Following up on the last article I wrote about bookkeeping and the importance of it, it is now time to prepare this information for your tax return. During the year, you will have had many transactions that you need to appropriately classify for your expenses. Whether you’re self-preparing or providing it to your accountant, you must have a way of organizing and making it easy for everyone involved in the process. This article will detail how to accurately classify your transactions and (hopefully) be able to maximize your deductions. This article will be primarily geared for house hackers. However, the same principles apply if you are owning a rental property.
Keeping The End In Mind
The biggest thing to be aware of with your rental properties is that all of your transactions for the year will go on the below lines for each property. If you have more than three properties, they will flow to additional pages. As such, you will need to classify between these expense buckets for each property you own. I have created an excel template that details the items below and provides explanations for what each of those items are. This gets a little more complicated for a house hacker and I will break that down below.
Tips for House Hackers
In this section, I will show you how to allocate expenses between rental (deductible) and personal (not deductible), understand why real estate taxes may not be deductible in the year of purchase, and detail why it’s important to keep track of your expenses by unit.
Allocating Common Expenses
In my first article, I showed you how to allocate your basis between your rental use (deductible) and personal use (not deductible). Fortunately, it’s the same way of doing it for expenses. Either you can allocate by the square footage of each unit or by bedrooms, whichever is most advantageous. For more details, see that article here and go down to the section titled “Allocating Between Rental and Personal.”
There are many expenses that must be allocated based on this percentage including but not limited to property taxes (see below as well for additional detail), insurance (including the mortgage insurance premium paid at closing and PMI), mortgage interest, common utilities (i.e. water). It is also important to note that all of these expenses must have been paid during the year to claim them as a deduction. Putting money towards your escrow does not count. What was paid out of the escrow does.
Common Expenses Example #1:
During the year, a four-plex was purchased and the individual elected to allocate based upon the number of bedrooms. There were ten total bedrooms in the four-plex, of which two belong to the owner. As such, 80% of common expenses are deductible. After ownership, the owner received water bills totalling $2,000. However, the amount paid during the year was $1,600. As such, this owner is entitled to a deduction of $1,280 ($1,600 * .8%). This amount will be included in utilities on Schedule E.
Common Expenses Example #2:
The owner’s unit (two bedrooms) and one unit in the four-plex, which has three bedrooms) is master-metered for utilities. As such, the owner is paying this. The owner is entitled to a deduction of 60% of this amount (three bedrooms/ five total bedrooms). The total amount billed was $2,500. However, the total amount paid was $2,000. Therefore, the owner is entitled to a deduction of $1,200 (60% * 2,000). This amount will be included in utilities.
Common Expenses Example #3:
Using the same percentages as example #1 above, the owner incurred numerous charges for expenses; (1) mortgage insurance premium at closing of $8,000; (2) monthly mortgage insurance premiums totaling $2,000; (3) insurance paid at closing of $1,700; (4) umbrella insurance of $300. These costs total $12,000. Additional amounts were placed into escrow of $1,000 for the year for insurance. Knowing that the amounts placed into escrow aren’t deductible expenses, we will use $12,000 for total expenses multiplied by 80%. The owner will get a $9,600 deduction on their return for insurance (line 9 on Schedule E).
Allocating Expenses Specifically for Each Unit
There are specific items that can get allocated to 100% of your rental (fully deductible) or 100% to your personal unit (not deductible). It makes sense that when you work on a specific unit that is considered a rental, that you would be able to deduct the full cost as it does not relate to the owner occupied unit. These items may include repairs, supplies, advertising, maintenance, etc. The same concept applies for rehabs as well. For rehabs, you will want to break out your additions specifically for appliances and land improvements as those are eligible for bonus depreciation. See my article regarding bonus depreciation. I will go through a couple of examples.
Using the same example of the purchase of a four-plex above, there were numerous charges for repairs for the rental units (units 2-4) of $2,000. All of the charges were for work done inside those specific units and not the unit of the owner. Therefore, the owner can claim a deduction of $2,000 for that. In addition, there was some exterior work done on the entire building (must be allocated according to the 80% above) totalling $1,500. That $1,500 must be multiplied by 80% ($1,200). Total expenses are $3,200 (2,000 + 1,200) and would go on line 14 for repairs on Schedule E.
Using the same example of the purchase of the four-plex above, immediately after purchase, one of the units was renovated for $25,000. Appliances were replaced ($5,000) and used the remaining $20,000 to upgrade the countertops and make other structural improvements. Given that this was not added to your unit, these improvements would be added to the rental portion of your house hack. The appliances would be eligible for bonus depreciation (meaning you could take $5,000 of the depreciation in the first year) and the remaining would be depreciated over 27.5 years.
Real Estate Taxes
When you buy a property (specifically in Chicago), you receive a property tax credit at closing. Depending on the amount of that credit, you may or may not be able to deduct that credit in the year of purchase or even the following year. Once you are able to deduct your property taxes, you will be able to deduct it the same way you do all other common expenses above. A few examples should clear things up.
An investor and non-owner occupant purchases a multi-unit property in December 2020. The amount of real estate taxes that were prorated were 110% of the prior year amount totalling $7,000. The real estate taxes that were paid and incurred in 2021 were only $6.500. Real estate taxes paid and incurred in 2022 were $7,000. As such, no amounts would be deductible in 2021 as the credit exceeded the amount of real estate taxes that were paid and incurred. For 2022, there will be a $500 reduction in the amount that can be claimed. In 2022, the investor may only deduct $6,500 ($7,000 - $500).
An investor and non-owner occupant purchases a building in April 2020. The amount of property taxes obtained at closing was $3,000. The amount paid and incurred in 2020 was $3,500. As such, the investor is entitled to a $500 deduction on their taxes in 2020. For 2021, the investor will be able to deduct the full cost of real estate taxes paid and incurred during the year.
Tracking Expenses Between Rental and Personal
It is not imperative that you track your expenses by unit. However, you do need to remember how to allocate between your rental and personal and which expenses correlate to your rental (deductible) and personal (not deductible). There are numerous opportunities to miss deductions if you are careless or can’t remember expenses from a long time ago. As such, I’d recommend going through your income and expenses on a monthly basis and summarizing using the spreadsheet linked above. Another benefit is that you will save yourself time (if you self prepare). If you outsource to an accountant, you will save them time and yourself money on their fees.
Wrapping it Up
Classifying expenses can be tricky. My hope is that the above examples can be of help when you have to get the information ready for your taxes. The excel template should also be able to provide a format that shows you what expenses go for each line. This will also make it easier for the preparer of your return to follow.
If you have questions on your real estate tax strategy, you can reach me (Aaron Zimmerman) at firstname.lastname@example.org.