Tax time is approaching. Tax time is always approaching, and if you’re renting out properties in Sonoma County, you are likely thinking about taxes all the time.
You’ll need to report the money you earn in rent as income. There’s no avoiding that.
But you can also take a lot of deductions and enjoy a lot of tax benefits that come with renting out homes to tenants.
We always recommend working with professionals. Partner with an experienced CPA or a tax accountant who understands shifting tax laws and can steer you towards the best deductions. The advice we are giving you today comes from our years of experience as Sonoma County property managers. However, it’s important that you consult with your financial professional. We can provide the 1099 at the end of the tax year. We can track expenses and receipts. But when it comes to filing, you’ll want someone who understands tax law inside and out.
Here are some of the tax advantages that we know you will not want to miss.
Depreciating Your Sonoma County Rental Property
Depreciation is always something your tax professional is likely to consider as you’re filing. This is a valuable tax tool for real estate investors and rental property owners, and we strongly encourage you to look into it. However, you have to know that it comes with some specific rules and requirements, and you want to make sure you’re making the right deductions. The depreciation benefit allows you to write off part of the loss of value that any property experiences as it ages.
The IRS sees rental properties as consistently undergoing deterioration, which might seem counterintuitive to you, since you’re likely making an effort to assist in your investment’s appreciation. But, the wear and tear that your rental property can expect to take on will turn into your depreciation loss. The IRS has established 27.5 years as the amount of time that residential property depreciations under its General Depreciation System.
You can also accelerate the depreciation loss with your rental property, which will help you lower your taxable income for the year at tax time, allowing you to keep more of your money.
As your tax preparer will know, you’ll almost always log the depreciation of your rental property on Schedule E of a standard 1040.
To claim depreciation as a deduction on your taxes, the following conditions are required:
∙ Unless you meet one of the very limited exceptions, you must own the property for which you are claiming depreciation.
∙ You need to collect rent from tenants living in that property. The property has to be an income-producing property.
∙ You must be able to determine the useful life of your property. It’s going to be different based on the type of property being depreciated. Everything has a different life cycle, or rate at which it wears down. For real estate, this is somewhat standardized, and the 27.5 years applies, unless your property is subject to the Alternative Depreciation System, in which case it’s 30 or 40 years (this is rare).
∙ The useful life of the property must be greater than 1 year. Nothing that wears out in less than a year can be depreciated on your taxes.
If you begin renting out a home in one year and sell it within that same year, you cannot claim depreciation on that property.
Another must-know: you can only claim depreciation on the physical structure. The land does not qualify for the depreciation deduction.
Deduct Business Expenses Associated with Maintaining Your Rental Property
You’re running a business when you rent out a home, even if it’s only one property, and that means the IRS allows you to deduct some of the expenses you incur while running that business. There are a few deductions you should always take advantage of when you’re claiming tax benefits, including:
∙ Insurance premiums that you pay on your investment properties.
∙ Professional Sonoma County property management fees.
∙ Additional professional fees such as accounting or legal costs.
∙ Maintenance and repairs.
∙ Home office deductions, if you use your home to conduct rental property business.
∙ Travel costs involved in visiting your rental properties.
When making these types of deductions on your taxes, it’s important that you claim only the ordinary and necessary expenses that are associated with managing and maintaining your investment property. Paying to advertise and market a vacant property, for example, is a necessary expense, so you can deduct any advertising costs. Your landlord insurance is tax deductible and so is the cost of keeping utilities on. However, upgrading from carpet to tile floors is an improvement, and that’s different.
If you’re confused about what’s permitted and what isn’t, you’re not alone. Even experienced real estate investors struggle with this. Talk to your tax professional. We typically direct owners to the IRS.gov website, which has an informative section called Tangible Property Regulations – Frequently Asked Questions. If you’re unsure about whether you’re deducting a maintenance cost or a home improvement cost, you might find your answers there. Those improvement costs are recovered through the depreciation deduction.
Speaking of Taxes: Try a 1031 Exchange
Tax benefits aren’t only available when we’re talking about potential deductions. As a rental property owner, you can access tax benefits even outside of those filing deductions. For example, you can defer the capital gains taxes you might have to pay when you sell a rental property.
With rental property sales, you’ll pay long term capital gains taxes on any properties you’ve owned for more than a year, and the amount you pay will depend on your income.
If you want to defer those capital gains taxes, you should consider a 1031 Exchange. In order to leverage this tax benefit, you will sell one rental property and then use the proceeds to invest in a similar property or even two properties. This will not completely erase your tax liability, but it will give you the opportunity to delay paying those taxes.
The 1031 exchange comes with a strict timeline and a lot of other requirements. You have to work with a Qualified Intermediary, and you have to make sure the money from the sale is held in escrow.
Here’s what you need to know and how to proceed if you decide to do a 1031 exchange:
- Confirm your property qualifies for a 1031 exchange. This program is a tax benefit meant for investment homes. You cannot sell the home you’ve been living in and reinvest the money to buy a vacation home, for example.
- You’ll need to exchange the existing property with a like property or properties. The new property you choose must have a value that is the same or higher than the original property. It doesn’t have to be exactly the same. You can sell a single-family home and buy a duplex, for example. Or, you can sell an apartment building and invest in two condos.
- Find one property, two properties, or three to exchange with your current property.
- Pay attention to the deadlines. You’ll need to identify a replacement property within 45 days of selling your original property. Then, you have 180 days to close on the new sale. The entire exchange must take place within the 180 days (meaning you don’t have 45 days plus 180 days – the clock does not reset).
- Use an intermediary and avoid taking any of the cash from the sale of your property. The intermediary will hold your funds until they can be reinvested in your new purchase. Ask your property managers for a referral.
If this makes sense for you and your investment goals, we always urge owners to consider completing a 1031 exchange in order to position themselves more favorably from a tax standpoint. Maybe you’re looking to release a property that isn’t working for your investment goals anymore. Instead of taking the profit in cash, re-invest those funds. It brings you a better tax benefit.
Taxes and Records
Taxes can make even the most confident real estate investor a little bit nervous. And we can tell you that the biggest mistake investors make is not documenting everything.
Good record-keeping is essential.
Hopefully, you’re working with a Sonoma County property management team that can provide monthly income and expense statements. A good system of record-keeping will help you check the progress of your rental property, prepare your financial statements, identify the source of receipts, keep track of deductible expenses, prepare your tax returns, and support items reported on tax returns.
Before you can deduct some of your rental property expenses, you’ll be expected to support them. Keep track of all your expenses, including travel expenses and management fees. Good records lead to valid tax returns. The IRS is strict about documentation and paperwork, and you don’t want to find yourself facing additional penalties and fees just because you cannot produce the right documents.
For some people, taxes are a breeze and just a necessary part of owning investment property. If you find yourself struggling and you have questions about taxes and how they apply to your rental property, we know we can help you. Please contact us at Redwood Residential Property Management if you have any questions.
Graduate of Empire Business School, Santa Rosa in 1998 with an AA degree in Office Administration. Lorena has over 30 years of experience in office administration. From the California State Legislature to North Bay Realtors Association and most recently with Sue Carrell & Associates.