Although investing in real estate can be a great way to build wealth and diversify your income, many rental property owners miss out on valuable tax-saving opportunities. Whether you’re renting out a single unit or managing several properties, several strategies are available to minimize your rental property taxes and save on capital gains taxes upon sale.
Understanding rental property taxes
There are two ways rental properties are taxed. First is rental income. For tax purposes, the IRS treats rental income as regular income for individuals, meaning your rental income is essentially ordinary income taxed at your tax bracket for the year.
Then, there is rental property sale. When you sell a rental property, you may owe capital gains tax on the profit of the sale if you sell the property for a higher price than what you paid for it. Additionally, if you sell the property for less than you paid but for more than your adjusted basis — reduced by depreciation deductions — you may still have a taxable gain due to the lowered basis, increasing your potential gain.
Your short-term capital gains tax rate — which is what is used if you hold the investment for up to a year — would be your normal income tax rate. For long-term capital gains tax rates (a year plus one day or longer), the rates are set at 0%, 15%, and 20% depending on your household income. Additionally, some of your gain may be recharacterized from capital to ordinary based on depreciation recapture rules.
Key strategies for minimizing taxes
For rental properties, tax planning is a key part of management. The best way to offset the taxes you owe is to keep track of all of your expenses and take a holistic look at the value of your rental properties.
Here are some key strategies for minimizing your rental property taxes:
Depreciation benefits
When you rent out properties, you report your rental income and expenses on Schedule E of your tax return — including the properties’ depreciation. The IRS allows you to deduct the decrease in a property's value over time due to wear and tear, spreading the deduction across years.
A cost segregation study can accelerate depreciation by identifying components of the property that can be depreciated over shorter time periods, such as 5, 7, or 15 years instead of the standard 27.5 or 39 years. This strategy can increase your deductions in the early years of ownership, improving cash flow.
To qualify, the property must meet specific IRS criteria. Work with your tax advisor to determine whether the property is depreciable, when it starts depreciating, and how the taxes surrounding it work.
Capital improvements vs. repairs
Not all property-related expenses are treated the same. Routine repairs (things like patching walls, fixing a shower faucet, or replacing a cracked window) are fully deductible in the year incurred. Capital improvements, on the other hand (such as adding a deck, installing a new HVAC system, or completely remodeling a kitchen) must be depreciated over time.
Misclassifying these expenses can cause you to miss out on immediate deductions and may even risk issues with the IRS. To stay compliant and maximize your deductions, keep detailed records to share with your tax partner every year.
Use of tax-deferred exchanges
If you’re planning to sell one rental property and purchase another, you may want to consider a 1031 exchange (named after section 1031 of the IRS code), which allows investors to defer paying capital gains taxes if the proceeds from the sale are reinvested into a similar property.
For example, selling a $400,000 property and reinvesting that money into a $500,000 property through a 1031 exchange lets you defer taxes you would otherwise owe on your gain. Although 1031 exchanges have strict timelines and criteria, utilizing them correctly can be an effective tool to scale your portfolio while preserving capital.
Deduct your expenses
Rental property owners often overlook deductible expenses related to travel and day-to-day operations. Commonly missed deductions include:
- Property management fees
- Legal and accounting services
- Advertising for tenants, including leasing commissions
- Landlord insurance
- HOA fees
- Home office expenses (if you manage rentals from a dedicated workspace at home)
Tax-loss harvesting
If you also invest in stocks or other assets, you can use tax-loss harvesting to offset gains with losses from other investments. For instance, if you sell a rental property at a gain, selling underperforming assets in the same year could reduce your overall tax bill. For more information on how tax-loss harvesting works, talk with your tax advisor; this strategy works best when paired with a long-term investment plan.
Basis step-up upon death
If you’re planning to pass your property to your heirs upon death, there’s an additional tax saving benefit for them, as your heirs’ basis in the property will be equal to the value at the time of your death. If your heirs then sell the property, there would be very little gain due to the increased basis. If they hold and operate the rental property, they would then begin to depreciate the stepped-up basis (as opposed to carrying forward the existing depreciation schedule).
Common mistakes to avoid
Even experienced rental property owners can fall into traps that reduce their tax efficiency. This includes:
- Misclassifying expenses: Treating capital improvements as repairs — or vice versa — can either shortchange your deductions or raise red flags during an audit.
- Failing to report all income: Income from short-term rentals, security deposits that aren’t returned, or rent paid in cash must all be reported.
- Neglecting depreciation: If you fail to claim depreciation, you not only miss a significant deduction, but you may still owe depreciation recapture when you sell — even if you didn’t benefit from the deduction.
Minimizing your rental property taxes requires more than just filing forms and collecting rent — it takes proactive planning, good recordkeeping, and a firm grasp of real estate tax rules. By leveraging the strategies above, rental property owners can maximize deductions, defer taxes, and improve their bottom line.
If you’d like to find out more about how to minimize your rental property taxes, reach out to your Mowery & Schoenfeld tax partner today.