How is rental income is taxed: the short version

Rental income is taxed as ordinary income. That means that if the marginal tax bracket you’re in is 22% and your rental income is $5,000, that you’ll end up paying $1,100. The math for that will look like this: $5,000 x .22 = $1,100.

How is a rental property defined?

“Any payment you receive for the use or occupation of property,” is how the IRS defines rental income.

The following also count as rental income:

• Advanced rent payments: If your tenant pays both the first and last month’s rent before moving in, then you’d count both payments as income for the year in which they’re received.
• Portions of the security deposit that you keep: The security deposit isn’t counted as rental income if it’s returned in full to the tenant. If, however, you keep a portion of the deposit for any reason, like to repaint the room, then that amount counts as rental income.
• Expenses your tenants pay for if they’re not required to do so: If your tenant pays their electricity bill and subtracts it from their monthly rent, then the sum used to cover the bill counts as rental income.
• Services rendered in place of rent payments: If your tenant provides you with services in place of rental payment, like charging you $50 for piano lessons, then that $50 counts as rental income.

What are general real estate investing guidelines?

Rental property provides you with several potential income streams. You collect rent monthly; your property appreciates over time; you earn equity in your home, which you can use to get a low-interest loan; and you can sell your property. To avoid paying capital gains taxes, you can do a 1031 exchange, which is when you use the profits from the sale of your property to buy a property of equal or greater value.

Before you invest in a rental property, consider whether you’re up to the demands of being a property manager. In addition to your physical labor, you have to factor in time. This could include time spent on tasks as diverse as making trips to the store to buy supplies to waiting for tenants to arrive for interviews; and emotional labor, since it can be stressful to interact with tenants, answer emergency calls, and deal with vacancies. Some of your responsibilities will include:

• Tenant Management— Finding tenants, screening tenants, writing up legal lease contracts, collecting rents, and evicting tenants if need be.
• Property Maintenance—repairs, upkeep, renovations, emergencies, etc.
• Administrative— bookkeeping, setting rent, taxes, paying employees, budgeting, etc.

You can hire a property manager to handle all of these duties, but they earn 4 to 12% of the collected rent, which can be a lot if you only have a single property. Although, if you have multiple properties, a property manager is well worth the investment.

There are various ways to calculate a property’s value using rental income, but there are two quick and easy ways to guesstimate your potential income:

• 50% Rule: Half your income will go to operating expenses, which doesn’t include mortgage payments. The other 50% can be used to make your monthly mortgage payments. This method can give you a rough idea of your income stream and potential profit.
• 1% Rule: Your gross monthly rental income, meaning the amount you make before taxes, should be at least 1% of your property purchase price, after repairs.

If you want to invest in real estate but don’t want to own any property, you can invest in Real Estate Investment Trusts (REITs). A REIT is a company that invests in a variety of real estate options. It can be traded privately, publically like a stock, or be public but not traded. REITS are a great way to invest in real estate without getting invested in real estate.

How do I report rental income on my tax return?

Depreciation

Depreciation is a yearly tax deduction you take based on the cost of your property and the maintenance thereof. Land is not included in depreciation because its maintenance is considered inseparable from its ownership, so when you calculate depreciation you subtract the cost of land. Depreciation is calculated over what the IRS calls the “useful life” of your residential rental property, which is the amount of time the IRS believes that the cost of renting your property outweighs the cost of maintaining your property. For rental properties, the useful life is 27.5 years (the useful life of commercial property is 39 years).

So, if your asset is valued at $300,000 and the cost of your land is $100,000, subtract the cost of the land and divide the remainder by 27.5. That’s your yearly depreciation deduction. The math for that will look like this ($300,000 – $100,000) ÷ 27.5 = $7,272.

In addition to depreciation, you have to keep depreciation recapture in mind as well. This is a tax applied to your depreciation deduction that you pay after you sell your property. The depreciation recapture tax rate is 25% and is applied to the total amount of the depreciation deductions you’ve made. In our above example, if depreciation is deducted over the entire course of the property’s useful life, then the amount you would pay in depreciation recapture would be (27.5 X $7,272) x .25% = $50,000.

A critical point about the depreciation recapture tax is that it’s applied even if you don’t take advantage of the depreciation deduction. That means if you decide not to deduct that $7,272 over the course of your property’s useful life after you sell your property, you’re still going to pay $50,000 in depreciation recapture taxes. So, take advantage of the depreciation deduction if only because you’ll be taxed as if you did.

Qualified Business Income (QBI)

There’s yet another tax break for rental property owners known as the Qualified Business Income (QBI) deduction, which lets you deduct upwards of 20% off your taxable rental income. The QBI has a threshold of $315,00 for married taxpayers and $157,000 for everyone else. If your income falls under the threshold, then you can take advantage of the full 20% deduction. Those who make more than the threshold can still get the deduction, but it’s a new and complicated deduction so you should consult a tax professional to make sure everything is copacetic.

Sample Rental Income Tax Return

Let’s do some math to get an idea of what your rental income will look like on your tax return.

Let’s say you bought a property for $300,000, your monthly rental income stream is $2,600, and you’re in the 22% marginal tax bracket. These are your expenses:

• $10,000 of mortgage interest.
• $2,000 of insurance.
• $1,000 of tenant-paid utilities.
• $3,120 for property management.
• $4,000 for real estate taxes.
• $500 of other deductible expenses.

Your total expenses are $20,620, and you can deduct $8,182 in depreciation, given the cost of your property and the value of the land. Your taxable income calculation will appear as follows.

