How Is Rental Income Taxed? What Landlords Need to Know
- Jan 24, 2023
- 8 min read
Are you a rental property owner or investor? If the answer is yes, you may have questions regarding how the government taxes the income you accrue from your properties. How is rental income taxed, and what deductions can you apply to your returns? Get the answers you need below.
How Is Rental Income Taxed Federally?
If you own a property and rent it out to someone else for at least 15 days per year, the Internal Revenue Service considers it a rental property and will tax it accordingly. So, how much is rental income taxed? In simplified terms, any income you generate is susceptible to the same income tax rates within your tax bracket.
However, when you ask the question, “Is rental income taxable?” the answer is more complex. Yes, rental income is taxable. However, not all of it is.
Rental Income Tax Rate
How much is rental income taxed? Generally, your rental property’s tax rate depends on whether you are an active or passive owner. An active property owner would take on management duties or have involvement in development and construction. If you play a role in daily operations or lead employees at the property, the rental income you receive is likely active. However, if you have a more silent part, which is common when property owners hire management services, your participation is passive.
How Is Rental Income Tax Calculated?
Calculating rental income tax begins with identifying taxable income. Examples include:
- Monthly rent payments
- Additional fees, such as parking or pet fees
- Penalty fees paid by the tenant
- Rent advances
- Any retained portion of the security deposit
You would not include any portion of the deposit that you return to the tenant.
Additionally, suppose you allow the tenant to deduct an amount of the rent to cover maintenance, landscaping, or anything a vendor would typically handle. In that case, you must still include that as taxable income. You will include it in deductible expenses next.
You can deduct expenses directly related to the property, such as the cost of cleaning, repairs, routine maintenance, landscaping, and utility services. In addition, if you pay homeowner association (HOA) or condominium fees or mortgage interest, those are also deductible. You can even subtract the insurance cost and expenses paid to professionals, such as accountants or attorneys. After you subtract all available deductions, you have your pre-depreciation taxable income.
Rental Income Tax Calculation Example
Assume you will collect $50,000 in gross income and pay $10,000 in expenses related to the property’s ownership and operation. In that case, your taxable income amounts to $40,000 before depreciation.
What Are Rental Property Tax Deductions?
Consider what expenses you can deduct from that income when calculating rental income tax.
What You Can Deduct
The IRS allows you to deduct most expenses related to owning and operating a rental property. Some deductible expenses relate specifically to ownership, such as mortgage interest and depreciation value. Others are operational expenses, such as repairs and utilities.
Mortgage payments include interest. If your rental property is still under a mortgage contract, you can deduct the total interest you paid for the year.
Maintenance and Repairs
Maintenance and repair costs can change drastically from year to year and leave a significant dent in the income generated by tenants. Keeping track of structural, electrical, plumbing, and aesthetic work conducted on the property allows you to deduct those expenses.
Depreciation refers to the deterioration of your property’s value over time. The IRS considers 27.5 years to be the average lifespan of a rental property in its original form. Therefore, you can deduct a portion of the home’s value from your taxable income for 27.5 years.
How To Calculate Depreciation
To calculate the deductible depreciation, take the value of your property minus the land value and divide it by 27.5. For example, if you paid $500,000 for the property, and the land is worth $50,000, your depreciation value would be $450,000 divided by 27.5, equaling $16,363.64. You can deduct that amount from your taxable income as well.
Insurance expenses related to rental property needs are deductible. Rental-related policies include flood, fire, liability, and theft coverage.
Employees and Contractors
Is rental income taxable if you hire anyone to work on the property? Yes, but you can deduct the value of their salary from taxable income. This includes property managers, office staff, and maintenance workers. The same is true if you hire anyone to handle contracted jobs.
Legal and Professional Services
Legal services are part of operating expenses. Therefore, you can deduct those expenses if you hire attorneys, accountants, property managers, or any other professional to help with the property.
Marketing is a business expense for rental property owners. If you pay for advertising in any medium, you can deduct those costs from your taxable rental property income.
