There are more than 50 million housing units occupied by renters in the U.S., according to the most recent census. Throughout the year, landlords use rent money collected from tenants to pay the bills and mortgage. But when tax time comes around, many investors are unsure of how rental income is taxed.
To clear things up, let’s look at the difference between rental income and earned income and the potential tax consequences of each type of income.
- Earned income generally requires withholding and paying federal, state, and local income tax and FICA.
- Rental income is usually taxed as passive income, similar to stock dividends or real estate investment trust (REIT) distributions.
- Tax on rental income is paid based on an investor’s marginal income tax rate.
- Ways to reduce taxable income from a rental property include depreciation, deduction of owner expenses, and reasonable travel expenses.
What is rental income?
Several items are considered to be rental income, according to these tips from the IRS:
- Application fees paid by a prospective tenant.
- Amounts received as monthly rent, including late fees, if any.
- Rent paid in advance, such as the first and last months of rent.
- Fees paid to cancel a lease early.
- Value of work done by a tenant in lieu of paying the rent, such as painting a house in exchange for free rent.
- Any portion of a refundable security deposit held by a landlord and used to cover unpaid rent or damage caused by a tenant.
Remember that a refundable security deposit received from a tenant isn’t rental income at first because the deposit is meant to be returned to the tenant. When a landlord receives a tenant security deposit, the payment is recorded on the real estate balance sheet as a short-term liability.
Understanding the difference between an expense and a liability can be complicated. That’s why so many landlords use rental property financial management software from Stessa to properly keep track of income, expenses, assets, and liabilities.
Instead of having to learn double-entry bookkeeping, a landlord simply enters the payment as a deposit. Stessa debits the balance sheet with the deposit liability and credits a landlord’s business account used to hold the security deposit.
Earned income vs. rental income
Real estate investors can receive two main types of income: rental income (sometimes known as passive income) and earned income (sometimes known as active income).
Earned income is income generated by an activity in which a taxpayer actively participates. Examples of earned income include wages reported on a W-2 from a full-time job, cash tips or sales commissions, winnings from a recent trip to the casino, or self-employment income earned from a small business or side gig.
What all of these types of earned income have in common is that a taxpayer has materially participated in an activity in exchange for a payment. Earned income is subject to payroll tax withholding, including federal income tax, state and local income tax (if applicable), Social Security and Medicare (also known as Federal Insurance Contributions Act, or FICA), and state and local unemployment taxes.
In most cases, income received from a rental property is treated as passive income for tax purposes. That means an investor generally doesn’t need to withhold or pay payroll taxes because most investors own rental property in addition to having a job.
Examples of passive income are interest and dividend payments from bonds or stocks, distributions from a REIT or real estate partnership, and net income received from a rental property. Taxes on rental income are paid based on an investor’s federal and state income tax bracket.
An exception to the rental income rule would be if an investor works in real estate full time. Situations like these can be complicated, which is why an investor may wish to consult with a certified public accountant (CPA) or tax professional.
How rental income is taxed
Income from rental property is taxed based on an investor’s marginal income tax rate. To illustrate, assume an investor is married filing jointly and reports a total taxable income of $250,000 from all sources. According to the most recent guidance from the IRS for tax year 2022, the marginal tax rate would be 24%.
Example of taxes on rental income
Now let’s assume an investor owns a single-family rental home worth $150,000. For depreciation purposes, the lot value is $10,000 and the annual income and expenses reported on Schedule E (Form 1040) look like this:
Rents received: $18,000
Cleaning and maintenance: -$1,200
Management fees: -$1,440
Mortgage interest (if property is financed): -$4,500
Property taxes: -$1,800
Total expenses: -$15,731
Total rental real estate income (or loss): $2,269
If an investor is in the 24% tax bracket, federal income tax paid on the net rental income in this example would be $544.56.
Taxable rental income vs. cash flow
Note that rental income for tax purposes isn’t the same thing as rental property cash flow, due to an investor claiming a non-cash depreciation expense. Assuming the total mortgage payment (principal and interest) was $6,444 per year, the annual cash flow received from the rental property in this example would be $5,416:
Rental income: $18,000
Operating expenses (excluding mortgage): $6,140
Mortgage payment: $6,444
Net cash flow: $5,416
So, even though the investor in this example received $5,416 in net cash flow, income taxes are only paid on $2,269 thanks to the power of depreciation.
What happens if rental income is negative?
The example above assumes there is taxable rental income, but in the real world of real estate investing, a rental property may generate a loss for tax purposes. For example, it could take longer than expected to find a qualified tenant and, consequently, the rent collected is less than anticipated. Or, repair costs could be higher than what was budgeted for.
Although there are advantages to the way rental income is taxed–such as not having to pay payroll tax–one of the drawbacks is that an investor cannot take a loss on the activity. While loss from a rental property can be used to offset other passive income gains (such as stock dividends), any net loss must be carried forward and can be used to offset passive income gains in future tax years.
For example, imagine an investor has a $1,000 loss from a rental property and there are no other passive income gains. If the property generates a taxable rental income of $2,269 the following year, an investor may use the $1,000 loss carryforward to reduce the taxable rental income for that year to $1,269.
Tips for reducing taxable rental income
Investors should report all income and expenses. Generally speaking, the tax laws in the U.S. are favorable to real estate investors. Here are some other ways an investor may be able to reduce taxable income from a rental property:
In addition to deductions for normal property operating expenses, such as repair and maintenance, property taxes, and insurance, an investor also may be able to deduct owner expenses to reduce taxable net income, including:
- Home office expenses when space in a primary residence is used for business purposes.
- Supplies such as printer paper, ink, pencils, or mobile phones used for business.
- Continuing education in real estate investing.
- Dues and subscriptions for investor clubs or real estate trade publications.
- Legal and professional fees related to a rental property business.
An investor also may be able to deduct reasonable travel expenses to go to and from a rental property. For example, even when a local property management company is hired to take care of a property, an investor still may wish to visit the rental and meet with the manager every now and then.
IRS Topic No. 511 Business Travel Expenses provides guidance on the types of travel expenses an investor may be able to deduct from rental income. As a rule of thumb, expenses must be reasonable, ordinary, and necessary for the business and not for personal purposes.
Residential real estate is typically depreciated over a period of 27.5 years. So, if the cost basis of a home is $140,000 (excluding the land value), the depreciation expense would be $5,091 per year.
If a capital improvement such as a new roof is made to a rental property, the cost of the improvement must be added to the cost basis and depreciated over the same number of years. For example, if an investor spends $10,000 to replace a roof, the additional depreciation would be $364 ($10,000/27.5 years).
However, between now and the end of the 2022 tax year, an investor may be able to use bonus depreciation to deduct the entire cost of a capital improvement in the same tax year the money was spent. If the extra deduction results in a rental real estate loss, the loss can be carried forward to use in future tax years.
How to automate income and expense tracking
Keeping track of income and expenses from a rental property can be complicated. Free rental property financial management software from Stessa automates income and expense tracking to help investors maximize profits and tax deductions.
After signing up for a free Stessa account, enter the rental property address, link business bank accounts and the mortgage account, and run reports like income statements and net cash flow with a single click. When tax time rolls around, the Stessa Tax Center helps investors manage preparing and filing taxes with ease.