Rental Income Tax – Complete Guide

Taxes aren’t pleasant to think about in a capitalistic society. There are dozens of types of taxes which makes taxes pretty complicated for laypeople to understand.

Different types of taxes can impact your income. Taxes on rental income is usually a subject of great debate during tax season.  It often leads to a bigger question: how is rental income taxed? The question may seem simple enough, but the answer can be complicated, especially for real estate investors. Tax laws can change frequently and without warning, leaving property owners with questions about how their rental income is or will be taxed. Misinformation around rent taxation can be one of the biggest stumbling blocks for real estate investors.

Buying rental property may make things even more complicated. It’s a good idea to learn more about taxes to help avoid financial trouble later. Let’s break down the concept of rent taxation to get a better understanding.

1- What Type of income is Rental Income
2- Rental Income is Taxable
3- How Is Rental Income Taxed
4- Rental Income Deductions
5- Tax Rate for Rental Income
6- How to Calculate the Rental Income Tax
7- How Much Tax Do I Pay on Rental Income

What Type of income is Rental Income?

Rental income is simply income earned from owning your property. Rental income includes rent payments, security deposits, and any other income a property owner accepts as a result of owning their property. You are supposed to include the rent you receive from a tenant in your gross income.

Additionally, you may deduct the expenses incurred from owning the property from the rental income before paying taxes. The income that’s subject to taxation is that which is left after expenses are deducted.

1) Advance Rent

Any payment you accept from the tenant before payment is due is considered an advance payment. You are supposed to include any advance payments in your total income for the year in which you received them.

For example, if you sign a five-year lease and you received $3,000 worth of rent for the first year and $3,000 for the last year at the same time, you must include the total amount in the first year’s rental income ($6,000).

2) Security Deposits

There are different conditions in place for security deposits. If you intend to use the security deposit against any contingency in the lease, you must include it in your rental income.

On the other hand, if you plan on returning the security deposit to the tenant towards the end of the lease, you shouldn’t include it in your income.

Likewise, if you have to use the security deposit as the final rent payment, you’ll also need to consider the payment as rental income and include it on your tax return.

3) Other Expenses Paid by Tenant

Any funds your tenant spends on paying utility bills or on maintenance expenses also fall under rental income. You may deduct the amounts as expenses but you have to include it in the first place.

Is Rental Income Taxable?

There are few things in the world that aren’t taxable–rental income is no exception because it’s subject to taxation under the law just like any other income source.

There are two types of rental businesses: passive and non-passive. Rental property is normally considered a passive business. Non-passive businesses include activities such as property development, operation, or management.

Another factor that impacts rental taxation is the nature of the owner’s involvement. If the owner manages the property then the owner is an active participant, while if someone else manages the property the owner is considered a non-active participant.

This distinction creates a difference in the tax deductions and, thus, impacts the overall tax.

How Is Rental Income Taxed?

Rent taxation considers all payments received for the rental property’s usage for the current tax year. These could include:

• Rent Payments: any or all tenant payments made during the current tax year;
• Advance Rent: any payments tenants have paid in advance, such as the last month’s rent. You would need to include that payment in the tax year you received it, not the year when the tenant moves out;
• Non-refundable Security Deposits: any sum of money you keep after the tenant leaves the property. If you refunded the security deposit when the tenant moved out, you wouldn’t need to report it on your taxes;
• Cancellation Fee: any fee collected from tenants when they terminate the lease before the end of the lease term;
• Services Received Against Rent: any service expenses or waivers charged against rent, such as an agreement made between you and your tenant in exchange for one month of free rent. The waived amount must be included in your gross rental income; and
• Expenses Paid by your Tenants: any payment made by your tenants when they were not obligated to pay them, like a maintenance expense. That cost is taxable rental income, and you have to report it.

Common Rental Income Deductions:

Multiple expenses can be deducted from rental income before taxes are applied. These deductions are effective in reducing income tax. Consider the following expenses as deductions to your gross rental income:

• Mortgage Interest
• Homeowners Insurance
• Repairs
• Maintenance and Cleaning
• Utilities
• Homeowners Association Fees

 

Bear in mind that not all expenses related to your rental property can be deducted. If you are confused about whether or not an expense is deductible, consult a tax professional.

1. Depreciation

This is the most effective deduction homeowners may make from their income. By definition, depreciation means that the property has sustained a loss of value due to normal wear and tear over the years. The average rental property takes 27.5 years to depreciate. To calculate depreciation, divide the amount you paid for the property by 27.5. You will get the depreciation amount per year.

