Taxes on rental property work much differently than an owner-occupied home, but in ways that can be very beneficial to real estate investors. As a basic rule, rental property investors should report all of their income and expenses as much as they legally can.
In this article, we’ll explain how rental income tax rates work, and how to use expenses from owning and operating a rental property to reduce taxable net income while still having plenty of free cash flow.
What to Know About Taxes on Rental Income
Income from a rental property is taxed as ordinary income, with a real estate investor paying tax based on their marginal tax bracket.
Federal income tax brackets in 2001 range from 10% up to 37%. So, if you are married filing a joint return and your total reported income is $300,000, 24% of your rental income will go toward taxes. If your rental property generates $4,000 in income this year, your tax will be $960.
How to Calculate Rental Income & Expenses
Now let’s look at an example of how to calculate income and expenses from a rental property. We’ll begin with a list of what income and expenses are, then estimate what taxes on the rental income will be at the end of the year:
According to the IRS publication Tips on Rental Real Estate Income, Deductions, and Recordkeeping, rental income is any payment received for the use or occupation of property.
Income from rental real estate includes:
- Rent received for the current period.
- Advance rent received before the period that covers it.
- Fee received for early lease termination.
- Expenses paid by the tenant that normally belong to the landlord, such as fixing a leaky roof.
- Property services received in lieu of rent must also be treated as income based on fair market value of the service, such as a tenant who is a painter repainting the house in exchange for two months of free rent.
Security deposits used as a final rent payment are also treated as advance rent received, but not if the security deposit is meant to be refunded to the tenant. If that’s the case, a refundable security deposit will appear as a liability on the property balance sheet.
Most of the costs of owning and operating a rental property can be expensed the same year they are incurred, while others must be depreciated over several years.
Common rental property expenses that can be immediately deducted include:
- Advertising and marketing
- Leasing commissions
- Property management fees
- Repairs and maintenance
- Materials and supplies
- HOA dues
- Mortgage interest
- Property tax
- Professional fees such as legal and accounting
- Licenses and permits
There are a lot of expense items to keep track of when you own a rental property. It can be far too easy to forget about a valuable deduction or to accidentally double-expense a cost that could trigger a tax audit.
That’s why so many successful real estate investors use free software from Stessa to simplify rental property finances and automate income and expense tracking.
Simply sign up for free, enter your rental property address, connect your business accounts, and generate unlimited monthly reports and tax-ready financials whenever you want.
Calculate Rental Income Taxes
Let’s assume you own a single-family home that rents for $1,200 per month. The property was purchased for $155,000 from the Roofstock Marketplace and was turnkey with a tenant already in place and no deferred maintenance.
The purchase price includes closing costs that need to be capitalized, the lot value is $15,000, and you financed the property with 25% down for a monthly mortgage payment of $476 P&I.
Calculating your rental income taxes would look something like this:
|RENTAL INCOME TAX WORKSHEET|
|Advertising & marketing||$0.00|
|Property management fee||$1,440.00|
|Repairs & maintenance||$1,250.00|
|Materials & supplies||$350.00|
|Licenses and permits||$45.00|
|Sub Total Profit/Loss||$4,015.00|
|Taxable Net Income before Depreciation||$963.60|
|Taxable Net Income after Depreciation||-$1,076.00|
|Federal Income Tax Bracket||24%|
|(2021 Federal Income Tax brackets from the Tax Foundation)|
|Rental Income Tax Due||-$258.24|
If you are in the 24% Federal Income Tax bracket for 2021, your rental income taxes due at the end of the year would be $963.60 before accounting for depreciation. After the depreciation expense, you would have a loss – at least for tax purposes – of $1,076 and owe $0 in rental income tax.
Alternatively, you can use a tool like Stessa to automate your property financials and make tax time a breeze.
Use Depreciation to Reduce Rental Income Tax
Depreciation is one of the biggest benefits of owning rental property.
You’ve probably read about some very wealthy real estate investors who have plenty of free cash flow but pay next to nothing in income taxes. As we’ve just seen from the above example, some real estate investors pay very little in taxes due to the depreciation expense on income-producing real estate.
Depreciation is an annual income tax real estate investors can take to recover the cost (or basis) of the property over time. This depreciation allowance is based on the idea that property value decreases over time due to wear and tear, deterioration, or obsolescence of the property. IRS Publication 946 explains in detail how to depreciate property.
Residential rental property depreciates over a period of 27.5 years, or 3.636% each year, excluding the value of the lot or land, because land does not wear out.
Some improvements to rental property, such as new appliances or carpet, depreciate over just 5 years. Again, in real life appliances and carpeting may last much longer, but for tax purposes and depreciation their useful life has come to an end.
Example of rental property depreciation
Using our single-family rental home from the above example, we know that the purchase price was $155,000. The purchase price includes closing costs such as title fees, transfer taxes, and recording fees that must be capitalized and depreciated over 27.5 years, instead of being expensed the year the cost was incurred.
To calculate the depreciation expense of the rental property, we subtract the lot value from the purchase price, then divide by 27.5 years:
- $155,000 Purchase Price – $15,000 Lot Value = $140,000 Amount to Depreciate
- $140,000 / 27.5 years = $5,091 Full Year Depreciation Expense
Qualified Business Deduction
In addition to depreciation, there’s one more tax deduction that most real estate investors can take. The Qualified Business Deduction (QBI) allows an additional deduction of up to 20% of qualified pass-through business income after all other costs such as operating expenses and depreciation have been made.
Also known as the pass-through deduction or Section 199A deduction, the rules for QBI can be complicated. Be sure to thoroughly review what the IRS says about QBI or consult with your tax professional to make sure you’re receiving every tax deduction on your rental property that you are entitled to.
Where to Report Rental Income on Your Tax Return
Form 1040, Schedule E, Supplemental Income and Loss, is used to report rental income on your tax return.
On Schedule E you can report your rental income, operating expenses, and depreciation. The schedule has space for three rental properties, but if you need more room you can attach as many Schedules E as you need.
It’s important to keep thorough records of the income and expenses reported on Schedule E, just in case your return is selected for an audit by the IRS. Good records help to monitor the ongoing profitability of your rental property, prepare accurate financial statements, track deductible expenses, and prepare your tax returns.
If you’re unable to provide documentary evidence of expenses – such as receipts, canceled checks, or bank statements – to support your expense deductions, you may be liable for additional penalties and taxes.
Rental Real Estate Income Tips from the IRS
Here are some tips on rental real estate income, deductions, and recordkeeping courtesy of the IRS:
- Rental income is any payment received for use or occupation of your property.
- Regular periodic rent payments, advance rent payments, and security deposits used as final rent payment are all considered to be rental income.
- Rental income also consists of non-cash receipts, such as work done by a tenant in exchange for free rent or utilities paid by the tenant that are normally a landlord expense.
- Fees received by a landlord from the tenant for canceling a lease are also treated as real estate income.
- Expenses for managing, conserving, and maintaining a rental property can be deducted the same year the expense is incurred.
- Necessary expenses include advertising and marketing, property management and professional fees, repairs and maintenance, materials and supplies, property tax, mortgage interest, and depreciation.
At first glance, calculating rental income tax seems easy, but as you dig into the details the rules for expenses and depreciation can become more and more complex.
Even with just one rental property, it’s easy to lose track of every deduction the IRS allows, or misplace receipts that prove the expenses you’re claiming are actually true.
Stessa makes it easy for real estate investors to automate income and expense tracking of unlimited properties, organize and store all of your real estate documents in the cloud, and run unlimited monthly reports and export tax-ready financials as often as you need them.