You can deduct utilities you pay for the tenant. For example, if you include water, sewage, and electricity as part of the rental agreement, you can deduct those expenses from your income.
Travel & Transportation
As a landlord or investor, you may need to travel for property tours or buy maintenance and repair supplies. You can deduct all travel expenses related directly to the property. However, keep these deductions reasonable because the IRS closely monitors them. A questionable travel deduction could result in an audit.
Qualified Business Income (QBI)
After deducting all operational, ownership, and depreciation expenses, you may qualify for a QBI deduction. When you ask, “How is rental income taxed?” you must consider your role as the property owner. This deduction can amount to as much as 20% of pass-through income for business owners registered as a sole proprietorship, partnership, or S corporation. Some trusts or estate plans may qualify as well.
Documenting Your Rental Property Expenses
Tracking your rental property expenses is vital when the time comes to file your tax returns. Staying organized ensures you get the most out of your investment. In addition to copies of your bank statements and prior-year tax returns, you will also need to keep records of the following:
- Mortgage and loan documents, as well as records from the purchase or sale
- Expense receipts for utilities, repairs, maintenance, marketing efforts, and tenant screening reports
- Copies of maintenance requests
- Proof of rental agreements and rent payments
- Invoices from vendors and other parties that worked on the property
You can track all expenses through accounting software. However, most property owners find it appropriate to hire an accountant to handle documentation.
How Is Rental Income Reported?
The IRS requires rental property owners to complete a 1040 form when filing an individual tax return or a 1040-SR if they are senior citizens. To report depreciation, you also need a 4562 form. These are Schedule E forms, which allow you to include more than one rental property. As your portfolio grows, you may need additional Schedule E forms.
What Should You Know About Selling Your Rental Property?
Selling your rental property has tax implications:
- The profit you make from the sale is subject to capital gains tax unless you have owned the property for under a year.
- If you took advantage of the depreciation deduction, you would owe taxes on the total value of your depreciation claims over the years.
- You can avoid paying capital gains taxes if you reinvest your profits into another property, but you must follow the specific rules for this loophole.
Rental property owners will need an intermediary to conduct the exchange that allows them to avoid capital gains taxes. This person or agency holds the funds you received from the sale until you purchase the new property, which must be of equal value or higher than the original property.
How Can a Property Management Service Help?
If you own a large rental property with several units or have multiple rental properties, you can hire a management service and deduct that expense from your taxable income. A qualified property management company will evaluate your property to ensure you charge the best rental rate for what you offer and will vet tenants to protect you from potentially costly issues. This company will draft leases, collect rent, and maintain the property. It also arranges repairs and keeps a transparent relationship with you about the budget.
Need Rental Income Tax Assistance?
How is rental income taxed? This is a complex question with situational circumstances you must consider. New property owners or anyone growing their rental portfolio should consider speaking with a tax professional to adequately identify all available deductions and make sure you receive the maximum return on your investment.
Can I Avoid Paying Taxes on My Rental Income?
You can avoid rental property taxes if your property qualifies as a personal dwelling. To be a personal dwelling, you must live in the property for 10% of the total days you rented it out each year or 14 days if 10% equals less than two weeks. This also means you cannot deduct the operational costs or depreciation you would do for a rental property. However, you can still deduct real estate taxes, casualty losses, and mortgage interest.
How Does the IRS Know if I Have Rental Income?
The IRS can learn about a rental property through tax audits, public records, real estate documentation, or an informant. However, it is better to report the property yourself and avoid penalties.
Is Rental Income Taxed as Capital Gains?
If you sell your rental property, you will pay capital gains taxes on the profits you made from the sale unless you use the profits to purchase another investment property.
Are Security Deposits Taxable?
No, security deposits are typically not taxable because you intend to return them to the tenant. However, if a lease concludes and you need to keep all or part of the deposit, it becomes taxable income.
Contact Us Today For All Your Rental Management Needs
Confused by all the intricacies of rental income tax? The professionals at All County Property Management for professional property management can help. Call us today at 1-855-245-7368.
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