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Posted Thursday, January 23, 2025
Table Of Contents
Rental Deductions Tax Preparation
Rental properties can be great investments and offer some ways to shelter your taxable income through rental deductions. However, there are several tax related issues during the purchase, management, and sale of your rental property which can ultimately affect your rental income tax rate.
The proper handling, coordination, and reporting of taxable events such as closing costs, repairs versus improvements, depreciation, 1031 exchanges (and even reverse 1031 exchanges) seemingly innocent HOA dues and mileage can improve your tax consequence. While incorrect tax reporting can start the slow brewing of future problems.
Why Have Setup Fees?
Why do we have setup fees at all? We must ensure your prior depreciation is correct (especially if acquired with a 1031 exchange), all assets are correctly identified with original cost basis including acquisition costs, and loan amortization is properly recorded. We see a lot of junk out there which is not big deal until you want to sell the rental property, and minimize your tax pain.
Why do we charge extra for short-term rental setups? They are more intensive because there are more questions that need to be answered from us (and from you!), and we have to comb through furnishings and other boot up expenditures to ensure they are properly handled.
Why would I need a 3115 with a cost segregation study? If your rental property has already been in service and tax returns have been filed, then we need to request permission from the IRS to basically accelerate your depreciation on your current tax return. Alternatively we could amend your prior tax returns which is messy and expensive. Also, there is some tax arbitrage potentially if your income is higher today than it was when you first purchased your rental property. Lots to discuss here!
Why do we charge extra for a rental property acquired in a prior year 1031 like-kind exchange? We need to confirm that the previous tax professional computed the exchange correctly since once we prepare the tax return, we own the data including prior data.
Rental Property Tax Return Preparation
Here are typical rental property tax prep fees that might be added to your individual tax return (Schedule E reported on Form 1040) or partnership tax return (Form 8825 reported on Form 1065)-
| Rental Tax Prep, Clean Records (The SRO Template) | 100 ea |
| Rental Tax Prep, Complex or Messy Records (disguised disorganization) | 200 ea |
| Add On: Streamlined State Tax Return (in addition to your resident state) | 125 |
| Add On: Complex State Tax Return (requiring business or gross receipts filings) | 200 |
| Add On: Cost Seg + 3115 | 550 |
| Add On: Short-Term Rental Activities (non-investor patrol) | 75 |
| Add On: Rental Property Sale | 250 |
| Add On: 1031 Like-Kind Exchange and New Setup | 500 |
| Add On: Complex 1031 (2:1, 1:2) and New Setup(s) | 750 |
Chat With a Tax Pro
Taxes can be tricky. Chat with a WCG human now and get questions answered.
Additional Rental Property Considerations
Here are some additional considerations during rental property tax return preparation.
Cost Segregation Study
How does all this black magic work? With a cost segregation report, or some say a cost segregation study, all the sticks, bricks and stuff inside are figuratively torn down and put into different piles. Some piles (5-year or 7-year) are eligible for accelerated depreciation, another pile would be a 15-year pile which varies a bit, and the remaining pile will revert to the 27.5- or 39.0-year typical residential or nonresidential commercial use depreciation.
Technically, and with full-on geek-speak, cost segregation separates property elements that are “dedicated, decorative or removable” from those that are “necessary and ordinary for operation and maintenance of the building.” These piles are called asset classes, and they are maintained separately within your property’s depreciation schedule.
From there, and with the help of bonus depreciation and in some cases Section 179 expensing, you compress the multiple years of depreciation into one. Yay!
Short-Term Rental Activities
If your average guest stay is 7 days or less and you materially participate in the activity (500 hours, 100 hours and more than anyone else, or substantially all hours) you likely qualify for the short-term rental loophole. Given the intricacies with STRs, and additional time and diligence spent, we commonly have an add-on fee for these types of rental properties. We are short-term rental experts.
Note: For those rental property owners on our real estate Investor Patrol Services platform, we waive the additional fee for short-term rental activities.
