You may have heard that buying a rental property can complicate your taxes. It’s true that rental property taxes are more complex than ordinary income taxes. But the tax implications of owning rental properties aren’t as complicated as you might think.
There are two sets of tax implications rental property owners need to know. The first is how the IRS treats the rental income your property generates. The second is how it treats the eventual sale of your rental property.
Here’s an introduction to what rental property investors need to understand about types of taxes on rental properties.
How rental income is taxed: the short version
If you own a property and rent it to tenants, how is that income taxed?
The short answer is that rental income is taxed as ordinary income. If you're in the 22% marginal tax bracket and have $5,000 in rental income to report, you’ll pay $1,100.
However, there’s more to the story. Rental property owners can lower their tax burdens in several ways. In fact, a profitable rental property might show no income, or even a loss, for tax purposes.
How to calculate rental income
First of all, it’s important to briefly define rental income. The IRS defines rental income as "any payment you receive for the use or occupation of property."
This obviously includes the rent payments you receive from tenants. If one of your tenants writes you a check for $1,000 per month to cover their rent, this is rental income. In addition, rental income could include the following:
- Advanced payments of rent that you receive. Say a tenant pays their first and last month of rent when they move in. You'd count both payments as rental income in the year you receive the money.
- The parts of security deposits that you keep. If your tenant gives you a $1,000 security deposit and you plan to return it at the end of the lease, it's not rental income. On the other hand, if you end up keeping $300 of the security deposit to cover various charges, that's part of your rental income.
- Expenses paid by your tenants if they're not obligated to pay them. If your tenant pays the water bill and deducts it from their rent each month, the cost of the bill is rental income.
- Services received from your tenants instead of monetary rent payments. Imagine that a tenant agrees to mow the yard of your rental property in exchange for a $100 rent reduction. You'd count that $100 as rental income.
Deductions from rental income
Now that we’ve defined rental income, it’s important to mention that you don’t have to pay tax on all of the rental income you collect. Expenses associated with the property are deductible against rental income. Allowable expense deductions may include:
- costs of cleaning and maintaining the property,
- mortgage interest,
- insurance costs,
- money you spend advertising the property,
- payments to a property manager,
- HOA dues or condo fees,
- property taxes
- services you pay for (such as utilities and pest control), and
- legal and other professional fees related to owning the property.
Here’s how this might work. Let’s say you rent a property out and collect $24,000 in rent for 2019. You can use these expenses to reduce the rental income:
|Other deductible expenses||($1,000)|
|Rental income after property expenses||$8,100|
The depreciation "expense"
The deductions available to rental property owners get even better thanks to depreciation. This is perhaps the best tax advantage that real estate investors get. In fact, depreciation is why many profitable rental properties show no income whatsoever for tax purposes.
When businesses spend money, there are two main ways they can deduct their expenses. Smaller purchases and immediately consumable items are generally deducted all at once. For example, if you spend $100 on office supplies like copy paper for your business, it can be deducted as a business expense on your tax return.
On the other hand, assets that have a useful life of a year or more, such as machinery, are deducted over time through depreciation. For example, if you spend $5,000 on a piece of equipment with a useful life of five years, you can take a $1,000 depreciation deduction each year for the next five years to deduct the cost.
Since real estate (hopefully) has a useful life span of more than a year, the cost of purchasing a rental property is deducted in this manner. Residential rental properties are deductible over a 27.5-year period. Commercial properties are depreciated over 39 years.
If you buy a residential rental property, you can divide the cost of acquiring the property (minus the value of the land) by 27.5 to determine your annual depreciation deduction. If you buy a rental property for $250,000 and the land is worth $50,000, you can deduct $7,273 per year as a depreciation expense. That's in addition to the other deductions discussed in the previous section.
During the year you buy the property and the year you sell, your depreciation expense is prorated based on the month in which you buy (or sell) the property. And you must stop claiming a depreciation expense after your cumulative depreciation expense adds up to your cost basis in the building.
