Everything You Need to Know About Rental Income Tax

We explore what landlords need to know about reporting their rental income tax and tax deductible expenses for their properties.

Real estate investment can be a lucrative venture, but it also comes with complex financial considerations, particularly when it comes to taxes. 

To ensure your rentals cash flow positively, you stay compliant with IRS regulation, and don’t overpay your taxes, there are a few things you should know about rentall income tax and accounting. We sat down with Christanne Wright, a certified public accountant (CPA) specializing in real estate taxes.

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Keeping Financial Records Throughout the Year

One of the first pieces of advice Christanne offered is the importance of staying organized and keeping financial records throughout the year. "It's crucial to maintain accurate, up-to-date records of income and expenses as they occur." Waiting until tax season to sort through a year's worth of financial transactions is at best a daunting task and at worst can lead to missed expenses and overpaid taxes. 

Christanne also suggested investors explore modern software solutions like Landlord Studio to track expenses, keep receipts, and document transactions in real-time. "This proactive approach not only reduces stress during tax season but also ensures that you're maximizing your deductions and minimizing the risk of errors on your tax return."

How is Rental Income Taxed?

Understanding how rental income is taxed is fundamental for any real estate investor. It forms the cornerstone of your financial strategy as it directly impacts your profitability. 

Christanne explained that the taxation of “rental income is typically considered ordinary income, and it's subject to federal and state income taxes. This means that the rental income you receive from your properties needs to be reported on your tax return."

However, as rental income is deemed passive income by the IRS it needs to be reported separately from ordinary W-2 income. Most real estate investors will need to file a Schedule E which is the part of the form 1040 that deals with supplemental income and loss, such as rental income and royalties.

Ordinary Income vs. Capital Gains

To comprehend the taxation of rental income, it's essential to distinguish between ordinary income and capital gains. Rental income falls under the category of ordinary income, which means it's taxed at your regular income tax rate. On the other hand, capital gains come into play when you sell a property at a profit.

"While rental income is considered ordinary income and is taxed annually, capital gains come into play when you sell a property, and they may be taxed at a different rate,” Christanne said.

Capital gains is taxed at either long term or short term capital gains rate and only needs to be considered upon the sale of the property. It’s advisable to talk to your tax advisor or CPA to discuss potential strategies for mitigating capital gains tax, such as a 1031 exchange.

Reporting Rental Income

You must pay rental income tax on any property for which you receive payment in return for use or occupation. Rental income is taxed as ordinary income and you pay according to your marginal tax bracket, which is between 10% and 37%.

Christanne underscored the necessity of diligent record-keeping, to “ensure you're reporting your rental income correctly” as well as helping you “claim deductions that can reduce your overall tax liability."

What Counts As Taxable Rental Income?

Obviously, any rent the tenant pays is counted as taxable income. However, as well as this you also have to report other forms of income as rental income including the following:

  • Advance rent payments. For example, if a tenant pays for the last month of the lease as well as the first month.
  • Any of the security deposit you end up keeping (such as to cover repairs) counts as taxable income rent payments. However, any you return to the tenant is not. You should make sure to carefully track how much deposit was collected, where it was kept, how much you kept, and how much was returned on your property balance sheet.
  • Expenses your tenant covered that a landlord would typically pay. This includes repairs as well as any agreements for payments you have, such as if the tenant pays utilities and subtracts the amount from the rent.
  • Property services in lieu of rent. You may ask a tenant to maintain the property (for instance, through landscaping or painting) in exchange for a discount on rent. You’ll need to pay for rental income tax on the amount you deduct from the service — and the amount should be the fair market value.
  • Fees for early lease termination.
  • Payments you receive through a lease-with-option-to-buy agreement.

Essentially, if you collect a payment, in either money or services from a tenant you need to report it as taxable income. However, it’s also worth noting that many of these are also deductible expenses. For example, if you keep $300 of your tenant’s deposit to cover repairs you would also report $300 of deductible expense for those repairs.

If you are a cash basis taxpayer (most people are), you’ll need to pay rental income tax for the year that you receive the payments, no matter when the amount is actually owed to you. This includes all the income you receive constructively, meaning it’s the full amount available to you by the end of the year, even if you haven’t yet taken possession of the funds — such as a check that you haven’t yet cashed.

