Even the savviest landlords can slip up on rental property tax rules. As a real estate agent, you can add value by warning clients about these five common tax mistakes – and how to avoid them. Here’s a quick listicle you can share to save your clients headaches and money.
1️⃣ Misreporting Security Deposits
New landlords often think every check from a tenant is “rent.” Not so. Security deposits are generally not income when received if you plan to return them to the tenant (irs.gov). For instance, your client collects a $1,000 security deposit – that sits in escrow and isn’t reported on this year’s taxes.
However, if a tenant breaks the lease or leaves damage and the landlord keeps some or all of the deposit, that kept amount becomes taxable income in that year (irs.gov).
Another twist: if a deposit is intended as last month’s rent or pre-paid rent, the IRS considers it advance rent, which is income upon receipt (irs.gov).
How to avoid mistake #1: Advise clients to clearly distinguish deposits vs. rent in their bookkeeping. Only count deposits as income if/when they’re forfeited. This ensures they don’t over-report income (and overpay taxes) or under-report when they keep a deposit.
2️⃣ Confusing Improvements vs. Repairs
This is a classic pitfall. A client replaces a roof and tries to deduct the $15,000 as a repair expense in one year – oops! The IRS sees a new roof as an improvement, not a minor repair, so it must be capitalized and depreciated over time (irs.gov).
In contrast, repairs (fixing a leak, painting a room, fixing a broken window) are deductible immediately as maintenance.
The rule of thumb: if it adds value, prolongs the property’s life, or adapts it to new use, it’s likely an improvement (think new HVAC system, room addition, remodeling) and not fully deductible upfront (irs.gov).
If it just keeps the property in good working condition without changing its value or use (fixing wear and tear), it’s a repair expense. Avoiding mistake #2: Encourage landlords to consult when in doubt – but as a quick tip, maybe share: “Replacing shingles that blew off = repair (deduct it). Replacing the entire roof = improvement (depreciate it).”
The IRS explicitly says you “may not deduct the cost of improvements” in the year paid (irs.gov). Knowing the difference prevents misfiling and possible IRS corrections.
3️⃣ Forgetting to Depreciate the Property
Surprisingly, some landlords, especially first-timers, forget to claim depreciation on the rental house itself. Depreciation is a huge tax benefit: residential rental buildings can be depreciated over 27.5 years, meaning each year a chunk of the property’s cost is deductible as an expense (realized1031.com).
If your client doesn’t take it, they’re leaving money on the table. And here’s the kicker – the IRS assumes they did take it! When the property is eventually sold, the IRS will calculate gain as if depreciation was claimed, and impose tax on “unclaimed” depreciation anyway (via depreciation recapture)(realized1031.com).
In simple terms, use it or lose it (actually, if you lose it, you still pay tax later as if you used it… double whammy!).
Avoiding mistake #3: Remind clients to start depreciating from day one of rental use. If they missed it in prior years, a tax professional can help fix it (often by filing Form 3115 for a catch-up adjustment).
But it’s best not to miss it in the first place. Show them an example: A $300,000 rental home could yield around $10,900 a year in depreciation deduction (building portion) – that could save maybe $2-3k in taxes annually, depending on their bracket.
Don’t let them skip this! It’s commonly covered in Real Estate CE courses because it’s so important.
4️⃣ Not Prorating Expenses for Partial-Year or Mixed Use
If a client only rented out their property for part of the year (or used it themselves for part of the year), they must prorate annual expenses. For instance, suppose a homeowner turned their primary home into a rental starting July 1.
Only expenses from July onwards are rental expenses; the January–June expenses were personal (and maybe deductible in other ways, like mortgage interest on Schedule A). Or if it’s a vacation home situation where they used it some days and rented other days, expenses need to be split between personal and rental based on usage days (hrblock.com).
A common mistake is trying to deduct the full year’s worth of property tax, utilities, insurance, etc., even though the property wasn’t being rented the whole year.
How to avoid mistake #4: Instruct clients to calculate what portion of time the property was rented and only deduct that fraction of otherwise allowable costs. If the home was rented for 9 months, they can generally take ~75% of the annual expenses as rental expenses (taxschool.illinois.edu) (hrblock.com) (the rest might still be personal deductions if applicable).
The same logic applies to a spare room: if they rent out a room, only expenses directly related to that room or a fair percentage of shared expenses can be deducted. Proper allocation is key. Keeping a log of rental days vs personal days will support those prorations if the IRS asks.
5️⃣ Misunderstanding Passive Loss Limits
Rental real estate often generates a paper loss (especially once you count depreciation). New landlords might excitedly think, “Great, I’ll use this loss to offset my salary and get a big refund!” – not so fast. The IRS classifies rental income as passive by default, and passive losses generally can’t offset active income like wages or business income (irs.gov).
There is a special exception: up to $25,000 of rental losses can be deducted against other income if the owner “actively participates” (pretty easy test) and their income isn’t too high.
This $25K allowance starts phasing out once AGI exceeds $100K and disappears at $150K income.
Many landlords don’t realize, for example, a couple making $200K with a rental will not be able to deduct rental losses that year – the losses get suspended.
Avoiding mistake #5: Educate clients upfront: “Rental losses are limited by passive loss rules. You might be able to use up to $25k of losses if your income is moderate, but high earners will likely have to carry those losses forward(investopedia.com).”
The unused losses aren’t gone – they carry over to future years to offset rental income or will fully unlock in the year they sell the property (so there’s a silver lining) (irs.gov) (irs.gov). By understanding this, clients won’t count on a tax break they can’t get right away.
If a client has significant income, you might mention the “real estate professional” route – if they qualify (which requires heavy material participation in real estate trades), rental losses can become non-passive. That’s a complex topic (and we have a whole explainer on it!), but at least they should know there are limits unless special criteria are met (investopedia.com).
The key is managing expectations: tax law might not allow immediate use of rental losses, which is a topic often covered in Real Estate License Renewal Courses focusing on investment property updates.
Avoiding Common Traps
By watching out for these five pitfalls – deposits, improvements vs repairs, depreciation, prorating, and passive loss limits – you can help your landlord clients avoid common tax traps.
A little heads-up from you, backed by insights you’ve gained through Real Estate CE courses and experience, can prevent costly mistakes. They’ll appreciate that you’re looking out for them beyond just the purchase and lease-up, reinforcing that you’re a knowledgeable partner in their real estate journey.
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For real estate professionals, understanding these concepts can be particularly valuable during discussions with clients about why REALTORS® and real estate agents are knowledgable professionals.
If you’re preparing for your Real Estate Continuing Education or looking to enhance your knowledge through a Real Estate Course, topics like tax benefits of residential rental property can help set you apart.
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