Income Property Operating Expenses and the IRS Tax Code
The industry standards for measuring returns to real estate investments are rate of return on equity and cash flow. To do this successfully, however, the calculation of annual cash flow must be made in a series of steps with meaningful data for gross scheduled income, vacancies and bad debts, operating expenses, and financing consideration.
In this discussion we'll focus on the operating expenses typically taken by real estate investors and then show you how the IRS interprets operating expenses.
Operating expenses are those expenses necessary to maintain and keep a rental property investment in service.
For example, maintenance and repair costs, property taxes, insurance, management fees, water and sewer, utilities, garbage collection, landscaping costs, pool service, telephone, and advertising are considered a rental property's operating expenses because they keep the property in service.
Operating expenses are not debt service (i.e., the mortgage payment) or the investor's personal income tax payment.
Debt service is later deducted to calculate cash flow before taxes (CFBT) and income taxes later deducted to calculate the cash flow after taxes (CFAT). But don't mistake them as expenses required to keep the investment in day-to-day operation.
Here's the schema:
Gross Scheduled Income - Vacancy = Gross Effective Income
Gross Effective Income + Other Income = Gross Operating Income
Gross Operating Income - Operating Expenses = Net Operating Income
Net Operating Income - Debt Service = CFBT
CFBT - Income Taxes Payable or (tax savings) = CFAT
Tax Code Interpretation
Operating expenses must be accurately accounted for income tax purposes because certain expenses may be paid by tenants under a net lease agreement and therefore must be offset by an appropriate addition to income.
If tenants under a net lease agreement, for instance, reimburse you five hundred dollars a year for maintenance and repair costs then that amount would be included as income (in effect neutralizing the expenses' impact on net operating income for that given year).
Moreover, expenses for the operation of rental property must be distinguished from expenditures for capital improvements.
Capital improvements are defined as expenditures that will lengthen the life of an improvement, make it more useful, or increase the value of the property. In this case, the IRS tax code states that that improvement must be capitalized and then depreciated (not deducted in full for the year it was expended).
There is a gray area (not unlike most tax issues) between the two definable extremes, however.
For example, if a hand full of shingles is replaced to repair the roof on a rental property in order to keep the roof from leaking, it may fall under the definition of an operating expense. However, if the same number of shingles were used to replace one section of the roof exposed to wear and tear by weather elements, the expenditure may be regarded as extending the life of the roof, and therein might not be classified as a repair, but a capital improvement.
Another potentially troublesome allocation is that of "reserves for replacements".
In a planning sense this is a proper allocation of cash flow because it enables investors to make annual allowances for anticipated future expenses. However from a tax shelter standpoint any allocation of funds in anticipation of future expenses cannot be deducted under federal tax code until they are incurred and paid.
Rule of Thumb
These tax shelter implications are, of course, significant to real estate investors. Whereas expenditures classified as an operating expense could be deducted in the year of the expenditure, those classified as a capital improvement must be depreciated over the appropriate life of the improvement. So always seek good tax counsel if you own real estate investment property.