On its own merits, rental property is often a good investment. When everything goes well, you get to pocket the profit from collecting rents every month, and you make even more money if you sell the property for more than you originally paid for it. Rental properties offer another way to make money, too: The Internal Revenue Service and many state and local taxing authorities offer various tax incentives for those who own rental properties.
Repair and Rehabilitation Credits
Some communities offer credits or other tax incentives to help with the cost of fixing up properties. For instance, you might be able to get a property tax abatement to help with the cost of rehabilitating a property in a blighted neighborhood or to defray the expense of using special materials to maintain a building or neighborhood’s historic designation. The federal government sometimes also offers tax credits for such purposes as helping with the cost of repairing storm-damaged areas or for general rehabilitation.
Green Upgrade Credits
In an attempt to encourage you to make your building more environmentally friendly, the IRS offers free money for doing projects like installing solar panels or a geothermal heat pump. While the credits vary with time, as of the date of publication, you can get back 30 percent of the cost of installing a solar system as a tax credit. Your state may also offer additional green tax incentives.
Sheltered Income & Growth
You don't get taxed on the rents you collect every month. You get taxed on your profit after you have paid your building’s expenses. Given that you may be able to apply some personal expenses -- like a portion of the cost of operating your car or cell phone if you use them as a part of your rental business -- to your taxes, the ability to write off expenses can be valuable. At the same time, the IRS also doesn’t tax you when your building’s value goes up. As long as you don’t sell the building, you don't have to pay taxes, and your equity will keep working for you.
One of the most valuable tax incentives to buy rental property is the ability to write off depreciation. The IRS assumes that a residential rental building will last 27.5 years, and lets you gradually write down its value over that period of time. For examples, a house worth $225,000 would give you an annual depreciation expense of $8,182 (225,000 / 27.5). Since you don’t actually spend that money every year, this is a free write-off that reduces your taxes without you incurring expense.
When you sell an investment that went up in price, the IRS levies capital gains tax on your profit. It can also hit you with depreciation-recapture tax when your sale price is above your depreciated value. They usually do this even if you're reinvesting the money. However, with real estate, you can put off paying these taxes indefinitely, as long as you keep using your profits to buy more investment real estate and do the transactions as what the IRS calls 1031 exchanges.
- City of Chicago: Economic Incentives for the Repair and Rehabilitation of Historic Buildings
- IRS.gov: Like Share Print Rehabilitation Tax Credit - Real Estate Tax Tips
- IRS: Letter, Office of the Chief Counsel, Number: 2011-0091
- IRS.gov: Publication 527 - Residential Rental Property
- Commercial Partners Exchange Company: 1031 Exchange - Defer the Tax, Retain the Gain
Steve Lander has been a writer since 1996, with experience in the fields of financial services, real estate and technology. His work has appeared in trade publications such as the "Minnesota Real Estate Journal" and "Minnesota Multi-Housing Association Advocate." Lander holds a Bachelor of Arts in political science from Columbia University.