How is Rental Income Taxed?

What is Rental Income?

Rental income is the revenue you receive as a landlord in exchange for allowing tenants to occupy your property. This can include residential units (houses, apartments, lofts), commercial spaces (offices, retail storefronts), or even industrial buildings. A lease agreement is used to outline the rental terms, such as the amount of rent to be paid, how often payments are due, and the duration of the lease.

When you rent out your property, the income you receive counts as taxable rental income. This income includes cash payments as well as the fair market value of any services or goods you receive in exchange for rent.

For nearly every landlord, taxes are based on a cash accounting system. This means you report rental income when you actually receive the money from your tenant and deduct your rental expenses when you pay them out.

How is Rental Income Tax Calculated?

The IRS considers rental income "ordinary income" for tax purposes. This means you'll add it to your other income sources when filing your tax return. Rental income is generally taxed at your regular income tax rates, unless you file as a corporation (LLC, S-Corp). Depending on which state you live in, you could owe taxes at both the federal and state level (except in states with no income tax).

While considered ordinary income, the IRS considers rental income "passive" income and requires separate reporting of rental income from your regular wages that are reported on a W-2. Most real estate investors file a Schedule E, a section of Form 1040 dedicated to reporting supplemental income and losses.

Only the net income generated by your rental property is taxable. Net income is calculated by subtracting all acceptable expenses from your gross rental income. For example, if your gross rental income is $10,000 for the year and your deductible expenses total $6,000, your net rental income would be $4,000. This net income would then be taxed at the corresponding tax bracket rate.

1. $10,000 (gross) - $6,000 (deducted expenses) = $4,000 (net taxable rental income)

What Counts As Rental Income?

Rental Income

The IRS describes rental income as "any payment you receive for the use or occupation of the property" and in addition to monthly rent payments, rental income includes:

1. Advance rent payments. These are any rent payments received upfront. If you collect a tenant's first and last month's rent upfront, both payments count as income in the year you receive them.
2. Security deposits. If you plan to return a tenant's security deposit at the end of the lease, it does not count as rental income. However, any portion you withhold to cover damages becomes taxable income. Security deposits used as a final rent payment are regarded as advance rent.
3. Lease cancellation payments. If a tenant pays you to cancel a lease early, the amount that you receive is considered rental income.
4. Tenant-paid owner expenses. If your tenant pays for an expense they aren't responsible for (e.g., appliance repair) and deducts it from their rent, you must report that deducted amount as income.
5. Property or services received instead of rent. If you agree to forgo rent in exchange for a service or property (e.g., tenant-installed fence, painting), you must include the fair market value of that service as rental income.
6. Lease with an option to buy. If the rental agreement gives your tenant the option to buy the property, the payments that you receive are considered rental income.
7. Partial interest. If you co-own a rental property, only report your share of the rental income (e.g., 50% ownership = 50% of rental income reported).

Rental Expenses

Landlords can reduce their tax burden significantly by claiming deductible expenses related to their rental income. These deductions must meet three criteria to be allowed:

1. Ordinary: The expenses must be common and expected costs associated with operating a rental property. Examples include maintenance, repairs, and utilities.
2. Necessary: The expenses must be essential for the upkeep or management of the property. This can include advertising for tenants, insurance premiums, and maintenance supplies.
3. Directly Related: The expenses must have a clear connection to the rental property itself. Costs for materials, repairs, and supplies used for maintenance are generally deductible.

It's important to keep in mind that improvements that enhance the property's value are not considered a deductible expense. You can, however, deduct the cost of repairs that maintain the property's existing condition. Additionally, if a tenant pays for an expense that qualifies as a deductible rental expense, you can claim that deduction as well.

Now let's delve into some of the most common expenses that can be deducted in relation to your rental property during the tax year:

1. Property management and leasing fees
2. Cleaning, repair, and maintenance costs
3. HOA or condominium dues
4. Landscaping fees
5. Utility services such as water, trash, or pest control
6. Mortgage interest
7. Rental or sales taxes
8. Property taxes
9. Legal and professional fees such as your accountant or attorney
10. Insurance costs

After collecting rent throughout the year, you'll need to determine your taxable income for tax filing purposes. This involves subtracting all allowable rental expenses from your gross rental income (total rent collected).

Let's look at an example: Imagine you collect $18,000 per year in gross rental income. If your annual expenses associated with owning and operating the property total $8,000, you're left with a net income of $10,000. This net income, also known as taxable income before depreciation, is what will be taxed as ordinary income on your tax return.

In simpler terms, the more deductible expenses you have, the lower your taxable income and potentially the less tax you'll owe. For instance, if you fall into the 22% tax bracket with a net rental income of $10,000, your tax liability would be around $2,200.

Lower Rental Income Taxes Through Depreciation

Depreciation is a valuable tax benefit for rental property owners. It allows you to spread out the cost of acquiring and improving your property (not including land) over its useful lifespan. This reduces your taxable income year after year.

Here's what qualifies a rental property for depreciation deductions:

1. Ownership: You must legally own the property, even if financed by a mortgage.
2. Income-Producing Use: The property must be used for business purposes, such as generating rental income.
3. Deteriorating Asset: The property must have a determinable useful life, meaning it's subject to wear and tear, becomes obsolete, or loses value naturally over time. Land itself is not depreciable because it doesn't deteriorate.
4. Minimum Lifespan: The property must be expected to last for at least one year.

Keep in mind that costs associated with land improvements (clearing, planting, landscaping) are considered part of the land value and are not depreciable. They are factored into the overall property value, which is a different tax concept.

