Owning rental property in San Diego is an excellent way to reduce your tax liability, and it’s never too early to begin planning for the next tax season. It tends to arrive quickly and without notice.
While you will be required to declare any rental income or other income you earn on your rental properties, you’ll also have the benefit of many tax deductions that are unique to rental property owners.
We are sharing this tax information with you from our perspective as experienced San Diego property managers. We also recommend that you consult with your own CPA or tax attorney before filing so you can be sure you’re taking all the benefits that are available to you.
Depreciation and San Diego Rental Homes
One of the best tax benefits enjoyed by rental property owners is depreciation.
The IRS allows you to write off the deterioration of your rental property, which leads to a loss of value. The general rate of depreciation for residential homes is set by the IRS at 27.5 years.
To claim depreciation, you must meet the following criteria:
- You must be the owner of the property.
- You must be earning rental income on the property.
- You must be able to document the useful life of your property. For real estate, this is somewhat standardized and the 27.5 years applies, unless your property is subject to the Alternative Depreciation System, in which case it’s 30 or 40 years (this is rare).
- The useful life of the property must be greater than one year. Nothing that wears out in less than a year can be depreciated on your taxes.
If you begin renting out a home in one year and sell it within that same year, you cannot claim depreciation on that property.
Deducting Operating Expenses on San Diego Rental Property
Your rental property is a business that earns income.
Because it’s a business, many of the operating expenses you incur are tax-deductible. The most common deductions for operating and business expenses include:
- Mortgage interest
- Insurance costs
- Property taxes
- Professional property management fees
- Additional professional fees such as accounting or legal costs
- Maintenance and accelerated depreciation on household items
- Travel costs involved in visiting your rental properties
- Home office costs
You can make tax deductions for the money you spend preserving the asset’s value and condition. You can also deduct general business costs, for example advertising a vacant property. That’s seen by the IRS as a necessary business expense.
Maintenance costs are deductible as well, but you have to be specific about what you’re maintaining. And be careful about what you consider maintenance and what is considered an improvement.
Improvements are not tax deductible. Anything you spend keeping your property safe and habitable is one thing. But, you cannot deduct for new wood floors when you decide to replace your carpet. The IRS does not allow you to deduct the cost of improvements that lead to the betterment of your property value.
Leveraging a 1031 Exchange to Defer Capital Gains Taxes
As you know, this is a great market for sellers, with property values and asking prices higher than they’ve been. The hot market has inspired a lot of investors to sell their rental homes in San Diego and the surrounding areas.
Selling means paying taxes. All the profit that’s earned on the sale of your property needs to be reported to the IRS, inviting capital gains taxes.
You can, however, defer the payment of those taxes if you’re willing to re-invest the earnings from your property sale.
To defer the capital gains taxes you’ll have to pay on the sale of an investment property, we recommend that investors consider a 1031 exchange. When you take advantage of this tax benefit, you are going to sell one rental property and then use the proceeds to invest in a similar property or a series of properties.
This will not eliminate your tax liability, but it will give you the opportunity to strengthen your investment portfolio and delay paying those taxes.
There are several important steps and timelines associated with a 1031 exchange. You need to move quickly to identify and close on a new property after you’ve sold the existing property.
- Make sure your property qualifies for this benefit. This tax program is meant for investment homes. You cannot sell the home you’ve been living in and reinvest the money to buy a vacation home. It has to be one income-producing property for another.
- You’ll need to exchange with a property or properties. The new property you choose must have a value that is the same or higher than the original property. If you walk away from the exchange with any profit, they will be taxable.
- Find one property, two properties, or three to exchange with your current property.
- Pay attention to the timelines. You’ll need to identify a replacement property within 45 days of selling your original property. Then, you have 180 days to close on the new sale. The entire exchange must take place within 180 days (meaning you don’t have 45 days plus 180 days – the clock does not reset). This can be a challenge now, with the market so hot and inventory lower than the demand. Be prepared to move quickly.
When you’re conducting this transaction, it’s necessary to use an intermediary. The intermediary will hold your funds until they can be reinvested in your new purchase. Ask your property managers for a referral if you’re not sure who to work with.
Don’t be afraid of those real estate losses when it comes to your investment portfolio. They can actually help you at tax time, and if you’ve surrounded yourself with some great property management partners and tax professionals, you’re likely to earn more and lose less on your entire portfolio.
We would be happy to tell you more about the many benefits of owning investment property in the San Diego market. Please contact us at San Diego Residential Property Management.