If you use the accrual method of accounting, you should report income as you earn it — and expenses for tax deductions as you incur them.

Rental Income Tax and Depreciation

One major way to manage your tax liability as a real estate investor is by taking advantage of depreciation. Depreciation is a tax benefit that sets real estate investing apart from many other types of investments.

Christanne explained that depreciation is the allocation of the cost of your property over a set number of years. For residential rental properties, this typically spans 27.5 years, while commercial properties have a 39-year depreciation schedule.

"What makes depreciation valuable to real estate investors is that it allows them to deduct a portion of the property's cost each year, even though it's not an actual cash expense. This can result in substantial tax savings."

For example, if you had a residential rental property worth $100,000 with a land value of $20,000 you would be able to deduct $2,900 per year in depreciation, which is a sizeable amount.

Rental Income Tax and Deductible Expenses

Rental income is generally taxed as ordinary income, and it's crucial to report it on your tax return accurately. However, real estate investors can offset their rental income by deducting various expenses related to their rental properties. 

"Deductions can significantly reduce your taxable rental income. It's essential to keep track of all eligible expenses associated with your rental property to maximize your deductions," Christanne said before going on to highlight some common deductible expenses.

  • Property management fees
  • Repairs and maintenance
  • Property taxes
  • Insurance
  • Utilities paid on behalf of tenants
  • Mortgage interest

For a more detailed breakdown of deductible expenses for real estate investors visit our Rental Property Deductions Checklist.

Keeping meticulous records of these expenses is vital, not only for reducing your taxable income but also for providing documentation in case of an IRS audit.

Deductions are more complicated if your rental property is also for personal use — even if you don’t use your property as a residence. In this case, you’ll need to split the expenses, deducting your rental expenses separately from your personal expenses.

You can avoid missing out on the full deductions you could be entitled to by limiting the amount of time you use the property yourself. You will only need to divide expenses if you personally use the property for more than 14 days or more than 10 percent of the days you rent the property (whichever is greater). 

If you want to use this tactic, it’s important to calculate how many days you’ll likely be able to rent the property — such as if it’s a vacation home and only in demand during certain times of the year.

Rental Income Tax Forms

You may need to file several rental tax income forms, even if your property is not for personal use.

The main form that owners of rental properties will need to file is a Schedule E form, which you file with your 1040. You report all your income and rental expenses on this form. If you have any personal expenses associated with your rental property, you may be able to deduct some of them using a Schedule A form.

For depreciation and improvements to your property use Form 4562. This allows you to report depreciation from the year you began leasing your rental property. Note that you’ll only be able to deduct a percentage of expenses in the year you incur them.

Finally, if net investment income tax applies to your rental income, you need to file Form 8960. Working through the form will show you if this form applies to your situation.

You may also be required to file a 1099 if you have paid any contractors over $600 during the tax year.

Find out more about required Landlord tax documents: Everything you need to know.

Navigating Potential Tax Code Changes

In recent times, potential changes to the tax code have been a topic of concern for many real estate investors. As real estate tax law can be complicated and changes often, Christanne advised investors to stay informed about proposed changes and work closely with tax professionals or CPAs who specifically specialize in real estate taxation.

"Investors should consider their investment structure, as changes in the tax code may affect individual investors differently than those operating through partnerships or corporations."

Final Words: Managing Your Rental Income Tax

Understanding how rental income is taxed is essential for real estate investors. It's not just about complying with tax laws but also about optimizing your financial strategy. Christanne Wright's expert insights shed light on the nuances of rental income taxation, emphasizing the value of deductions, depreciation, and meticulous record-keeping for successful real estate investing.

Navigating taxes as a real estate investor can be complex, but with proper planning, organization, and the guidance of tax professionals, you can optimize your financial situation and maximize your returns. 

The easiest way to manage this is to use software that does all the hard work for you. 

Landlord studio dashboard

Landlord Studio makes it easy to keep a record of your income and expenses by automating processes and reducing manual data entry with features such as bank feeds, smart scan receipts, and online rent collection.

The software also creates professional reports that you can customize and share with your accountant, stakeholders, or anyone else who needs the information. Best of all, you’ll have everything ready for your rental income taxes at the end of the year.

* First 3 properties free.