How to Calculate Depreciation on a Rental Property

As a rental property investor, you can claim the cost of acquiring and improving your property over its "useful life" as determined by the IRS. For residential rental properties, this useful life is 27.5 years, while commercial properties have a 39-year timeline.

The calculation involves three key steps:

1. Cost Basis: This is the total investment in your property, including the purchase price, closing costs, and any capital improvements made.
2. Separate Land Cost: Land itself is not depreciable. Therefore, you'll need to allocate a portion of the total cost basis to the land value and subtract that from the remaining amount to determine the depreciable value of the building itself.
3. Straight-Line Depreciation: This is the most common method used for rental properties. It involves spreading the depreciable cost basis (building value) evenly over the useful life (27.5 years for residential properties). This translates to a yearly depreciation amount you can deduct from your taxable income.

For example, let's say your rental property has a cost basis of $100,000, with a portion allocated to land value. The remaining depreciable cost basis for the building might be $80,000. Using straight-line depreciation, your annual deduction would be $80,000 divided by 27.5 years, resulting in $2,909 per year. It's important to note that depreciation deductions only begin once the property is placed into service (rented out) and are typically prorated for the first and last year of ownership.

Tax Implications and Seeking Professional Help

While depreciation lowers your taxable income each year, keep in mind that the IRS might apply "depreciation recapture" when you sell the property. This means you might be taxed on some of the previously claimed depreciation deductions.

Given the complexities involved, consulting with a tax professional for guidance on calculating and claiming depreciation for your rental property is highly recommended.

Deducting Mortgage Interest

Mortgage interest is a popular rental property deduction. You can usually deduct mortgage interest as a business expense for investment properties like a rental.

How to calculate rental mortgage interest

Each year, you'll receive an IRS Form 1098 from your mortgage company. This form details the total amount of interest you've paid on your mortgage throughout the year.If your mortgage payment includes an escrow portion that covers property taxes and insurance, this information should also be included on the 1098 form.

It's important to understand where you need to report mortgage interest on your tax return. Interest paid on a home mortgage for your primary residence goes on Schedule A of Form 1040 or 1040-SR. In contrast, interest paid on a mortgage for a rental property is reported on Schedule E, dedicated to reporting supplemental income and expenses related to rental properties.

How to report mortgage interest expense

Your mortgage lender will also send a copy of Form 1098 to the Internal Revenue Service (IRS), who will then use that information to cross-reference what you report on your federal tax returns.

In addition to reporting rental income and mortgage interest expense, Schedule E is also used to report operating expenses to the IRS, including advertising, maintenance, repairs, property management fees, supplies, and taxes among other key items.

Frequently Asked Questions

Is Rental Income Earned Income?

The IRS distinguishes between "earned income" and "unearned income" when it comes to taxation. Earned income typically comes from wages, salaries, or business profits from active participation. Rental income, on the other hand, falls under the category of unearned income, alongside interest, dividends, and other passive sources of income.

There are a few exceptions where rental income might not be considered taxable. For example, if you occasionally rent out a property you use as your personal residence for less than 15 days in a year, the income generated wouldn't be subject to taxes. However, you are unable able to deduct any rental-related expenses from your taxes in this situation.

If your property serves both rental and personal purposes throughout the year, things get a bit more nuanced. You'll need to split your expenses between personal and rental use based on the respective usage duration. Only expenses associated with the rental period can be deducted on your tax return. This approach mirrors how you would separate business and personal deductions for a traditional business.

Can Landlords Deduct Unpaid Rent from Rental Income Tax?

The short answer is "no." Unpaid rent is not a tax deductible rental expense.

While the idea of deducting unpaid rent might seem appealing, the reality is a bit more complex. According to the IRS, you can only deduct unpaid rent if you report it as income in the year it was originally due. This essentially means switching from the cash accounting method (reporting income when received) to the accrual method (reporting income when it's due).

For most landlords, the hassle of switching accounting methods does not pay off in the end. The deduction for unpaid rent only serves to offset the income you've already reported, resulting in no additional tax savings. There's also no option to claim unpaid rent as a casualty loss on your taxes.

On the bright side, the IRS doesn't consider unpaid rent as taxable income, so you don't need to report it on your tax return.

What happens if I don't pay taxes on my rental income?

Rental income is considered taxable income by the IRS, and failing to report it on your tax return can lead to a range of unwanted consequences. Here's what you might face:

1. Penalties and Interest: The IRS can impose penalties and interest charges on the unreported income.
2. Audits: Unreported income can trigger an audit, which can be a lengthy and stressful process.
3. Criminal Charges: In severe cases, the IRS may pursue criminal charges for deliberate tax evasion.
4. Liens and Levies: To collect unpaid taxes, penalties, and interest, the IRS may place liens on your property or even levy (seize) your assets.

By accurately reporting your rental income and maintaining excellent record keeping, you can avoid these potential consquences and ensure you're filing your taxes correctly.

Do I pay taxes on rental income from another state?

Even if your primary residence is in a different state, you'll still need to file a tax return in the state where your rental property is located. This typically involves submitting IRS Form 1040 or something similar.Tax laws can vary by state and locality, so it's important to stay up-to-date on any specific requirements that might apply to your rental properties in different locations.

The Bottom Line

While investing in real estate offers attractive tax benefits through various deductions, rental income is still taxable. To ensure a hassle-free tax filing process, maintain meticulous records of both your rental income and rental expenses throughout the year. Remember, consulting with a financial advisor and tax professional is always a wise move when navigating your finances and rental properties.

This blog is for informational and educational purposes only, and does not claim to be official legal advice. Always consult with a lawyer or Certified Public Accountant to fully understand your Tax responsibilities.