Short-Term Rental with Substantial Services
If you have a short-term rental similar to above, but provide substantial services then your rental activities are reported on Schedule C… read that again… Schedule C of your individual tax return and subjected to self-employment taxes. Yuck! What the heck are substantial services? According to IRS Publication 527, substantial services are-
If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C. Use Form 1065, U.S. Return of Partnership Income, if your rental activity is a partnership (including a partnership with your spouse unless it is a qualified joint venture). Substantial services don’t include the furnishing of heat and light, cleaning of public areas, trash collection, etc. For more information, see Pub. 334, Tax Guide for Small Business. Also, you may have to pay self-employment tax on your rental income using Schedule SE (Form 1040 or 1040-SR), Self-Employment Tax.
Think hotel or hunting lodge.
Real Estate Professional Status
Let’s quickly review the simplified basics of real estate professional status–
- You materially participate and provide personal service hours of 750 or more in real property trades or businesses, and
- Over half of your time spent on all activities where you perform a personal service must be spent on real property trades or businesses (this includes W-2 jobs and small businesses). If you work 2,080 hours as a 9-5er W-2 suit, you will need to work 2,081 hours in real estate. Sure, no one wears suits anymore, but you get it.
If you meet these two, you are what the Internal Revenue Code refers to as a qualifying taxpayer, or what the industry calls a real estate professional. But you are not done! The final step is to demonstrate material participation as a real estate professional in each of your rental activities.
We are also REPS experts.
Disposition or Sale of a Rental Property
When you sell your rental property, including a 1031 or 721 exchange (don’t forget about Delaware Statutory Trusts), there will likely be an add-on fee of $250 for a straight-up sale or $500 to $750 for a like-kind exchange. This is where the rubber hits the road in terms of capital gains, and we need to spend the extra time to ensure a) your purchase price is correctly being considered including acquisition costs, b) improvements are accounted for and c) selling expenses and other things are factored in.
Rental Property Tax Deductions
A lot of rental property owners miss out on tax deductions for not knowing how to position themselves correctly. For example, deducting travel expenses to and from your rental. Or the optimized way to deduct cell phones, mileage, and home offices. What about repairs and improvements? What about de minimis safe harbor from IRS Notice 2015-82 which states that items $2,500 or less are considered immediate rental deductions and do not have to be depreciated? How about the Small Taxpayer Safe Harbor for repairs that exceed $2,500? There are two other rental property safe harbors- small taxpayer and routine maintenance.
Can you deduct rental property expenses during renovations or when the property is vacant? Generally Yes, but there are some things you need to be aware of.
WCG CPAs & Advisors are real estate CPAs and we can help maximize your tax deductions. Check out our rental property tax prep template.
Rental Property Owned by Partnership
We encourage short-term rentals to be owned by partnerships (i.e., a multi-member LLC). Why?
First, the historical audit rate of partnerships (Form 1065) is 0.4%. Super low compared to individual tax returns (Form 1040) which might be 4% to 12% depending on your income levels. Why does this matter? When you have a big cost segregation depreciation plus your big startup expenses such as furniture and supplies, and you then have a big tax deduction against your big W-2 income because your passive losses are no longer limited with your big material participation, it raises some eyebrows.
Second, with a partnership tax return, we can mechanically show your capital contribution (at-risk money) including recourse loan debt. Why does this matter? Let’s say you invest $250,000 into a new business, and that business loses money. The IRS sees your “partner basis,” the $250,000, within your 1040 tax return, and suddenly the $100,000 first-year loss doesn’t seem so out-of-whack. A short-term rental is certainly a business activity; sure, you might not have a profit right away, but you will make money someday (otherwise you wouldn’t do it, right?).
Please visit our business entity tax return preparation page for fees associated with partnerships owning rentals. There are some other good things, but there are some pitfalls too.
Rental Property Bookkeeping
WCG specializes in real estate investors and as such we provide accounting services for rental properties. Rental properties are a business like any other, and the proper tracking of revenue and more importantly the associated expenses are essential. The bookends to the varying service levels are your common single-family rental (SFR) home and that large commercial property with several tenants. That’s the X axis. The Y axis becomes tax return complexity based on number of owners, number of activities (rentals) or both. There are many considerations; please click on the button below to learn more about our rental property accounting services.
Vacation Rentals
Let’s say you have a ski condo in Aspen and you use it from time to time, and you also rent it out to others. If your personal days exceed 14 days or 10% of the days it was rented to others at fair market rates, then you have to prorate your rental deductions and expenses based on rental use percentage.
