How Rental Property Tax Deductions Can Improve Property Returns

Even though high-interest rates may cause a rental property to lose money now, it could still be a profitable investment in the long run after factoring in rental property tax deductions, property appreciation over time, and potential refinancing at lower rates.

The key takeaways from this generic example are:

High rates could make the rental currently unprofitable.
But tax deductions on rental losses improve the situation.
Appreciation over time will also make the property more valuable.
Refinancing at lower rates will enhance profitability.

IMPORTANT: The following information is provided for information purposes only and does not constitute professional tax advice. Sources for this article are publicly available online and should be taken with a “grain of salt.”

Please consult a qualified tax and legal professional for specific advice.

Let’s look at an example to illustrate how maximizing tax deductions can improve returns on a rental property investment.

Rental Property Investment Example

Sarah earns $125,000 annually from her job in Texas or Florida (two states without State Income Taxes).

She purchases a rental property for $450,000, putting 25% down ($112,500) and financing the rest ($337,500) at a 7.5% interest rate. Her annual rental income is $36,000.

Over 5 years, Sarah claims total depreciation deductions of $30,000 on the property. She then sells the property for $550,000, paying an estimated 8% in selling expenses.

Categories of Deductible Rental Expenses

The IRS allows multiple categories of rental property expenses to be deducted:

Operating Costs: Utilities, repairs, insurance, fees, maintenance. Sarah deducts $4,850 annually.
Mortgage Interest: Interest paid on the rental loan. Sarah deducts $25,313 annually.
Property Taxes: Taxes paid on the rental property. Sarah deducts $11,250 annually.
Travel: Mileage for rental-related trips. Sarah deducts $495 in mileage annually.
Depreciation: A portion of property value is deducted each year. Sarah deducts $9,000 in depreciation.

Meticulous rental property record keeping and consulting a tax professional help maximize eligible deductions.

Impact of Deductions on Capital Gains

When Sarah sells, her taxable capital gain is calculated as follows:

Sale price: $550,000
Selling expenses: $44,000
Net proceeds: $506,000
Less purchase price: $450,000
Initial capital gain: $56,000

However, the depreciation she claimed over the years gets recaptured at a 25% rate:

Depreciation recaptured: $30,000
Tax rate: 25%
Tax owed on depreciation: $7,500

So the $56,000 capital gain is increased by $7,500 of depreciation recapture to $63,500.

At a 15% capital gains rate, Sarah would owe $9,525 in capital gains taxes.

Sarah could complete a 1031 exchange to defer the capital gains tax by reinvesting the proceeds into another rental property.

Benefits of Maximizing Rental Property Tax Deductions

By maximizing eligible tax deductions, Sarah reduced her rental income tax burden over the years she owned the property. This results in thousands of dollars in tax savings.

What would make this transaction worthwhile from a tax and appreciation standpoint?

Property appreciation in the area
Population trends
Lower rates to refinance (the sooner, the better)
Sarah’s timeline and risk tolerance
Sarah’s income increases over time

Careful planning with a tax advisor can help investors use deductions to their maximum benefit.

The tax deductions and long-term appreciation can sometimes benefit investors, even with high interest rates that result in rental losses. Consult a tax professional for advice specific to your situation.

Read this article describing 11 Benefits to Rental Property Ownership.