Let's continue the example from the previous section. This investor collected $24,000 in rent for the year. After subtracting expenses associated with owning the property, their rental income is $8,100.
Now, if their cost basis in the property (less the land’s value) is $200,000, they would also have a $7,273 depreciation expense to deduct. This would bring their property’s income down to $827 for tax purposes, even though the property’s actual profit for the year was nearly 10 times that amount.
The Qualified Business Income deduction
After deducting all of a property’s expenses and depreciation, rental property owners can get yet another tax break. This is the Qualified Business Income (QBI) deduction, also known as the pass-through income deduction.
The QBI deduction allows taxpayers to deduct as much as 20% of their pass-through business income. This includes income they receive from a pass-through entity like an LLC or S-Corporation. Rental income from an investment property meets the definition as well.
There are taxable income thresholds of $315,000 for married taxpayers and $157,500 for all others. If you're under the threshold, you can take the entire 20% deduction. But even those with substantially more income could get a deduction. This is a new and complex deduction, so consult a tax professional if you aren’t sure whether you qualify.
An example of calculating taxable rental property income
Let's go through a full example.
You bought a duplex in 2017 for $300,000. According to an assessment, the land’s value is $75,000. Both units of the duplex are occupied, and each generates $1,300 per month in rental revenue, so your annual rent is $31,200. You’re in the 22% marginal tax bracket. For 2019, you anticipate having the following 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.
This adds up to $20,620 of expenses. In addition, you have an $8,182 annual depreciation deduction based on the residential nature of the property and its land value. So your taxable income calculation for 2019 looks like this:
In addition, we’ll say that you're under the income threshold for the QBI deduction so you can deduct 20% of the taxable rental income. Instead of $2,398, you would only have to pay tax on $1,918.40 of your profits. Based on your 22% marginal tax rate, this means that you would owe $422.05 for the year.
Reporting rental income on your tax return
Rental income is reported on your tax return using Form 1040, Schedule E. On this form, you list your property’s rental revenue, expenses, and depreciation. If you have more than three rental properties, you’ll need to use more than one copy of Schedule E -- although your totals only need to appear on one.
The IRS monitors tax returns with Schedule E more closely than those without it. So it’s important to keep good records.
If the IRS audits your return, you need to fully document the rental income you’ve received as well as every dollar of expenses you claim on your tax return. This can include copies of canceled checks, receipts, or other forms of documentation. As a general rule, you should hang on to them for at least three years after filing your return.
What if you only rent your property some of the time?
Do you have a rental property that you also personally use, like a beach house? There are two special rules you need to know.
If you rent out your property for fewer than 14 days of the year, you don’t have to do anything. The tax rules in this discussion don’t apply to you and you don’t have to pay any income tax on the rental income you receive. And, when you sell the property, you treat any profit as if it were made on a personal residence, not an investment property.
As an example, if you rent out your beach house for one week this summer and make $2,000, you can keep that money 100% tax-free.
The other rule also has to do with a 14-day period. To treat a property as a rental property for tax purposes, you cannot use it more than 14 days per year or 10% of the days it was rented, whichever is greater.
So if you rent your vacation home for 180 days this year, you can use it for as many as 18 days without sacrificing the rental property expense benefits.
If you use the property for more days than this rule allows, you can still deduct your expenses, but only up to the amount of rental income the property produced. In other words, your property’s expenses cannot be used to produce a loss for tax purposes.
When you sell: two taxes to worry about
When you sell a personal residence, the tax implications are easy to understand. Profits aren’t taxable up to a certain point. Beyond that point, they're treated as capital gains.
Rental properties are more complicated. There's no exclusion, so any profit you make on the sale is taxable. Plus there’s another type of tax you’ll need to worry about: depreciation recapture.
Here’s what you need to know about each of these and how to get out of paying them.
