As a rental property owner, you have countless expenses each year.
Between repairs, regular maintenance, insurance, construction projects, equipment, and other costs, your expenses can quickly add up.
Fortunately, the IRS recognizes many types of rental business expenses. Many are fully deductible from your taxable income each year. This means you can subtract those expenses from your rental income and pay less tax.
Other expenses aren’t fully deductible, but they are depreciable. This means you can deduct a portion of the expense each year until you’ve recovered the full cost. You’ll still have to pay tax on these expenses when you sell the property, but depreciation gives you more capital to work with.
All deductions help you recover your rental expenses and do more with the capital you have.
Here are three types of rental expenses and how to deduct them from your rental income.
- Operating Expenses
What Are Operating Expenses?
Most of your annual expense report will consist of operating expenses. Operating expenses are the day-to-day, typical expenses that directly benefit your rental business and keep it running.
Rather than listing all the possible operating expenses, the IRS provides four criteria:
- Ordinary and Necessary – The expense must be a typical expense that helps your rental business in some way. Advertising fees, cleaning, maintenance, insurance, and supply costs are all expenses that meet the ordinary and necessary criteria.
- Current – The expense must benefit your business for less than a year.
- Directly Related to Your Rental Activity – The expense must be directly related to your rentals. If it also has a personal use, you can only deduct a portion of it.
- Reasonable in Amount – The cost must be expected for the type of expense.
Examples of operating expenses include the cost of rent on your office space, cleaning supplies, repairs and preventative maintenance, insurance, and employee compensation.
Deducting Operating Expenses
Operating expenses are fully deductible expenses. This means you can subtract the total amount from your income in the year you incurred it. That amount will never return for you to pay tax on as long as you list it on Schedule E (IRS Form 1040).
- Capital Expenses
What Are Capital Expenses?
Capital expenses are not day-to-day. Instead, they represent long-term investments that benefit your business for several years.
Like operating expenses, there are four criteria for capital expenses:
- Long-term Property – It lasts for more than one year.
- Subject to Wear and Tear – It wears out over time and has a finite usable lifespan.
- One Year Ownership – The title to the property must be in your name for at least one year.
- Rental Business Use – You must use it (at least partly) for your rental business.
The following are capital expenses: furniture, lawn equipment, buildings, personal property like computers, TVs, pools, vehicles, garages, appliances, and improvements to your property.
Deducting Capital Expenses
Capital expenses are not fully deductible. Instead, you depreciate capital expenses through a series of depreciation deductions. Over the course of the item’s recovery period (listed in the tax code), you deduct a percentage of the expense. You stop depreciating when the expense is fully recovered.
When you sell your property, the IRS will “recapture” the deductions you took. This means you’ll eventually pay tax on those amounts.
- Start-Up Expenses
What Are Start-Up Expenses?
Start-up expenses are expenses incurred before you’re officially in business. They are separate from operating and capital expenses because you can’t deduct expenses incurred before your property is ready to rent.
Here are examples of possible start-up expenses: minor repairs, office supplies, rent, insurance premiums, permits, and research costs.
Expenses related to the actual building purchase are added to the building’s basis and aren’t start-up expenses.
Deducting Start-Up Expenses
Start-up expenses are fully deductible up to $5,000. If an expense would otherwise qualify but exceeds the $5,000 limit, you must depreciate it in equal installments over 15 years.
Be sure to record and keep proof of the date you put your property in service. This could be a Zillow listing, newspaper ad publication, or other proof that your property is ready to rent.
Rental Expenses and Your Taxes
Tracking and deducting your rental expenses can seem overwhelming given the myriad of rules the IRS enforces. However, you have many resources on your side. Reviewing the tax code, hiring a tax expert, and using expense tracking features on your property management software are all ways you can mitigate the stress and successfully file your rental taxes.