate deductions, whatever expense is ordinary and necessary to conduct business is typically deductible. Those deductions can be taken in the year they are incurred. Examples of such deductions are as follows:

  • Maintenance and repairs
  • Utilities
  • Advertising
  • Legal fees
  • Property management fees
  • Insurance
  • Employees
  • Mortgage interest
  • Depreciation

Let’s look at some of these money-saving deductions in more detail below.

Mortgage Interest

Very few people purchase multi-million dollar apartment buildings for all cash. The vast majority utilize multifamily financing. And financed properties come with interest payments. That interest is tax deductible for real estate investors.

Asset Depreciation

Depreciation is the paper loss the IRS allows to compensate you for the wear and tear to the property over time. Each depreciable fixed asset has a “useful life” (period) that the IRS defines. That is the period over which that asset can be depreciated.

For multifamily real estate, that period has historically been 27.5 years. That means that every year in that 27.5-year window, one can depreciate or write off 3.636% of the building’s (not land) value.

Using accelerated depreciation and bonus depreciation, you can front-load a portion (10% to 30%) of the depreciation into the first few years of ownership. But whatever schedule you use, depreciation creates a paper expense that is tax deductible.

Property Taxes

If you own a home as your primary residence, you know all about property taxes. Property taxes apply to other resident-occupied properties, like multifamily apartments. But, like other apartment expenses, property taxes are deductible.

Pass-Through Tax Deduction

Qualified Business Income (QBI), also known as the pass-through tax deduction, can further reduce your tax burden. This tax deduction was passed into law with the Tax Cuts and Jobs Act and isn’t scheduled to end until after 2025.

It provides qualified individuals with a tax deduction worth as much as 20% of net rental income derived from a pass-through entity like an LLC.

Property Management & Maintenance Expenses

Property management fees are another deductible expense for rental real estate.

Repairs and maintenance are also fully deductible expenses you must claim in the year they’re incurred. However, rental property owners must remember that repairs and maintenance (R&M) are part of keeping a property habitable. R&M is different from capital expenses that extend the life of the property or add value to it. 

Capital expenses must be depreciated over time, while repairs and maintenance are real estate deductions that can be taken fully within the same tax year. 

Other Deductions

For business purposes, a few other operating expenses are also tax deductible. Tenant screening services, travel, and legal fees are just a few other costs that may be deductible from apartment operations.

These allowable deductions can offset taxable income and make real estate a highly tax-efficient investment.

FAQs on Real Estate Deductions

Now that we’ve covered the tax-deductible expenses, let’s tackle a list of frequently asked questions.

What Is a 1031 Exchange?

When you sell a profitable asset, you typically incur capital gains tax. A 1031 Exchange circumvents that. It allows real estate owners to sell and exchange their property for a like-kind replacement property without paying capital gains tax. Instead, that tax is deferred.

By deferring taxation, the owner has more capital to grow their wealth. 1031 Exchanges are a powerful tool for wealth accumulation. However, to successfully execute a 1031 Exchange, there are specific rules you must follow. Following these rules is imperative to avoid the IRS disallowing the exchange and taxes coming due. 

How Do I Report Rental Income and Expenses?

Rental income is typically reported on a 1041 or 1040-SR, Schedule E.

What Real Estate Tax Records Should I Keep?

It would be best if you kept all your tax returns. In addition, you should keep documentation of all income and rental expenses for the property. You may need to keep these records longer than the standard recommendations so that you have clear documentation to establish the basis of the property.

Keep receipts, bills, and canceled checks. It’s also a good idea to keep various business records that may or may not be related to your tax situation, such as tenant histories, employee paperwork, and security deposit logs.

What Are The Best Ways to Invest in Real Estate for Taxes?

If you don’t have the expertise or the ability to dedicate significant amounts of time toward managing properties, then the best way to invest in real estate is passive

You can accomplish this by fractional ownership in an individual investment property through syndication or a diversified portfolio of properties in a fund.

While real estate has excellent tax benefits for passive investors, active investors who legitimately qualify for real estate professional status have enhanced tax benefits. 

Also, know that REITs are stock-focused on the real estate sector. They can be helpful to the right investor for various reasons. However, REITs are very different from direct ownership of real estate. Therefore, they don’t get the same tax benefits as direct ownership.

How can we help?

Whether you’re an experienced investor or new to direct multifamily investing, we’re here to help.

We look forward to hearing from you.