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Rental property Tax – Basics you need to know

Once you’ve finally decided to take the initiative and plan out your new rental property empire, preparing for the tax on your properties should be next on your list.
While you might have read that rental property tax is far too complicated and you must seek out professional help, it is actually not too different from taxes on anything else.
Let us get into some details to help guide you through this part of your planning process.
Although many landlords know how to calculate taxes on rental properties, it may be worth reaching out to a tax professional if you need to fine-tune your tax planning.

Overview – How Rental Income Works

The IRS may seem terribly soulless at times, but this is for the most part because the design of the tax system is to make sure they can collect as much tax revenue as they can without being overly greedy. Even with all the rules involved in that venture, there are several deduction allowances you should be aware of:

From a top-level view, there are two basics steps in the calculation of rental property tax

  • Income from rent payments is taxed as ordinary income
  • Deductions for expenses related to the property as well as future value

We will get more into these steps and explain. The first one is relatively simple, but the deductions are crucial and can be complicated. That is how you hear about real estate investors who pay nearly nothing in taxes (though that is not the goal for one just starting out).

Calculating Rental Property Revenue

When you get started in real estate, it might be easier to think of the finance side of things like a regular publicly traded business might.  

For one thing, thinking about the rent collected as income is a bit of a misnomer – This is not technically income but revenue. It is the starting point for everything that follows later.

However, there are several types of revenue charged to tenants. It depends on the standards expected in your region, but here are a few points to consider:

  • Advance payments – if you collect something like first and last month’s rents, that last month (assuming it falls in the next year) gets reported as revenue in the current year.
  • Security deposit – most landlords require a security deposit, and most tenants expect one. However, it should technically not be reported as revenue until earned, whether in part or whole. Only the portion of the deposit that gets used by the tenant is revenue to the landlord.
  • Tenant-paid expenses and services – if the tenant pays for the water bill or provides a service like lawn mowing for a reduction in rent, you still report the total rent amount as revenue.
Rental Property tax

Rental Property Income Deductions

Now for the complicated part – deductions. Many expenses come as requirements of providing a safe and sufficient living space for tenants. For these reasons, they are deductible from gross revenue (rent collected) to obtain a taxable income figure. Here are some ordinary expenses:

  • Property taxes
  • Mortgage interest
  • Insurance costs
  • Utilities
  • Landscaping
  • Cleaning and maintenance costs
  • HOA dues
  • Legal fees

This list is not exclusive, so it is good practice to keep track of every dollar that goes into each property to help reduce your rental property tax.  

To give an example, if you collect $15,000 in rent from a particular property, and the total expenses (for simplicity’s sake) comes to $8,000 then your taxable income for that property is $7,000.

Rental Property Revenue

Calculating Depreciation Expenses

Another part of calculating the net income is including the depreciation of the building.

As of this writing, the IRS takes the value of the building (not including the land value) and divides it over 27.5 years. It is an expense you can deduct to arrive at the taxable income, which will help calculate your rental property tax.

So, continuing with our example above, if you paid $100,000 for the whole property, and the value of the land is $45,000, the building itself is worth $55,000.

The result is then divided by 27.5 for an annual depreciation value of $2,000. This figure reduces the $7,000 taxable income from earlier to a final taxable income figure of $5,000.

Report the depreciation of rentals on Form 4562: Depreciation and Amortization.

Qualified Business Income (QBI) Deductions

If your rental properties are bought and managed as a business (meaning as a sole-proprietorship, LLC, partnership, or S-Corp) you may qualify for an additional deduction of 20% after all of the other deductions are taken out.

It is referred to as the Qualified Business Income (QBI) deduction or 199A in IRS-speak. There are limitations involved, so this may be a good argument to make you consider consulting an expert to ensure you comply with the rental property tax rules. 

How do I report rental property tax on my tax return?

As an individual, you report the income and deductions for rental properties on Schedule E: Supplemental Income and Loss. The total income or loss computed on Schedule E carries to page 1 of your form 1040, U.S. Individual income tax return.

When calculating your rental property tax remember that these deductions aren’t meant to be a handout, and if it seems too easy, you might want to have a tax expert double-check.