Rental Use % = Days Rented / (Days Rented + Days Used Personally)
Ok, so you use the rental use percentage to limit your rental deductions. Now what? Can you create a loss? Perhaps. If the rental property activity triggers vacation rules, then No. Vacation rules apply when 1) the rental was rented for less than 140 days during the year, or 2) personal use days exceeds 10% of the rented days. Prorated rental deductions and expenses are limited to income (in other words you cannot have a rental loss). Here is a sample Vacation Home Worksheet from our tax software. Don’t laugh, but here is H&R Block’s AirBNB Guide which is very good at explaining all this.
If vacation rules do not apply, then you could have a net rental loss. Could? Yes, could. There is ordering rules where mortgage interest and property taxes are used first to offset rental income, and operating expenses and rental depreciation are applied next. If operating expenses and rental depreciation create a net rental loss, then that loss is carried forward.
We have to briefly mention the Bolton Method or what is also called the Tax Court Method (which WCG CPAs & Advisors uses). Before TCJA it was quite simple; if you itemized, then Bolton / Court Method was better. If you used the standard deduction, the IRS Method would be better. With TCJA, you must run both scenarios. Bolton Method is basically rental days divided by days in the year, whereas the IRS Method is rental days divided by number of days used for any purpose. The Bolton Method usually results in a lower percentage, and therefore a lower allocation of mortgage interest and property taxes to the rental activity.
The Masters Rule stems from Internal Revenue Code Section 280A(g). It is a unique rule in which homeowners who rent out their property for 14 days or less in a tax year are not considered to be engaged in the activity for profit, and therefore do not have to claim the rental income. This property could still be considered a second home where mortgage interest and property taxes are still deductible. Yeah baby! They call it the Masters Rule from those who rent out their homes for the Masters Tournament in Augusta, Georgia.
Otherwise vacation rules do not apply, but your rental deductions and expenses are limited based on rental use percentage. The good news is that you can still have a net rental loss if those prorated rental deductions exceed the rental income.
State Problems With Your Rental Property
It is easy and common to overlook rental property and real estate investment nuances at the state level. Here are some random considerations-
Required to File Tax Returns with Tax Loss
Although your rental property has a tax loss, you are usually required to file a state tax return. Why? You have an income-producing asset in their state (taxing jurisdiction), and they have the right to inspect your books and records to ensure your reported tax obligation is as you say. Wow! We geeked out there.
Some States Do Not Recognize Accelerated Depreciation
California, for example, does not recognize bonus depreciation and has different limits for Section 179 expensing. This is another reason to prepare and file state tax returns for your rental property although it might have a federal tax loss. In other words, you could very easily have a tax loss on your Form 1040 individual tax return but have taxable income on your state tax return. Don’t shoot the messenger.
California and REPS
California does not conform to Real Estate Professional Status (REPS), and as such while your rental losses might be deductible on your federal tax return, they might be limited on your California state tax return. Yuck.
State Capital Gains on Your Rental Property
The federal tax code has a separate graduated tax system for long-term capital gains, and it is either 0%, 15% or 20% plus the possible net investment income tax of 3.8%. We call this a preferential tax rate. This sounds wonderful. However, most states do not have a preferential tax rate for long-term capital gains.
Backup Withholdings by Property Managers
Who wants to pick on California some more? Excellent. If you own a rental property in California and you are not a California resident, your property manager is legally obligated to do what the accounting industry calls “backup withholding.” Here is a blurb from their website–
California law requires withholding of tax by persons having the control, receipt, custody, disposal, or payment of items of income, commonly termed “withhold at source.” (Title 18 California Code of Regulations (CCR) section 18662-1(a)(1)). As a property manager providing services to nonresident property owners, including but not limited to renting, leasing, or collecting rent or lease payments on behalf of the nonresident owner, you are considered the withholding agent for California withholding purposes. As a withholding agent, you are required to withhold 7% on rent or lease payments to nonresidents when the total payments of California source income, excluding property management fees, exceed $1,500 for the calendar year.
