Every Landlord's Tax Deduction Guide

Introduction
The tax code is full of deductions for landlords. Before you can start taking advantage of these deductions, however, you need a basic understanding of how landlords pay taxes and how tax deductions work. This chapter gives you all the information you need to get started, including:

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• how the IRS taxes landlords
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• how tax deductions work
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• how forms of property ownership affect landlord taxes, and
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• IRS audits -- how they work and how to avoid them.
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How Landlords Are Taxed

When you own residential rental property, you are required to pay the following taxes:

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• income taxes on rental income and profits from property sales
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• property taxes, and
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• Social Security and Medicare taxes (for some landlords).
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Let's look at each type of tax.

Income Taxes on Rental Income

You must pay federal income taxes on the income (rent and other money) you receive from your rental property each year. When you file your yearly tax return, you add your rental income to your other income for the year, such as salary income from a job, interest on savings, and investment income.

This book covers rental property deductions for federal income taxes. However, 43 states also have income taxes. State income tax laws generally track federal tax law, but there are some exceptions. The states without income taxes are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. For details on your state's income tax law, visit your state tax agency's website, or contact your local state tax office. You can find links to all 50state tax agency websites at www.taxsites.com/state.html.

Income Taxes on Profits When You Sell Your Property

When you sell your property, any profit you earn is added to your income for the year and is subject to taxation. Profits from the sale of rental property owned for more than one year are taxed at capital gains rates. These rates are generally lower than income tax rates -- usually 20% lower, except for taxpayers in the lowest tax brackets. (See Chapter 5 for an example of the tax effects of a rental property sale.)

However, you may be able to defer tax on your profits -- perhaps indefinitely -- by selling your property through a like-kind exchange (also called a section 1031 exchange or tax-free exchange). This kind of exchange involves swapping your property for similar property owned by someone else. These property swaps are subject to complex tax rules that are beyond the scope of this book, since they have nothing to do with income tax deductions. For more information, see IRS Publication 544, Sales and Other Disposition of Assets.

Social Security and Medicare Taxes

Everyone who works as an employee or who owns his or her own business must pay Social Security and Medicare taxes. These are two separate taxes:

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• a 12.4% social security tax, up to an annual income ceiling or cap -- in 2006, the cap was $94,200 per year, and
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• a 2.9% Medicare tax on all employee wages or self-employment profits.
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Together, these amount to a 15.3% tax, up to the annual Social Security tax ceiling. Employees pay half of these taxes themselves and their employers pay the other half. Self-employed people must pay it all themselves.

You may have to pay (and withhold) Social Security and Medicare taxes if you hire employees to work in your rental activity -- for example, if you hire a resident manager. The employer's share of such taxes is a deductible expense. (See Chapter 12.)

Fortunately, the income you earn from your rental property is not subject to Social Security and Medicare taxes. (IRC sec. 1402(a)(1).) This is so even if your rental activities constitute a business for tax purposes. (See Chapter 2.) This is one of the great tax benefits of owning rental property. A person who owns a hot dog stand must pay the 15.3% self-employment tax on his or her annual profits, whereas a person who owns a rental house or other real estate need pay no self-employment taxes on his or her rental income.

There is one exception to this rule, which will not apply to many readers of this book: you must pay Social Security and Medicare taxes on rental income if you provide "substantial services" along with the rental. This exception would apply, for example, if you owned a boardinghouse, hotel, or motel and provided maid service, room service, or concierge services. The exception does not apply to services commonly provided for residential rentals, such as repairs, cleaning, maintenance, trash removal, elevators, security, or cable television.

In addition, if you qualify as a real estate dealer, you'll have to pay Social Security and Medicare taxes on your annual profits. (See Chapter 2.)

Property Taxes

Property owners in all states pay property taxes imposed by cities, counties, and other local governments. They are a tax on the value of your rental property. Property taxes are not covered in this book.
How Income Tax Deductions Work
The tax law recognizes that you must spend money on your rental properties for such things as mortgage interest, repairs, maintenance, and many other expenses. The law allows you to subtract these expenses, plus an amount for the depreciation of your property, from your effective gross rental income (all the money actually earned from the property) to determine your "taxable income." You pay income tax only on your taxable income, if any. Expenses you can deduct from your income are called tax deductions or tax write-offs. These deductions are what this book is about.

Although some tax deduction calculations can get a bit complicated, the basic math is simple: The entire tax regimen for rental real estate can be reduced to the following simple equation:

Effective Gross Rental Income
minus Operating Expenses (including mortgage interest)
minus Depreciation and Amortization Expenses
= Taxable Income

(People who analyze real estate investments don't include mortgage interest as a real estate operating expense, but it is an operating expense for tax purposes.)

EXAMPLE: Karen owns a rental house. This year, her effective gross rental income (all the income she actually earned from the property) was $10,000. She doesn't pay tax on the entire $10,000 because she had the following expenses -- $5,000 in mortgage interest, $1,000 for other operating expenses, and $2,000 for depreciation. She gets to deduct these as outlined in the above equation: