Free Educational Video
What Can You Deduct on Rental Property?
Total Watch Time: 14 Minutes and 55 Seconds
What Can You Deduct on Rental Property? – Video
Bob Weaver, CPA: I want to see a show of hands. How many of you have been on vacation recently? Of those people, how many of you looked at property while you were on vacation? Okay, good. We’ve got a couple of people; those are my people. Some people go on vacation and say, “Oh, look at the sunset.” I go on vacation go, “Oh, look at the mold.”
I am a real estate investor. I’ve been a real estate investor for years. My wife, when people asked her, why she picked me, she said, “Oh, he was a cute little fixer-upper. He had potential for good cash flow.”
I’ve been a real estate investor since 1986, and I managed a property for my dad prior to that. I’ve got real estate in my blood and I love it. I think about it. Like I said, I go on vacation to look for more property. That’s my idea of fun. Kick the hole in the wall, find more. Are those termites? Yes, those are termites.
Anyway, I’m a tax guy. I’ve been a tax guy with real estate investing. During my first four years, I probably didn’t work with that many real estate investors, but since 1987, I’ve been working with real estate investors.
I did a bunch of stuff in my big firm. When I went out on my own in 2002, I focused almost entirely on real estate investors in single family apartments, and land. You name it, I worked with it. I love the single family investors because I’m one too. I would never invest in commercial properties. It’s too risky. I like owning real estate. Running real estate is less risky than the stock market. That’s my perspective. You’ll see some things in this that will reflect my perspective here.
Let’s get started here. Don’t take this to the bank. If you think something applies to you and you want to know more about it, seek professional advice. Don’t just go after what I say here, because everybody’s situation is different. You may not hear it right. Call an adviser. Call me. I’ve got bandwidth for more clients and I’d be very happy to help you.
Tax free income and the expense from real estate. Your goal is to make money in the end. My former partner used to say it’s all about cashing the rent checks. We’ll start with the income side, we’ll go through some of the expenses, and then we’ll talk about some of the rules related to it. If I bore you, it’s only because I’m a tax guy and I’m an accountant. I’m a linear thinker, and a lot of you are a lot more creative than I am. Let’s get going here.
We have the tax free income and expenses from real estate and rentals, and we’ll start out with a couple things. We all know the rent, that’s where your income starts, but we got a couple of special things related to rent. There are a lot of rules that a lot of people don’t know is that the prepaid rent that you get, some markets you get prepaid rent, some markets you don’t, but in the prepay rent, the first and the last month rent are both taxable when you get them as rent. We’re starting up at the top-line of your income statement.
The prepaid rent is income, but deposits aren’t necessarily income. We all have an option here. We can either keep track of our deposits and hold on to them and not include them in our income. When we return the deposit we’ll spend our money to do a fix up, keep whatever’s out of the deposit to pay for that. You won’t deduct the expenses to clean it up. You’ll just remove it from the deposit and then the rest becomes income to you. You give back with no deduction what part of the deposit you give back and then the rest goes to cover the expenses that you had.
A lot of people get the money. They just don’t want to keep track of it. They take it into income and then they deduct the deposit when they get it back. That’s your basic income line of your tax return while you’re reporting the rent. We have a lot of expenses. I get a lot of questions. We can all pretty much figure it out that you get a property management, insurance, utilities, interest and property taxes, and repairs, but a lot of people don’t realize you can get there auto on travel expenses. A lot of people don’t realize it. We’ll go into a something called depreciation, and then question marks on your start-up expenses, in particular education here.
Anyway, so are you on travel? If you take time to visit your rentals, whether they’re five miles away, or whether you’re hopping on a plane to go visit your rentals as I did Dallas this summer, that’s an expense that you can deduct against your rentals. If you’re going to and from, maybe you self-manage, and you do some of your own repair work, take the mileage. Go on to and from. Virtually everybody seems to miss this.
Next thing that I want to talk about are the start-up expenses and education. Education for– Basically, the role here is that you can deduct the education. Once you own your first rentals, this is an incentive to go out and get a rental for those of you who don’t have one yet. As soon as you have a rental, you’re in the business. Now you can’t deduct the education to get in the business. That’s true of any business that you might get into. Once you’re here, once you have your first rental, you’re in the business. Now your education – if it helps you become a better investor it becomes deductible. Kathy’s book, for example, is deductible. How is that?
Bob: Then start-up expenses, you can have a lot of things related to travel to a market when you buy it, that sort of thing. For that, first, we’re going to get to deduct that as a regular expense, but we do get to deduct that as a start-up expense. Meaning that once we bought the rental, the first rental, all the cost that we have related to going and picking up that property, becomes what we call start-up expenses, and then we get to write it off when we finally put that in the service. These are some expenses that a lot of people don’t know about.
A lot of people confuse cash flow and taxable income. Most of the items that you get in your cash flow are folded into your taxable income, but the principal that you pay is obviously coming out on your cash flow, but not a taxable deduction. We can place that principal that you’re paying down the debt with what we call depreciation. The lowering of your value of your property over time because it’s getting wear and tear. We’re allowed to take a wear and tear provision called depreciation.
You get property taxes, you get repairs, you get capital expenses. What’s a capital expense? This is something that a lot of landlords struggle with. When they go to their accountant they say, “What do I have to capitalize,” meaning, what can I write-off and what can’t I write-off right? We have repairs for capital expenses. That’s a question we get a lot of it. We got a lot of new rules that are fairly favorable to the taxpayer, sort of changing the tide from we have to capitalize everything to you come to me, we’ll go through it and you’ll capitalize very little when we’re done. You capitalize amount into paid to acquire produce a tangible property.
When you lock-in and you buy a piece of property, all the cost that you pay to the title company, and that all are related Freddie/Fannie stuff. All that stuff gets capitalized into the cost of your acquiring a property.
A capital expense creates a betterment and the gaps to a different use, or a new use, or results on a restoration. These are new provisions. This is interesting– a betterment adapts to a newer different user results in the restoration.
These are the keywords that we’re going to focus on now. For those of you who have properties, those who you had to put on a new roof, those of you who had to put in new improvements. This is an important feature for you. To repair is to restore to a sound state or amend
or while a replacement constitutes a substitution. You took the old one out and you put the new one in.
Another key question definition is this unit of property. It includes all the components that are functionally interdependent. I’ll go through what functionally interdependent means. It’s placing in service of one component depends upon the placing in service of another component. There are special roles. This comes into a play particularly in the HVAC system in roofing. A lot of you have had to go in and replace a furnace, a lot of you had to go and replace an air compressor, hopefully it didn’t get stolen.
Related Article: Top 18 Landlord Tax Deductions to Maximize Your Profit
We used to say replacing that burned-out compressor was a capital expense every time. Now we have a possibility, depending upon the amount of the compressor, that we can actually write off that compressor because the HVAC system is a unit of property. The whole HVAC system is a unit of property. We have a furnace, we have ductwork, we have an air compressor, we have all the wiring. When you figure that out, you got to figure out, “Is this basically more than half of the unit of property?”
We know that 25% we’re probably getting to the point where clearly say for this unit of property. Figure it out. How much is this compressor worth to the whole property? Anything basically under 50, I’m telling people to consider writing it off. If what you’re replacing, for instance, the roof. You’re doing a re-roof? You’re putting on new asphalt shingles on your roof? You haven’t replaced anything. This is a completely deductible expense. We used to have to capitalize that roof. We like these new rules that let us do things like write off roofing and that sort of thing. We always used to have to capitalize. When you do have to capitalize something, now we get to estimate the value of what we’re replacing and write that off.
When you buy a house, do you ever get to know how much was the roof worth? Nobody ever puts that into numbers for you. You get to estimate it under any reasonable basis. If I have to replace the whole roof and roof trusses because I’ve got some serious structural problems, you’re going to have to capitalize the replacement. It’s probably at least a $10,000 roof that you replaced. There’s still a lot of value on that roof, but you chose to replace it. We’ll write off the old roof and take a $10,000 deduction for it. We’ve got these new rules and I consider them to be a real opportunity for tax deductions because let’s face it, how many of you want to pay tax on your rentals? That’s the expected answer.
I’m here to tell you about the kinds of things that we’re doing in the CPA world now with some of the new rules that we’ve got. We’re really trying to get, I want you to all have positive cash flow. Who doesn’t want positive cash flow? Same answer. The whole idea is if you have positive cash flow, we’ll go back to this graphic here, if you have a positive cash flow, we’re replacing the principal you pay with the depreciation.
If you’ve got a positive cash flow the only place you can go to maybe wipe that out is to take depreciation and make sure that these expenses all get deducted because if these expenses don’t get deducted, you’ll have positive cash flow and even higher taxable income. That’s what we’re all about in the CPA world.
It’s trying to take that positive cash flow that you get and turn it into no taxable income. If you do this, if you get to the point where you can quit your day job, we can make your taxable income zero, and you won’t pay any income taxes. You have to get to the point where– The whole point is I want you in positive cash flow so you don’t have to worry about somebody’s deduction rules. We don’t want you to have to pay taxes on it. My goal on every client of mine is to make sure they get into positive cash flow properties and they pay no income tax on them.