How Does Rental Income Tax Work & How to Calculate It

Rental income is great for landlords, property managers, and investors looking to build income streams. However, rental income is taxable and requires the right approach to keep the IRS happy. The good news is a rental income is often a tax win for landlords and can save you money in the long run. Here's how it works.

How Does Rental Income Work?

Rental income is generally taxed as ordinary income on your annual tax return. However, the IRS provides real estate investors with several deductions to lower tax burdens each year.

How to Calculate Rental Income

Calculating rental income is generally straightforward. Add up all your rental income across all tenants, including fees, advanced rent payments, and forfeited security deposits.

What About Security Deposits?

Security deposits are not counted as income on a rental property. Instead, they are considered assets or liabilities. If a landlord keeps the deposit due to damage to the apartment or a break of the lease, it becomes taxable income.

How to Calculate Rental Expenses

Landlords spend a significant amount of money keeping up their rental properties, which the IRS considers expenses. Here's a look at some of the ordinary expenses you can usually deduct on your tax return:

• Cleaning, repair, and maintenance costs
• Property management and leasing fees
• Advertising costs
• Landscaping service fees
• Utilities
• Pest Control
• Insurance
• Mortgage interest
• Property taxes
• Rental or sales taxes
• Property taxes
• HOA dues
• Legal fees
• Trash removal fees
• Accounting expenses

Once you've noted all of your expenses, deduct them from your rental income. If you collect $20,000 per year in gross income on your rental property and spend $10,000 on related expenses, your taxable income is $10,000.

What Is Depreciation on Rental Properties?

Depreciation is considered a non-cash expense, which you can legally deduct from your tax return. Landlords could calculate their $125,000 property on $25,000 worth of land has a depreciation of $3,636,36 each year. However, the land isn't counted as depreciation because it can't wear out.

How Much is Rental Income Tax?

Rental property tax depends on your marginal tax bracket, which ranges from 10% to 37%. If your tax bracket is 22%, you'll also pay 22% on your rental income.

However, landlords may also benefit from the 1031 Exchange Bill. This tax code has been on the books since 1921 under Section 1031 of the U.S. Internal Revenue Code. If you sell an investment property and reinvest the proceeds from the sale within a specific amount of time, you can avoid paying capital gains taxes. The time limit is currently 45-days. However, the tax code is being challenged in 2021 and could limit how beneficial it is to landlords.

How to Report Rental Income on Tax Returns

Landlords should report all rental income on their tax returns. In most cases, you will use Schedule E (Form 1040) to document all of your income and related expenses from rental real estate. If you fail to report rental income, the IRS can levy penalties. Intentionally leaving out rental income can also result in a fine for a fraudulent return, which can include 20% of the amount underpaid and a 7% percent penalty for the entire total owed.

What Is a Pass-Through Income Deduction?

The Tax Cuts and Jobs Act (TCJA) established a new tax deduction in 2018 that is scheduled to run through 2025. A pass-through business is a sole proprietorship, partnership, or S-corporation that reports its income on an individual income tax return.

The TCJA is good news for landlords. Tax deductions on a "pass-through business" can be as high as 20% on your net rental income from your income taxes.

What If You Only Rent Out Your Property Sporadically?

It's always better to err on the side of caution when it comes to your taxes and rental income. However, some IRS rules can ease the hassle of tax reporting.

Section 280A gives tax-free rental income if a dwelling is rented for fewer than 15 days during the year. The rental days don't have to be consecutive, and you cannot deduct rental expenses like depreciation and utilities. However, if you're a landlord with several units and rents a single room in your home, Section 280A may be worth exploring.

Can I Still Use My Own Rental Property for Personal Use?

Some landlords want to rent out their vacation homes or dwellings to offset the costs. However, if you want to fully deduct losses on your rental property and take advantage of tax deductions, you can't use your property for personal use for more than 14 days, or 10% of the days the unit is rented during the year. You should calculate your use by whichever number is greater.

If you exceed this rule, you can still make deductions on your rental properties, but only to the extent of your rental income. In other words, you won't be able to take advantage of all of those deductions and depreciation and report a net loss.

How Should I Document My Rental Income?

The more organized you are with your rental property finances, the easier it will be to manage. The IRS recommends keeping records to substantiate any deductions you make with your rental income. Receipts, canceled checks, and bills can also support your deductions. If you are ever audited over your rental properties, additional taxes and penalties could be imposed without evidence that supports your deductions.

Being organized and over-prepared is best practice when it comes to your taxes. It's far cheaper to hire a bookkeeper or use your time and resources to track and document everything than deal with the expenses of an audit.

When to Call In an Accountant for Your Rental Property Taxes

The IRS provides plenty of resources and documentation on calculating your rental income and making deductions. Keep in mind tax codes change frequently and aren't always understood. When in doubt, hire an accountant with rental property experience to guide you through the best possible deductions for your business.

Final Thoughts

Remember to verify any information with your accountant using the most up-to-date IRS information before filing your taxes.

Dealing with rental income tax doesn't have to be a stressful experience with the proper planning and approach. Ready to elevate your rental property business? Find the right tenants right now and improve the way you market your property with Apartment List.