Investing Assets & Markets Real Estate Investing Rental Property Operating Expenses and Cash Flow It's as much about what's not included as what is By Jim Kimmons Jim Kimmons Jim Kimmons is a real estate broker and author of multiple books on the topic. He has written hundreds of articles about how real estate works and how to use it as an investment and small business. learn about our editorial policies Updated on September 19, 2022 Fact checked by Yasmin Ghahremani In This Article View All In This Article What Is an Operating Expense What's Not Included in Operating Expenses Rental Property Operating Expenses Frequently Asked Questions (FAQs) Photo: fStop Images / Getty Images When you're investing in real estate, you want to create a rental property cash flow analysis to make sure you're going to have a positive cash flow and profit. But some investors make mistakes about which costs should be classified as operating expenses. That can skew the outlook for a property, causing you to possibly make a bad investment decision. Or it could result in faulty financial reporting of a property you already own, making it harder to tell how well your rental is actually performing. Here, we'll break down what exactly is and isn't included in operating expenses. Key Takeaways Understanding operating expenses helps you determine what kind of cash flow and profit you can expect from a rental property investment, or how well a property you already own is performing.Operating expenses are maintenance costs that ensure the property can produce income, such as property taxes, insurance, and management fees.Mortgages, capital expenses, income taxes, and depreciation are not considered operating costs. What Is an Operating Expense Operating expenses are costs that are necessary to maintain a property and make sure it can produce income. They're costs that affect the day-to-day operation of the property. What's Not Included in Operating Expenses It's helpful to first know what's not considered an operating expense. Mortgage Payments "Debt service" is a major component of cash flow, positive or negative. Monthly payment is necessary for non-cash purchases. But when you're evaluating possible rental property purchases and you see a figure in the financials for operating expenses, a mortgage payment isn't included in that number. That's because financing terms are different for different investors, and your interest rate or down payment aren't predicted upfront. You'll not only have to pay those other expenses but your principal and interest payments as well. Always be sure to analyze the cash flow of the investment with great care. Depreciation Depreciating your rental property is one of the major perks involved with cash flow—the money you either take out of your pocket or put into your pocket from your rental enterprise. But it's not included in your operating expenses. The IRS allows you to depreciate a rental home over 27.5 years. Take the value of the home and subtract out the land value (which doesn't depreciate in value). Now divide the result by 27.5 to get the annual amount you can claim as a tax deduction. Remember, this is money you really haven't spent. It's just a calculation for tax purposes. Consult with an accountant to nail down the finer details. Capital Expenses Money you spend on repairs and improvements such as a new roof or a water heater are capital expenses. These can vary by investor, so they're not included in operating expenses. For example, one investor may choose to upgrade fixtures while another does not. Investor Income Taxes Property taxes are included in operating expenses, but income taxes are not. These are not directly related to the property's ability to produce rental income, so you wouldn't include them in operating expenses. Rental Property Operating Expenses There are few surprises in what is included in operating expenses, although identifying them and calculating them can be tricky in some cases. These are considered operating expenses because they're linked to the daily operation of the property and affect its ability to be rented. The expenses listed here are also tax deductible. Property taxes: These are usually the largest operating expense for real estate investments. It's recommended you get a detailed analysis of the city's or municipality's budget to estimate future increases in real estate taxes. Marketing and advertising: These are expenses associated with running ads for tenants, as well as for hosting and maintaining a website or blog dedicated to your rental business. Insurance: Your annual insurance premium is deductible as an operating expense even though it might also be escrowed and included in your mortgage payments. Utilities: You can deduct as an operating expense any utilities that you pay, including water, sewer, and trash collection. Management: You can deduct the cost in the year paid if you hire professional management. These fees vary, but often cost about 8% of the monthly rent. Maintenance and repairs: You can't deduct major items like renovation, although they're often depreciable for tax purposes. You can deduct normal maintenance and repairs to the dwelling, however. Landscaping and pool care: These are operating expenses and they're deductible as well. Accounting and legal: Fees you pay to an accountant or attorney related to work performed for your rental property are deductible as operating expenses. Snow removal and pest control: These are valid operating expense deductions as well. Frequently Asked Questions (FAQs) Why is it important to know what costs are included in operating expenses? Accurately estimating operating expenses for a rental property allows an investor to make a correct analysis of the property's potential for generating cash flow. It also helps you identify opportunities for increasing profits.If you already own the property, knowing your operating costs helps you evaluate just how well the property is performing. What is a good percentage for operating expenses for rental property? Depending on the type of real estate, operating expenses may be 35-80% of gross operating income. To calculate the operating expense ratio, you'd divide the monthly expenses by the monthly rent. For a basic house or duplex, this is typically 35-45%. But luxury real estate, such as a vacation home, may have an expense ratio of 70-80%. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. New York University. "Understanding Net Operating Income." IRS. "Publication 527, Residential Rental Property." Page 11. Mike E. Miles, Gayle L. Berens, Mark J. Eppli, Marc A. Weiss. "Real Estate Development Principles and Process Fourth Edition." Page 179. Urban Land Institute. Stessa. "Which Expenses Are Operating Expenses for Rental Property?" Zillow. "Investing 101: Estimating Rental Property Expenses."