If you own rental real estate, you must be aware of tax responsibilities on the federal, state, and (in some cases) local levels. With this knowledge, you can ensure that all rental income is reported on the applicable tax returns.
Types of Rental Income
As an investor, correctly categorizing your rental income is critical for both tax and financial planning. In general terms, rental income can be classified into two categories:
- Active income: This stems from hands-on activities like short-term rentals or managing properties. Examples include daily rentals or properties where you’re significantly involved in the operations.
- Passive income: This is generated from long-term leases where you aren’t actively involved in the day-to-day operations.
Taxable vs. Non-taxable Rental Income
Recognizing the distinction between taxable and non-taxable rental income is fundamental to ensuring tax compliance.
What constitutes taxable rental income?
Taxable rental property income primarily includes the rent you receive from your tenants on your residential rental property. This not only encompasses the regular monthly payments that your tenant pays but also any advance rents or fees for canceling a lease.
If a tenant provides services (like property maintenance) in lieu of rent, the fair market value of those services is also considered taxable.
Examples of non-taxable income
There are specific instances where the rental income you receive might be exempt from taxes. For example, if you rent out your personal residence for fewer than 15 days within the calendar year, the rent payment income is generally non-taxable.
Additionally, security deposits that you plan to return to your tenants at the end of a lease aren’t considered income, unless you keep a portion for unpaid rent or damages.
Rental Income Tax Rates
Rental income taxed is subject to both federal and state taxation, each having its own set of rates and regulations.
At the federal level, taxes on rental income are determined by your overall taxable income, which means as your income rises, so does the percentage you owe. You can find the IRS tax and earned income credit tables here.
State tax rates, on the other hand, vary depending on your residence, with some states imposing no income tax at all.
Familiarize yourself with both federal and state tax structures to ensure you’re meeting obligations and optimizing potential deductions.
Strategically managing your deductible expenses can reduce your taxable rental income. Familiarizing yourself with common deductions ensures you’re not leaving money on the table.
Here’s a list of common rental property tax deductions:
- Mortgage interest: Interest paid on a loan used to purchase or improve the rental property can be deducted.
- Depreciation: Over time, rental property naturally wears out. This decline in its value can be deducted annually.
- Property taxes: Taxes paid to local governments based on the property’s assessed value are deductible.
- Maintenance and repairs: Costs incurred to maintain or restore the property to rentable condition can be deducted.
- Insurance premiums: Premiums for property, liability, and other types of insurance related to your rental are deductible.
- Utilities: If you cover utilities for your rental property, those expenses are deductible.
- Travel expenses: Costs related to traveling for property maintenance or business-related activities can be deducted.
- Legal and professional fees: These are expenses for services like attorneys, accountants, or property management.
Depreciation and Amortization
Depreciation and amortization are important tax tools for rental property owners.
Depreciation allows landlords to deduct the gradual decline in the value of tangible property, like the building itself, over a set period, typically 27.5 years for residential real estate in the U.S. This recognizes the wear and tear properties experience over time.
Amortization pertains to intangible assets, like a zoning variance or a leasehold interest. Instead of deducting the entire cost at once, landlords spread out the deductions over the asset’s useful life.
Both practices can significantly reduce your taxable income.
How to Calculate Rental Income Taxes: The Basics
Calculating rental income taxes involves a clear understanding of both your income and allowable real estate tax deductions. Follow these steps for a more structured approach:
- Determine gross rental income: Begin by tallying all the rent payments you’ve received during the year, including advance rents or any other fees paid by the tenant.
- Factor in additional income: If you’ve received income through services in exchange for rent, add this to your gross rental income.
- Deduct allowable expenses: From your gross rental income, subtract deductible expenses. These can include mortgage interest, property taxes, insurance, maintenance costs, and depreciation.
- Calculate net rental income: Gross rental income minus allowable expenses equals your net rental income.
- Apply tax rates: Use your net rental income figure, consider your overall income bracket, and apply the relevant federal and state tax rates.
- Consider self-employment taxes: If rental activities are your primary business, you might also owe self-employment taxes.
How to Report Rental Income
Effectively and accurately reporting rental income is pivotal for tax compliance and financial accuracy. These points will help you navigate the process:
- Gather relevant documents: Collect all records of rent receipts, expense invoices, and other relevant financial documents.
- Use the right IRS form: Typically, rental income is reported on Schedule E (Supplemental Income and Loss) of the IRS Form 1040.
- List each property separately: If you own multiple properties, individually report the income and expenses for each one on Schedule E.
- Report all income: Detail every dollar of rent received, including advance rents, services rendered in exchange for rent, and other nontraditional income sources.
- Detail allowable deductions: On Schedule E, list out all deductible expenses. This can include costs like interest, taxes, and depreciation.
- Transfer totals to Form 1040: The net figure from Schedule E will then be transferred to your main tax return, IRS Form 1040.
Remember, you also need to file a state tax form based on the location of your rental properties.
No two real estate investors share the same rental property strategy. For this reason, the way you tackle rental income taxes will be unique. Here are some special considerations that could pertain to your specific situation:
Vacation rentals and short-term rentals
Properties rented out for fewer than 15 days a year, often considered vacation rentals, generally do not require you to report the income.
However, if you’re consistently renting an investment property on platforms like Airbnb or Vrbo, it’s essential to report this income.
Note: Specific tax deductions are also available for these rental types, so keep meticulous records of related expenses.
Passive activity loss rules
Rental activities are often considered passive by the IRS, meaning losses from these activities can only offset passive income, not active income (like wages). There are exceptions, especially for active participants in the rental activity, but investors must understand these rules.
Renting a portion of your primary residence
If you rent out a section of your primary home, such as a basement or a spare bedroom, you’ll need to allocate expenses between the rental activity and personal use. Only the portion attributed to the rental activity can be deducted.
Also, if you qualify for the home sale tax exclusion, renting part of your primary residence could affect your eligibility.
Final Thoughts for Real Estate Investors
Rental real estate offers significant financial opportunities, but it’s essential to effectively manage your tax responsibilities.
Understanding these details and putting them into practice for your tax benefit can help maximize profitability and ensure tax compliance.
Dreading tax season?
Not sure how to maximize deductions for your real estate business? In The Book on Tax Strategies for the Savvy Real Estate Investor, CPAs Amanda Han and Matthew MacFarland share the practical information you need to not only do your taxes this year—but to also prepare an ongoing strategy that will make your next tax season that much easier.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.