Doing Business in California
This section should be called California state return matters. We use California for a couple of reasons- first, they have aggressive tax law and second, a lot of states call it progressive tax law and adopt many of California’s initiatives. Could you be considered doing business in California with your non-California rental property? Yes! Here is a blurb directly and very much self-servingly from California’s Franchise Tax Board 3556 LLC MEO–
Paul is a California resident and a member of a Nevada LLC. The Nevada LLC owns property in Nevada. The LLC hires a Nevada management company to collect rents and provide maintenance. Paul has the right to hire and fire the management company. He occasionally has telephone discussions from California with the management company in Nevada regarding the property. He is ultimately responsible for the property and oversees the management company. Paul conducts business in California on behalf of the LLC. The LLC must file Form 568.
All these state issues come from our State Problems With Your Rental Property KB article from our rental book.
I Just Got A Rental, What Do I Do?
I just got a rental, what do I do? Purchasing a rental property is certainly challenging, but operating one to build wealth and find tax efficiency is equally challenging. This is our second book. Our first book, Taxpayer’s Comprehensive Guide to LLCs and S Corps, was first published in 2014 and was well-received by small business owners and tax professionals, so we thought a book on rental properties and real estate investments would be equally helpful. So, here we are with our second iteration, or the 2025 edition. We plan to update annually.
Our rental property book starts with entity structures and moves into asset management such as acquisition, cost segregation, rental safe harbors, repairs versus improvements, accelerated depreciation, partial asset disposition, and 1031 like-kind exchange. From there we discuss various rental considerations like passive activity losses, short-term rental loophole, real estate professional status, and material participation including what time counts, and what time doesn’t count.
Finally, the good stuff! Rental property tax deductions such as travel, meals, automobiles, interest tracing, home office and common expenses. Fun!
It is available in paperback for $19.95 from Amazon and as an eBook for Kindle for 15.95. Our book is also available for purchase as a PDF from ClickBank for $12.95.
How To Purchase
If you buy our 420-page book and think that we didn’t help you understand rental property tax laws, let us know. We never want you to feel like you wasted your money. If you are ready to add some insightful reading into your day, click on one of the preferred formats. Amazon is processed by Amazon, and the PDF is safely processed by ClickBank who will email you the PDF as an attachment.
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| $19.95 | $15.95 | $12.95 |
Real Estate Professional IRS Election
To qualify as a real estate professional, an individual must dedicate the majority of their time to real property businesses. These businesses include:
- Development or redevelopment
- Construction or reconstruction
- Acquisition or conversion
- Rental
- Management or operation
- Leasing and/or brokerage
In addition, more than half of the personal services performed in all businesses during the year must be performed in real estate businesses. So, if you have a garden variety W2 job working 2000 hours a year, you need to spend 2001 hours in real estate activities. Wait! There’s more. Second, your hours worked in the real estate activity must be more than 750 hours. Steep thresholds.
If you own multiple rental properties each will be considered a separate entity and you must satisfy the above requirements on each property independently unless an election is made to treat all those interests as a single activity. This election is simply a statement that is attached to your tax return. And under Revenue Procedure 2010-13, you can make the election retroactively (typically requires amending a tax return just for the election).
Once you qualify as a real estate professional, you must materially participate in the operation of your rental property business. This is where it gets tricky, and this is where most rental property owners get into trouble. If you cannot prove material participation in your rental activities, you will be subjected to passive loss limitations (currently $25,000).
Realtors and agents beware! Just because you spend 3,000 hours hauling around buyers doesn’t mean you are a slam dunk for the real estate professional designation. Real estate agent DOES NOT automatically qualify you. The material participation rules must be met, and the 750 hours dedicated to your rental activity is outside your work as a real estate agent, realtor, broker, etc.
Also, and this is commonly missed by tax professionals, by being a Real Estate Professional, you can avoid the net investment income tax (NIIT). As such, if you have taxable rental income (profits), you might want to avoid this pesky 3.8% additional tax.
For more information directly related to the IRS definition of real estate professional and the tests for material participation please click on the button for a our updated blog post including tax court cases-
CostSegEZ Preferred Cost Segregation Provider
Cost Segregation in a Nutshell
How to Annoy Your Tax Accountant in 6 Easy Steps
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