Wading into the arena of rental property taxation may seem daunting. After all, when we look at the literature written about both rental property income and the sale of rental properties themselves, there’s a lot of technical languages!
However, these are all terms a layperson can understand, and what once seemed impenetrable will soon make sense. Even tax professionals start off as tax amateurs. The difference is education, so let’s start the lesson!
What Is Considered Rental Income?
Rental income is any money you’re paid in exchange for being able to occupy one of your properties. Any income made from any of your properties must be reported. This includes advance rent, which is any amount you get in advance of the period of time that is being paid for. Advanced rent is included as part of the income in the year that you were paid.
Are security deposits taxable?
Security deposits used as a final rent payment also count as advance rent, but do not count security deposits as income if you intend to return them at the end of the lease. Do include, however, any portion of the security deposit used to cover any sort of expense since that counts as income. Repairs, for example, that are paid for by the security deposit must be reported.
Similarly, any fee paid to cancel the lease also counts as income, as does any expense the occupant covers that gets deducted from their rent. This means that if your tenant pays for utilities and the cost of utilities is deducted from their rent, then the amount deducted is income you must report.
The same goes for any services a tenant may offer in exchange for rent. If they’re a babysitter and they watch your kids, that’s rental income. if your rental agreement gives your occupant the option to buy the rental property, then the payments made toward that purchase count as rental income. Lastly, if you own a portion of a rental property then the income you made must also be reported.
How to calculate rental income?
Owning a rental property is a significant investment. Luckily, there are all sorts of tax deductions you can make to make it a more affordable undertaking! Given the complicated nature of these calculations and recordkeeping required, working with a tax professional is a good idea.
What Rental Income Deductions Can I Claim?
There are many deductions you can take as a rental property owner. This includes depreciation, mortgage interest, operating expenses, property tax, and repairs. This makes investing in property easier, although there are also important considerations that affect the selling of property as well.
Ordinary and necessary expenses
Ordinary and necessary expenses are technical terms that refer to two different types of costs. Ordinary expenses are defined with broad language because they include expenses that are generally associated with your industry. If you’re a landlord, for example, paying an electrician is an ordinary expense. Necessary expenses, meanwhile, earn the ball-park honorific of “appropriate”. This includes advertising, insurance, interest, maintenance, and utilities. These are things you absolutely must account for in order to run your rental property as a business, successful or otherwise.
You can subtract the cost of maintenance that’s required to keep your property in good operating condition. You can also deduct any expenses paid for by the tenant if you subtract them from the cost of rent. You cannot deduct, however, the cost of improvements, which are specific changes toward the betterment, restoration, or adaptation of the current property toward a new use. The difference, then, between maintenance and improvement is that maintenance is necessary for the function of your property while improvement is not.
Depreciation is a tax deduction you subtract from your taxable income based on the amount you spend on purchasing and repairing a real estate property. It’s a deduction that’s spread over the duration of your property’s useful lifetime, which is what the iRS calls the amount of time a property is capable of generating cost-effective income. For rental properties that’s 27.5 years; for retail and commercial properties that’s 39 years. Depreciation makes owning and repairing a property much more affordable, but it’s also something that’s subjected to tax in and of itself. This tax is known as depreciation recapture.
What Records Should I Keep?
Keep records of your rental income and expenses. This is information you’ll need if your tax return is selected for audit. If that happens and you can’t provide evidence to backup the claims you made on your tax return, you may be forced to pay more taxes and even penalties.
You also have to be able to provide evidence of portions of your expenses in order to deduct them. Bills, canceled checks, receipts, etc are all necessary to backup your expenses. Luckily, the same records you use to monitor your real estate activity and prepare your financial statement are the records you’d use to prepare your tax returns.
What is the Qualified Business Income deduction?
Also known as the pass-through income deduction, the Qualified Business Income (QBI) deduction allows you to deduct upwards of 20% off your pass-through business income. To put it another way, this means you’ll end up paying 20% less on your income taxes.
The following types of companies are pass-through businesses:
- Limited liability company (LLC)
- Limited liability partnership (LLP)
- S corporation
- Sole proprietorship (a one-owner business in which the owner personally owns all the business assets)
Businesses that specialize in investment and investment management qualify for the QBI deduction. That includes your rental properties! The way you calculate your QBI depends on whether your total taxable income falls above or below certain income thresholds. Those thresholds are $157,500 for a single filer and $315,000 for a married couple filing jointly.
Total taxable income is all of your income added together minus some deductions. If your total taxable income is less than the threshold, just multiply how much you make off your rental property by 20% and that’s your QBI deduction. But if your total taxable income is above the threshold then things get tricky.
Your deduction will be the lesser of 20% of your QBI deduction vs the greater of 50% of your W-2 wages paid to your employees or 25% of W-2 wages paid to employees plus 2.5% of your unadjusted asset basis (meaning the cost of the property in question).
What is an example of a Qualified Business Income deduction?
This is a little complicated, so let’s look at an example. Let’s say you bought a property for $1 million, that you make $150,000 off your property yearly, that your business has no employees, that you’re married, and that your total taxable income every year is over $500,000. These are the specifics you’ll need to figure out your deduction.
You make over the married couple filing jointly threshold, so you’ll be going the second route. Your QBI deduction would be $30,000 ($150,000 x 20%). You have zero employees, so you’re going to be choosing the greater out of 0 (50% of what you pay your zero employees) or 2.5% of your unadjusted asset basis, which is $1 million. That makes $25,000 ($1,000,000 x 2.5%) the greater of those two choices. Remember, your deduction is the lesser of the two choices, which means that out of $30,000 and $25,000 that you’ll be going with the latter ($25,000).
