How Rental Property Income is Taxed

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If you are considering investing in rental properties, it is very important to understand the tax implications involved. Rental property income is taxed a bit differently than those on owner occupied properties or ordinary income taxes.

Taxes on rental property are complex and can easily complicate your taxes if you choose to buy a rental property. However, with some knowledge of rental property income taxes, it actually isn’t as bad as it might seem. Here is a quick introduction on how rental property income property is taxed, as well as helpful tax knowledge you will want to know.

How taxes on rental income works

If you plan to own a rental property and rent it out to tenants, you are probably wondering how the income you make will be taxed. First, it is important to define rental property income. According to the IRS, rental property income is payments you receive for the use or occupation of property. This obviously includes the monthly rent that comes from rental tenants.

In short, rental income is taxed as ordinary income. This means that any net income your rental property generates is taxable as ordinary income on your tax return. You, as the real estate investor, would pay tax based on your marginal tax bracket. For example, if your rental income for the year is $10,000 and you fall into the 22% tax bracket, you can expect to owe $2,200 back in taxes. However, that is the short version of how rental property income is taxed. There are also exceptions and ways investors can pay little to no taxes at all.

Calculating Rental Income and Expenses

While you already know rental income includes the regular payments you receive from your tenants, there are other types of rental income you might come across with your property. These secondary types of income include:

  • Advanced rent payments made by tenants before the period that covers it (usually at the first and last of the month).
  • A penalty fee received for the tenant terminating a lease.
  • Extra monthly rent fees such as parking fees, pet fees, or appliance rental fees
  • Any expenses paid by the tenant for services usually covered by the landlord (law care, painting, home maintenance, repairs, etc.). These are often in lieu of regular rent and based on fair market value of the service.
  • A portion of the security deposit that is not returned to the tenant after their lease ends. This income is used to pay for the damages caused by the tenant.

To calculate your rental income, you will also want to factor in the many expenses involved in owning and operating your rental property. Most of these expenses can be expensed the same year they are incurred, while others must be depreciated over a period of time. Rental expenses that can be deducted include:

  • Money spent towards advertising/marketing
  • Fees paid to property manager
  • Mortgage interest
  • Insurance costs
  • HOA dues or condo fees
  • Costs of repairs/maintenance/cleaning
  • Services you pay for (utilities, pet control, etc.)
  • Leasing commission
  • Property taxes
  • Professional or legal fees
  • Licenses and permits
  • Travel expenses

As you can see, there are many expenses to keep track of when owning a rental property. Go through each expense one-by-one to ensure all are accounted for. Some, like repairs, travel, insurance, interest and legal fees, may even be eligible for deductions.

Be sure to discuss all potential deductions with your tax advisor. Once you have your expenses, subtract them from the income earned from your rental property. The number you arrive at will be your taxable income before depreciation.

Determining Depreciation

When calculating your rental property income includes deducting depreciation. As one of the best tax advantages property investors can get, this is one you will not want to miss. It is by deducting depreciation that many investors use to reduce their amount of taxable income. Through this they are often able to show no income and make more profit.  

Depreciation is a non-cash expense that can be deducted on your tax return for a period of time. These deductions must follow tax laws and guidelines set by the IRS. When it comes to property expenses, there are two types. These include those smaller purchases that can be deducted at once and those larger assets that are deducted through depreciation over time.

Real estate is a larger asset that usually has a useful life of several years or more. As a result, depreciation is deducted from it for a set period of time the IRS deems it to have a useful life. For residential rental properties, properties are deductible for 27.5 years. For commercial rental properties, properties are deducted for 30 years.

Qualified Business Income Deduction

There are more ways to reduce your taxable income than just depreciation. After deducting expenses and depreciation, investors can get yet another favorable tax break. The Qualified Business Income Deduction (QBI) allows self-employed people or small business owners to deduct up to 20% of their pass-through business income.

Entities that are eligible for these deductions include sole proprietorships, partnerships, S corporations, and limited liability companies. Rental income from a property also falls under eligibility guidelines. Rules for taking QBI deductions can be quite complicated. Make sure you fully understand the IRS’s rules on QBI and consult with your tax advisor to ensure you get the right deductions.

Reporting Rental Income

Property investors report their rental income on their tax return using Form 1040, Schedule E. Form 1040 is the income tax form that anyone filing federal taxes will need to submit. Along with requiring the usual personal information such as social security and dependents, it will also require investors to report their rental earnings.

Schedule E is a crucial form for rental investors as it is used to report income loss from such properties. Here, you will report your total income, expenses, and depreciation for each rental property that you own. If you have more than three rental properties, you’ll need to fill out a second Schedule E and only report the totals on one of the forms.

Investors want to provide the IRS with accurate information. To ensure everything runs smoothly during tax season, it is important  to keep well-maintained records of their expenses and rental income. Keep and file away records of any rent checks, expense receipts, and any relating paperwork or financial statements.

If you have a property manager or work with a property management company, they will provide you with a year-end profit and loss statement you can also use. These records will come in handy when making deductions and verifying numbers. Of course, be sure to review this profit and loss statement and include anything your property manager may have left out or was not aware of.

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Final Thoughts

Managing rental real estate income can be a complex undertaking, especially when it comes to understanding how rental income is taxed. Whether it's a residential rental property or an investment property, the key is to accurately report rental income and understand the tax implications. From the purchase price to security deposits, the way you calculate rental income tax involves understanding both your total annual rental income and the deductible expenses you can claim. It's essential to consider elements like tax deductions and how they impact your taxable rental income.

To calculate rental income, you must consider not only the revenue generated but also subtract various allowable deductions, which can include anything from mortgage interest to maintenance costs. These factors help determine your rental real estate income and ensure you're adhering to the necessary guidelines for rental income tax. It can be an intricate process, but having a thorough understanding will help maximize your benefits and minimize your liabilities.

Given the complexities surrounding how rental income is taxed, consulting with a tax professional can be an invaluable step. They can help you navigate the intricacies of rental income, including how to calculate rental income tax, understand security deposits, and identify the right tax deductions for your specific situation. Properly managing your rental property investment goes beyond the purchase price; it's about optimizing your financial future with diligent planning and execution. By relying on expert guidance and understanding the essential principles, you can ensure that your investment remains profitable and compliant with all tax regulations.