Capital gains taxes
If you held the rental property for more than a year, your profits on the sale will be taxed as long-term capital gains. These get favorable tax rates when compared with ordinary income. For 2019, here’s a look at the capital gains tax brackets:
|Long-Term Capital Gains Tax Rate||Single Filers (Taxable Income)||Married Filing Jointly||Head of Household||Married Filing Separately|
|20%||Over $434,550||Over $488,850||Over $461,700||Over $244,425|
In addition to these rates, higher-income taxpayers may also have to pay an extra 3.8% net investment income tax.
Most rental properties are held for over a year. But if you sell real estate at a profit after owning it for one year or less, the profit is a short-term capital gain. So it's taxable as ordinary income at your marginal tax rate.
Depreciation recapture tax
The depreciation "expense" that you’re entitled to each year can save you tons of money when it comes to taxes.
The drawback is that the IRS wants its money when you sell the property. Like many other investment-related tax benefits, you can’t get out of paying taxes forever.
Think of it like a traditional IRA. Investors can deduct their IRA contributions on their tax returns in the year they’re made. That way they don’t have to pay annual taxes on dividends or capital gains. But when they withdraw money, it's taxable income. The same concept applies here. It's called depreciation recapture tax.
Depreciation initially reduced your taxable rental income, which is taxed as ordinary income. Because of that, depreciation recapture is also taxed at ordinary income tax rates (as opposed to favorable long-term capital gains rates).
I’ll go through an example in the next section. The key point is that if you held a rental property for 10 years and used a $5,000 depreciation expense each year, you'll owe depreciation recapture tax on $50,000 when you sell.
If you didn’t claim depreciation on a rental property, you’ll still get hit with depreciation recapture tax. The IRS calculates depreciation recapture based on "allowed or allowable" depreciation. So you can’t get out of this by not claiming depreciation expenses.
An example of the sale of a rental property
Let’s look at a simplified example of how this might work in the real world.
Let’s say you spend $250,000 to acquire a rental property. According to the property’s assessment, the land is worth $50,000 and the building is worth $200,000. This gives you a depreciation expense of $7,273 per year. We’ll say that you’re in the 24% marginal tax bracket for ordinary income and the 15% bracket for long-term capital gains.
You hold the property for six years and sell it for $280,000, so you have a $30,000 long-term capital gain on the sale. Based on your 15% capital gains tax rate, you owe capital gains tax of $4,500.
In addition, you've been allowed a total depreciation expense of $43,636 over your six-year holding period. You’ll pay a 24% tax rate on this amount for a total depreciation recapture tax of $10,473.
Adding your depreciation recapture tax to your capital gains tax shows a total tax bill of $14,973 on the sale of the property.
A 1031 exchange can help you avoid taxes when you sell
That sounds like a huge tax bill. But there's good news for investors: you can avoid paying capital gains and depreciation recapture taxes when you sell a rental property. You just need to use a 1031 exchange.
I won’t get into too much detail here -- we have a 1031 exchange page that contains everything you need to know. The general idea is that if you sell an investment property, you won't pay any taxes on the sale if you use the proceeds to buy a similar property.
You have to buy the new property for the same amount as or more than what you sold the first property for. And it needs a similar financing structure.
If you sell an investment property for $300,000 with a $150,000 mortgage remaining, your new property must cost at least $300,000 and have financing of the same amount or more.
And you need to identify properties within 45 calendar days of the sale of the first property. You have to close on the new property within 180 days, too.
There are other rules for completing a 1031 exchange, so be sure to do your research before starting the process.
Defer to a professional if you’re not sure
I’ve covered most of the tax concepts rental property owners need to know, but not every situation is black-and-white. Like with most other tax concepts, there are gray areas.
For example, you might not be sure if a certain expense is deductible. Or you may not know how to value the land your rental property is built on for depreciation. Maybe you aren’t sure if you can claim the QBI deduction or for how much.
There’s no way to cover every possible tax situation you might run into as a rental property owner. If you come across a rental property tax issue and you aren’t sure what to do, consult a professional. A tax attorney or a reputable and experienced tax preparer can answer your questions.
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