It’s tax season. For most landlords, this means locating your rental finances and trying to understand how to organize your hundreds of invoices for the IRS.
Rental property taxes are some of the most complex there are. Without understanding the nuances of the tax code, there are only so many deductions you can claim. However, learning even a little about the different types of rental expenses could save you hundreds of dollars and hours of frustration.
One major category of expenses is operating expenses. Because you can get substantial tax breaks for operating expenses, it’s important to understand how the IRS treats them.
Below is an overview of operating expenses and some tips for managing them for your taxes.
What is an Operating Expense?
Operating expenses are the ongoing, day-to-day expenses required to keep your business running.
They can range in amount and don’t need to be small expenses. Operating expenses include maintenance, advertising, materials and supplies, office rent, and employee salaries.
Instead of listing every possible operating expense, the tax code provides four criteria for qualifying expenses. The expense must be:
- Ordinary and necessary – A common expense that benefits your rental business.
- Current – Its benefits expire within a year (not a long-term asset).
- Directly related to your rental business – It’s not a personal expense.
- Reasonable in amount – The amount is suitable for the type of expense.
The following are all examples of operating expenses.
- Repairing water damage from a leaky faucet
- Preemptively replacing the filters on an HVAC system
- Utilities and rent for your office
- Cleaning services you use before a showing
- Advertising fees
The following are NOT operating expenses.
- A golf outing (not ordinary or necessary)
- Installing new hardwood flooring (not current)
- Donations (not directly related to your rental business)
How Are Operating Expenses Treated by the IRS?
According to the IRS, all operating expenses are fully deductible in the same year they occurred.
In simple terms, this means that you can subtract operating expenses from the rental income you report to the IRS. This way, you pay less in taxes because you have less recorded income. To think about it another way, deductions help ensure that you are only taxed on the profit you make from your rentals.
Deductions are great news for you. Deducting expenses fully in one year means you’ll never have to worry about them again. Unlike depreciation deductions, operating expense deductions are never “recaptured” later in taxes when you sell your property.
Tracking Your Operating Expenses
Your goal should be to secure as many deductions as possible. You should list and qualify your expenses as operating expenses in your books whenever possible.
The importance of keeping excellent records cannot be understated. If you are audited, you need solid proof that your expenses are what you said they were.
Here are a few tips for tracking your operating expenses for the IRS.
Property Management Software
Property management software is one of your best tools for tax preparation. Even if you use tax preparation software, you still need a way to track your daily expenses throughout the rest of the year.
Property management software offers expense tracking, which allows you to log and organize your expenses based on IRS categories. You can also easily access metrics and financial reporting tools like profit/loss reports that will be helpful to you come tax season.
Many software platforms also offer tax form auto-generation. For instance, Buildium offers 1099 e-Filing.
Schedule E is part of IRS Form 1040. It’s where you report your rental income and losses, including all your expenses for the year.
Schedule E is also where you decide whether each maintenance expense was a repair or improvement. If an expense meets the four criteria for operating expenses listed above, it’s a repair that you can deduct the same way.
If you’ve already been using an expense tracking tool, it’s easy to export your expenses and list them in the appropriate categories on Schedule E.
Understanding Rental Taxes
Rental property taxes are not an easy subject to master. However, by understanding the tax code’s basic concepts and types of expenses, you will be well prepared to get the best deductions for your rental business.