To keep the math simple, we’ll say you get to take the full 20% QBI deduction. So, that means your taxable income is ($2,398 – [$2,398 X 20%]) X 22% = ($2,398 – $479.60) X 22% = $1,918.40 X 22% = $422.05. So, that’s $422.05 you owe for the year. All that goes on Form 1040, Schedule E when you file your taxes.

Glossary of Terms

Financing: This is the amount of money lent to you by the bank expressed as a percentage of your property’s original value. The remaining amount is your down payment.

Amortization: (# of Years): This is when you divide a loan into a string of regular, consistent payment. The make-up for the payment, however, changes over time since a portion goes toward interest, and a different portion goes toward the principal. If you make an amortization table, you can see how much more principal and interest you have left to pay over time, which can be useful for making decisions ranging from budgeting to refinancing.

Interest Rate: Your interest rate is the fee the bank charges you for lending you money. It’s a percentage of your principal that you pay every month. The principal is the amount of the bank gives you.

Financed Return (ROI): Your ROI is the ratio of loss or gain relative to the size of your investment. It is usually expressed as a percentage.

Principal Paydown: The principal paydown is when you make payments only toward your principal. As you pay down more of your principal, you end up paying less interest since the less time it takes you to pay off your principal, the less interest you pay since interest is a percentage of your principal.

Net Cash Flow: This is the amount of income an operating business makes over a period of time.

Cash On Cash Return: This is the measure of your gross rental income stream relative to your mortgage payments for a particular year.

Your effective tax rate: This is the amount of taxes you pay on your taxable income. It is the average of all the tax brackets that your income is subjected to, combined with the deductions and credits that make your potentially taxable income less. Your effective tax rate applies only to your federal income taxes, so it excludes state and local taxes, for example. The alternative to your effective tax rate is your marginal tax rate, which is the highest bracket at which your income is taxed. The way you calculate your effective tax rate is by dividing your total income by your total taxable income. The result is expressed as a percentage.

Land Value as % of purchase price: This is a figure that’s important to know for several reasons. Land, for example, is excluded from depreciation, so you have to subtract the value of your land when you’re calculating your yearly depreciation deduction. There are many different ways to calculate the percentage of your purchase price that’s land, but a quick and dirty guestimate is that your land value is 20% of your purchase price

Net Operating Income (NOI): Your net operating income is all the money you make off your property after you’ve subtracted all the reasonable necessary operating expenses. Your NOI is a pre-tax figure. Some examples of operating expenses include insurance, legal fees, repair costs, etc. Your revenue may include more than just rent. Parking, vending machines, and laundry are other examples of ways in which your property can make you money.

Cap Rate: Your cap rate is your NOI divided by the current market value of your property. It provides you your return on investment as a percentage over the course of a single year (mortgages are excluded from the calculation). While this figure is useful, it shouldn’t be used independently of other metrics of evaluation because it’s not robust enough to provide a full picture of your property’s worth. The year you used to make your calculation, for example, could have been a particularly good year for you and, as a result, would provide an incomplete picture of your asset’s value. So, it can be useful to graph the cap rate over time.

Common questions

What rental expenses can I claim?

Not all rental income is taxed. Property expenses are deductible against rental income. Some deductions you can make include:

• Cleaning and maintenance
• Mortgage interest
• Insurance costs
• Your marketing budget for your property
• Property management fees
• Fees charged by your condo or homeowners association (HOA)
• Property taxes
• Services you pay for (gas, gutter cleaning, etc)
• Professional fees associated with your property, such as legal expenses or budget keeping.

Here’s an example of how your deductions might look if you collected $30,000 in rent:

What if I rent out a room in my home?

Renting a room is just like renting an entire property. All the same rules apply, you just have to divide particular expenses between the part of your house you live in and the part you rent out, effectively treating your home as two separate properties. You can even deduct depreciation on the portion of your home you rent out.

What do I need to do for my Airbnb income?

To begin with, you have to rent your property for more than 14 days per year. Otherwise, you don’t need to report it. You do, however, have to report income and expenses if you rent your property for more than 14 days per year, or if you live in the house more than the greater of 14 days or more than 10% of the number of days you rent the property (20 days, for example, if you lease it for 200 days). You can learn all about the ins and out of Airbnb, including how to file your income, here.

How do I claim mortgage costs?

There’s no simple answer to this question because there are so many factors to consider. Your wealth, tax bracket, home cost, etc. will all impact what percentage of the closing cost that may or may not be tax-exempt. Additionally, you need to see which approach, taking a standard deduction or deducting your closing costs, will save you the most money.

The IRS lists the following costs as deductible:

• Sales tax issued at closing
• Real estate taxes charged at the closing
• Mortgage interest paid at closing
• Real estate taxes that were paid for by the mortgage lender
• The interest you paid at the house’s purchase
• Loan origination fees (a.k.a. “points”)

The following are not deductible:

• Pre-move-in utility charges
• Fire and flood insurance or certificates
• Pre-closing rent (if you moved in early)
• Mortgage refinancing
• Title fees
• Real estate commissions
• Costs of appraisal
• Home inspections
• Costs of reporting credit
• Transfer taxes
• Attorney fees

Consulting with a financial advisor will help you figure out how best to handle your mortgage closing.

What are key tax dates?

The most crucial tax day is April 15th, which is the due date for individual tax returns. Although, in 2020, due to the Coronavirus pandemic, the due date for individual taxes was moved up to July 15th. Other important dates can be found here.