Besides the cost of the rental property, You need to educate yourself about how much you may deduct annually for depreciation.

These could include:

• Renovations / Remodeling
• Furniture
• Insulation additions
• Heating and air conditioning
• Flooring
• Landscaping

 

2. Mortgage Payments

If you have purchased your property with a home loan and are still paying the monthly installments, you may deduct it from your rental income. This makes a major difference when it comes to paying taxes on your rental income.

3. Maintenance

Owners routinely have to spend money on maintenance to keep their property in good, habitable condition. The amount of money you spend for maintenance can be deducted from your gross income for tax purposes.

4. Managerial Expenses

Employee wages are tax deductible if the owner hires someone, regardless of the person’s length of employment.

5. Insurance Premiums

Any amount of money the owner spends on insuring their property is tax deductible.

6. Legal Fees

Fees paid for an attorney, accountant, and advisor fees are also tax deductible.

7. Other Rental Related Expenses

If you spent money on any rental-related activity related to the property such as traveling to stores to purchase material for the property, this, too, can be deducted from your gross rental income.

Pro Tip: Always keep a clean and well-maintained record of the expenses you plan to deduct from your gross rental income. You’ll need to make a file with copies of all rent checks, business receipts, or other documentation of all rental-related expenses spent on the property.

Before completing and submitting your federal income taxes, double-check that all your information is accurate in case you’re selected for audit.

Tax Rate for Rental Income

Once you have calculated the rental income and expenses you can deduct from the rental income, it’s time to calculate the total tax rate.  In some cases, qualified business income (QBI) also applies to the rental income.

That means investors may qualify for deductions upwards of 20.0%. Apply a 20% rate to your taxable income, which is, and you will get $478, which you can deduct from taxable income as qualified business income (QBI).  So, now the remaining taxable income will be $1920.

How to Calculate the Rental Income Tax:

Rental income tax is treated similarly to federal income tax. If you fall within the 22% marginal tax rate, you’re responsible for paying all applicable rental income tax.

Here are Some Steps to Follow to help with that:

1) Add up all payments you’ve received while it was occupied by a tenant over the year, be it security deposits, advance payments, or monthly rent.

2) Deduct all property expenses spent over the course of the year as we addressed above (i.e. depreciation, maintenance, etc.).

3) The resulting amount is the total income to which you’ll need to apply the 22% tax rate.

How Much Tax Do I Pay on Rental Income?

Let’s calculate rental property tax using the following example:

Suppose you purchased a property in 2017 for $300,000.  If the property generated $1,300 each month, your annual rental income would be $31,200. If you are in the 22% marginal tax bracket, your taxable income after expenses would be:

• $2,000 of insurance
• $1,000 of tenant-paid utilities
• $8,000 of mortgage interest
• $4,000 for property tax
• $2,893 for property management

 

Your expenses total is $17,893, and if we apply   (divide the home price by 27.5 to calculate annual depreciation), the total expense would be $28,802. Now, subtract total expenses ($28,802) from the annual income($31,200), so the total taxable income left is.

How to Report Rental Income on Your Tax Return

You will report all rental income on Schedule E of your Form 1040 tax return. If you received rent payments for January 2021 in December 2020, you would have to report the January rental income on your 2020 tax return. Or if your tenant paid the last month’s rent in advance, you’ll also notify that in the year it was received.

If you have more than one rental property, fill out as many Schedule E forms as needed to list the income for every property.

What if You Occasionally Rent Your Property?

What if you have a property that you use personally but rent out occasionally like a beach property? There are two different situations that you should know.

1) First, if you rent out a property for 14 days or less annually, you don’t have to pay anything. The tax applied to rental income does not apply in this case, so you would not have to pay any rental income tax. And if you sell such property, you may consider the profit as made on a personal residence. Like, if you rent out your beach house for a week and earn $1000, you can keep all the money tax-free.

2) The second situation has to do with 14 days. For a rental property to qualify for the tax bracket, you cannot use it more than 10% of the days it was rented or 14 days per year, whichever is greater.

For example, if you rent out your home for 240 days, you can use it for a maximum of 24 days without sacrificing the rental property expense benefits. According to this law, if you use the property for more days, you can still deduct your expenses. But, you can only deduct an amount up to the rental income the property generated.

Final Words:

Most people mistakenly only include monthly rent in their rental income. From a legal perspective, any payments received while your property was occupied fall under rental income.

If you received a security deposit or last month’s rent in advance, this should also be included in the total rental income. Try not to be intimidated by rental tax rules–you can get a sense of your tax liability using simple math.