Real Estate Tax Deductions Checklist for Investors

Rental property owners deduct the ordinary and necessary costs of operating a rental on Schedule E in the year they pay them: mortgage interest, property taxes, insurance, repairs, management and professional fees, utilities, advertising, supplies, and rental travel. Improvements and the closing costs of buying the property are not deducted at once; they are added to the property's basis and depreciated, and loan points and other loan costs are deducted over the life of the loan. Three IRS safe harbors let you deduct many costs that would otherwise count as improvements if you meet their conditions.

Deductible in the year you pay: the Schedule E checklist

Part I of Schedule E has a line for each common rental expense, and each property gets its own column.

Three limits apply across the list. You cannot deduct the value of your own labor. While a rental sits vacant and available for rent, its operating costs and depreciation stay deductible, but the rent you did not collect is not a deduction. And if you report on the cash basis, unpaid rent is not deductible because it was never counted as income.

Travel expense deductions for rental property investors covers mileage logs and overnight trips, and the home office deduction for landlords explains when a home office qualifies.

Costs you capitalize instead of deducting

To capitalize a cost is to add it to the property's basis (its cost for tax purposes) and recover it over time instead of deducting it in the year you pay.

Splitting land and building. Land is never depreciated, so divide your total cost, including the closing costs above, by the relative fair market values of land and building at purchase; if you are unsure of those values, you can use the property tax assessment's ratio. A $350,000 total cost assessed 80% building gives a $280,000 building basis, or about $10,182 of depreciation for a full year using a 27.5-year recovery period. Depreciation starts when the property is ready and available for rent. The first year and the year you dispose of it are prorated under the mid-month convention, which treats the start or end as occurring halfway through that month.

What is not part of basis. Fire insurance premiums, rent for living in the property before closing, and amounts placed in escrow for future taxes and insurance are not added to basis. Real estate taxes you reimburse the seller for are usually deductible as taxes.

Points and loan costs. For a fixed-rate mortgage fully repaid in equal monthly principal-and-interest payments, an optional IRS test treats points as de minimis if they total less than 0.167% of the loan amount for each full year of the term. De minimis amounts can be deducted in equal yearly shares. $3,000 of points and lender fees on such a $300,000, 30-year loan is under the $15,030 cutoff ($300,000 x 0.00167 x 30), so you can deduct $100 per full year. If the loan ends early through a sale, a payoff, or a refinance with a different lender, you can generally deduct the remaining amount that year; after a refinance with the same lender, it is generally deducted over the new loan instead.

How depreciation works on rental property covers the depreciation schedules and first-year bonus depreciation.

How the three safe harbors settle repair versus improvement

An expense is an improvement if it betters the property (fixes a material, meaning significant, defect that existed before you bought it, materially enlarges it, or materially increases its capacity, strength, or quality), restores it (replaces a substantial structural part or rebuilds it to like-new condition), or adapts it to a different use. Otherwise it is a repair; the Schedule E instructions call replacing an entire HVAC system an improvement. A safe harbor is an IRS rule that, when you meet its terms, settles the treatment in your favor without a case-by-case test.

Small taxpayer example. Your rental house's building cost $250,000, so its limit is $5,000: 2% of $250,000, which is less than $10,000. If you spend $1,800 on repairs and $2,700 on new flooring this year, the $4,500 total is under the limit, so you can elect the safe harbor and deduct all of it, including flooring that would otherwise be depreciated as an improvement. Spend $5,600 and the safe harbor is unavailable for that building for the year; you then sort each cost under the regular rules, and the de minimis and routine maintenance safe harbors still apply. The year's total includes amounts you deduct under the other two safe harbors.

Will the deductions lower your tax this year?

Deductions first offset the rental's own income. A loss beyond that is passive: it generally offsets only passive income, and the unused part carries forward to later years. If you own at least 10% and make decisions such as approving tenants and repairs, up to $25,000 of rental loss a year can offset wages, phased out as modified adjusted gross income (figured without the rental loss) rises from $100,000 to $150,000. Real estate professionals (more than 750 hours and more than half of their working time in real estate businesses) can use losses from rentals they materially participate in against any income. The passive loss rules for real estate investors explain both tests.

Keep receipts for every deduction and track repairs separately from improvements, since you need improvement costs to figure depreciation and your gain at sale. Tax audit protection for landlords lists the records to keep, and tax planning for rental income shows how deductions fit with depreciation and the tax at sale.