Good thing that that 2.5% is there because most property owners don’t have W-2 employees. Even if you hire a property manager that’s usually done through a separate entity, which means that they too wouldn’t count as an employee.
What is an example of calculating taxable rental property income?
Let’s look at a sample sale to appreciate all the moving pieces you have to keep track of when paying taxes on the sale of a rental property. Imagine you spent $250,000 on a rental property. The land is worth 50k and the building is $200,000. You’ll need to know the value of each since depreciation doesn’t apply to land. Depreciation is paid out over the course of your rental property’s useful life span, which is 27.5 years. So, $200,000 ÷ 27.5 = $7,273 per year in depreciation per year. As far as your income is concerned, for this example, your marginal tax bracket for ordinary income is 24% and your bracket for long-term capital gains is 15%. Now let’s see what happens when you sell that property!
Six years after buying the property, you sell it for $280,000, which means you have to pay capital gains on your $30,000 profit. Since you’re in the 15% tax rate, that’s $4,500. You were able to deduct $43,636 thanks to depreciation, which means that you have to pay taxes on the amount you deducted from your taxes (depreciation recapture). You have to pay those taxes even if you don’t take depreciation so long as you qualify for it, so you might as well take advantage of depreciation because the IRS will treat you as if you did! So, that’s going to be $43,636 x 24% = $10,473. 24% is the depreciation recapture tax rate.
Add all your taxes together, $10,473 + $4,500, and you end up with $14,973 in total taxes.
When do I owe taxes on rental income?
Rental income is reported on tax returns most often using Schedule E (Form 1040). This is used to report both income and expenses. These taxes can get pretty complicated to file, so it’s a good idea to work with a tax professional. How complicated? See below!
How to Report rental income on your tax return?
Once you’ve got Form 1040, Schedule E, Part I, list your total income, expenses, and the depreciation of each of your rental properties. You’ll complete as many Schedules Es as necessary given the number of rental properties you own.
You may find that your rental expenses were greater than your rental income, in which case your loss may be limited. Consult the passive activity and at-risk rules to see just how much loss you can deduct. Consult Form 8582, Passive Activity Loss Limitations, and Form 6198, At-Risk Limitations to see if your loss is limited.
Additionally, if you get any personal use out of your rental property (like using your property for vacations or living in it yourself), then your rental expenses and losses may also be limited. Consult Publication 527, Residential Rental Property if this applies to you.
As you can tell by the number of forms you have to consult, a tax professional would be very handy when it comes to reporting your rental income. Better safe than sorry!
What if I only rent my property some of the time?
There are two things you need to know if you use your rental property yourself. If you rent your property for under 14 days every year, then you don’t have to do a thing. The tax rules don’t apply and you don’t have to pay income on the rental income you earn. Additionally, when you sell the property, the profit is treated like it was made off a personal residence as opposed to an investment property.
The other rule is that for your property to be a rental property, you can’t use it for more than 14 days out of the year or 10% of the days it was rented, whichever is greater. So, if you rent your property for 200 days, you can use it for upwards of 20 days without compromising rental property expense benefits. If you exceed the number of permitted days you can still deduct your expenses, just only up to the amount of rental income your property produced. This means that your expenses cannot be counted as a loss on your taxes.
What are the Tax Implications When Selling Real Estate?
So, as you’ve already seen, there are many rules to follow when it comes to the taxes you’ll pay on your rental property income. There are also rules to follow when selling your rental property. Some of these rules may even make you reconsider selling your property, to begin with! That’s okay, however, because if you’ve managed to make a decent income off your rental property then why pull out of the game! Unless, of course, you have a financial emergency that’s thrown your life into upheaval, in which case, pull out! But do so cautiously! Remember, real estate has low liquidity, so it may not be an ideal source of funds if you’re scrambling for cash. Using the equity you’ve acquired may be a better route than selling off your property.
When I sell, what taxes do I need to worry about?
When selling your property you’ll have to pay capital gains taxes and depreciation recapture. However, a 1031 exchange is a way to get around those taxes, and a route you may consider taking for several other reasons as well.
Capital gains taxes
If you hold your property for more than a year, which you need to do in order to take advantage of depreciation, then you’re going to end up paying capital gains taxes. The table below was provided by TaxFoundation.org, although you should double-check to see if the rates have been altered due to legislative changes.
Depreciation recapture tax
Depreciation is a tax deduction that you get to take on a yearly basis to make owning and maintaining a property easier. Over the course of the useful lifespan of your property (27.5 years for a rental property and 39 years for a retail or commercial property), you get to make deductions. But when you sell your property, the IRS takes a tax that’s 24% of how much depreciation you deducted in total and 24%. You’re going to want to take advantage of depreciation because the IRS will tax you for it whether you make the deductions or not! If you opt out, they’ll just take the amount you would have depreciated if you opted in!
How does a 1031 exchange help avoid taxes when I sell?
You might have noticed the taxes adding up and hoped for a way out. Well, there is a way out: a 1031 exchange! That’s when you take the profits from selling your rental property and use it to buy a property soon after of equal or greater value. Doing so delays paying capital gains taxes and depreciation recapture. And you can just keep making 1031 exchanges!
1031 exchanges are a great way to change up the sort of property you’re investing in. You can, for example, get a property that’s easier to manage.And if you die having made a 1031 exchange but without having sold off the property, your heirs won’t have to pay the deferred taxes! Although, they may have to pay the estate tax, so it is wise to consult with a financial planner.
Now that you know your way around the taxation of both rental property income and rental property sales, you may be thoroughly convinced that working with a tax professional is the way to go. But it always helps to know what to talk about with your tax professional, as well as any other authority you consult with. After all, an informed decision is better than an uninformed one. And now you’re informed enough to start deciding!