Paying property taxes can feel like an incredible burden, especially when you own rental properties. Operating expenses, financing costs, and property taxes can feel like they take any profits you’d earn from your rental property, making it difficult to get ahead.
Tax deductions are often a way to reduce liabilities and increase profits, but are property taxes deductible?
Unfortunately, investment property real estate taxes aren’t deductible on Schedule A, like the deduction homeowners may take on the home they live in full time. But, the good news is there may be a way to write off the hefty cost of property taxes and increase your profits.
Here’s everything you must know about rental properties and real estate taxes.
What Are Property Taxes?
Property tax is the tax real estate owners pay to own commercial or personal property. The local city or county government determines the property’s assessed value and calculates the property taxes accordingly.
Most state and local government agencies rely on property taxes as income, and all states charge property taxes, although the tax rates vary by location.
In any state, if you fail to pay your property taxes, your taxing authority will place a lien on the property or hold a tax lien sale. This means you must satisfy the lien before selling or transferring the property and could be subject to large penalties and fines.
You pay property taxes whether you finance the property with a mortgage, pay mortgage interest, or pay cash for the property.
Understanding the Property Tax Deduction
A property tax deduction is money paid for state and local taxes that homeowners may be eligible to deduct from their federal income taxes. It reduces the income taxes owed on property taxes paid on an eligible property.
Home and property owners must pay real estate taxes whether they live in the property or rent it to tenants. If you are the owner of record, you must keep up with the property taxes owed to avoid liens on the property.
You should include the total cost in your rent charges to ensure you have enough to cover the monthly mortgage payment, property taxes, and other operating expenses and still make a profit.
What property taxes are deductible?
You may be eligible to write off property taxes paid on a primary residence, vacation property, or land each tax year. You may also deduct property taxes paid on cars, RVs, and boats.
Did you notice that we didn’t mention rental property tax deductions? That’s because the property tax deduction for your principal home or vacation homes doesn’t apply to rental properties.
Still, there are ways to get a lower tax bill as a real estate investor if you prove your real estate investments are a business and not passive income.
Are any property taxes not tax deductible?
Technically speaking, real estate investors cannot deduct property taxes paid on Schedule A (Itemized Deductions), but there is a way around it, which we’ll discuss.
In general, you also cannot deduct property taxes on the following:
- Unpaid property taxes
- Property taxes on a home you don’t own (such as helping a relative pay their taxes)
- Any portion of a tax bill that’s for a service, like trash collection or sewer systems
- Transfer taxes
- Commercial property
Handling property taxes in an escrow account
If you have an escrow account to handle your property taxes, you can only deduct the taxes paid for the tax year. Your property tax bills will show how much property tax you paid, regardless of how much money you might have put into your escrow account.
Your lender determines how much money you must put in your escrow account based on the local taxes and any other accounts you have included in your escrow account, such as homeowners insurance. They may collect more money than they pay, as some lenders require a cushion to ensure your account isn’t short.
For example, suppose you paid $10,000 into your escrow account, but your lender pays only $5,000 for your real estate tax liability. In that case, you may only deduct the $5,000 paid if you’re eligible for the deduction. Your lender will reassess your escrow payment each year to ensure you don’t overpay or underpay the amount needed.
What Is the Maximum Property Tax Deduction?
The Tax Cuts and Jobs Act of 2017 (TCJA) limited homeowners of a principal residence to a maximum deduction of $10,000 for property taxes on their full-time home. In addition, the TCJA increased the standard deduction, and only taxpayers claiming itemized deductions can take advantage of the property tax deduction.
This limits the number of homeowners who can take advantage of the deduction. With a higher standard deduction, it won’t benefit many taxpayers to itemize deductions.
However, if you actively participate in your real estate business, you may be eligible to deduct the full amount of your property tax payments on your investment properties, regardless of the $10,000 limit on owner-occupied properties.
Claiming the Property Tax Deduction
There are two ways you can claim the property tax deduction. The proper method depends on whether you claim taxes on a primary residence/vacation home or rental property.
Claiming the property tax deduction on a primary residence
To claim the property tax deduction on your principal residence, you must have itemized deductions that exceed the standard deduction.
For 2023, the standard deduction is $13,850 for single filers and $27,700 for married filing jointly taxpayers. If your total deductible expenses, including property taxes, exceed these amounts, you may claim the property tax deduction.
To verify the amount of property taxes paid, check your property tax bill or paid receipt from the county when you paid them. If you have an escrow account, you can log into your county assessor’s website and see the total amount of taxes paid on the tax records or contact your mortgage servicer to determine the total amount paid.
When claiming the property tax deduction, you must file IRS Form Schedule A, which provides an itemized list of the eligible deductions into which property taxes fit.
Claiming the rental property tax deduction
How can you deduct local property taxes paid on a rental property? You don’t live there, so it’s not a principal residence, but it’s also not a vacation home. So, can you deduct your tax payments and get the tax benefits?
There is one loophole: write off local real estate taxes as a business expense. However, to do this, you must prove you have a real estate business and aren’t just trying to earn a passive income from a property.
Here’s the problem: generally, the Internal Revenue Service considers real estate income passive, which is not eligible for business tax deductions. But there’s a loophole. If you can prove you materially or actively participate in the real estate business, you may be able to deduct the real property taxes paid as a business expense.
In true IRS fashion, there are a couple of ways to qualify:
- Real estate professional: You spend at least half your working hours on your real estate business and spend a minimum of 750 hours per year on it.
- Material participation: You spent at least 100 hours per year on your real estate rental business and worked at least as much as anyone else involved in the business.
Since the real estate taxes paid are a part of your business administration activities, you aren’t subject to the same $10,000 limit that the Tax Cuts and Jobs Act implemented.
This means you may deduct a larger amount of taxes paid, reducing your liabilities and increasing your profits. You’re still subject to the $10,000 limit on your primary residence, but any rental properties owned will not be subject to the same rules.
To claim your investment property real estate taxes, you must report all rental income and expenses, including property taxes, on Schedule E of the federal tax return. Ensure you have ample proof of the amount paid for taxes by providing your paid tax bill or the receipt from your local government agency.
Tips to Maximize Your Property Tax Deduction
As a real estate investor, you want to limit expenses and increase profits. While it takes a little work to prove you qualify, here are a few ways to maximize your property tax deduction.
Ensure you materially or actively participate in real estate
If you don’t meet the IRS guidelines for materially or actively participating in real estate, you lose the ability to write off many expenses, including property taxes.
Don’t let your activity be considered passive if you want to make your real estate business a major source of income.
Prepay property taxes
If your state or county allows it, prepay your property taxes to get the deduction in the year you need it.
This works well when you have a lot of capital gains to pay taxes on, such as after selling a property for large capital gains.
Work with a tax attorney or advisor
Working with a tax advisor or attorney can help determine what steps you can take to maximize your property tax deduction and any other deductions to maximize your profits and save money on your tax liabilities.
If you wonder if “are property taxes deductible,” it depends on the type of property in question. If you itemize deductions, you can likely deduct property taxes on your primary residence; however, it’s not that simple for rental properties.
To be eligible to deduct taxes on investment properties, you must meet the IRS guidelines regarding real estate professionals, and then you can deduct the expenses as a business expense.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.