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Taxes on Rental Property

How Rental Property Income Is Taxed

taxes on rental property

Understanding how taxes on rental property apply to rental income can be challenging if you own rental properties. Simply put, all rental revenue must be declared on your tax return, and in most cases, the associated expenses can be deducted.

It’s critical to understand how real estate tax reporting operates. Whether you already own a rental property or are considering making your first investment. After all, taxes might be the difference between a profitable rental property and one that loses money. Rental property owners should be aware of two types of taxes: those that apply to your rental revenue and those that apply to your property’s eventual sale.

Rental income taxes function differently from owner-occupied property taxes but in ways that can benefit real estate investors. Property investors should, as a general rule, declare as much of their income and costs as they legally can. Although this form of tax preparation seems confusing, it is much more easily understood when broken into more digestible parcels of information. Here is what you need to know when you are just getting started.

What Qualifies as Rental Income?

This question may seem like it has a simple answer. However, the last thing you want to do when filing a rental income tax return is claim more or less than the correct amount.

Rental income is taxable to you if you rent out your property and receive cash or the fair market value of items or services in exchange for the use of real estate or personal property. Most rental property owners buy rentals for an additional income, which implies they treat rental income as income when they get it and subtract expenses when they pay them and hope to make a profit.

The following items make up rental income:

  • Regular rent payment
  • Rent paid in advance
  • Payments made for a terminated lease

If the taxpayer intends to return the security deposit to the tenant at the end of the lease, it is normally excluded from rental income. However, if the taxpayer holds part or all of the deposit during any year because the tenant does not comply with the lease terms, the amount held is included as rental revenue for that year.

Keep These Less Common Occurrences in Mind…

If the tenant covers expenses, the amount paid by a renter for any of your expenses that is in your name, is included in your rental income. For example, assume that a renter pays the rental property’s water and sewage bill, which they exclude from their rent payment. The amount paid by the renter for expenses qualifies as rental income. You may still deduct the cost but if the rental pays your mortgage payment… the total payment is income, and you can only deduct the interest and or real estate taxes if they are included in your payment.

If you receive property or services in place of a cash rental payment, it must be counted as rental income. For example, suppose your tenant is a painter who offers to paint your rental in exchange for two months’ rent. Rental income is the amount the tenant would have paid for those two months.

Even with lease-to-buy agreements, payments must be declared as rental income.  If your tenant has the opportunity to buy the property under the rental agreement, the payments you receive are considered revenue.  Any partial interest in a rental property requires you to disclose your share of the rental revenue for your portion of a rental property.

What Are Rental Expense Deductions?

Just like ordinary income tax filings, rental income taxes follow a similar income-minus-expenses structure like regular income. Therefore, you can reduce it by deducting permitted costs, effectively lowering your tax bill. For example, as a rental property owner, you can typically deduct your expenditures for maintaining and managing the property, including payments for:

  • Advertising
  • Expenses for transportation and lodging (related to managing the property)
  • Maintenance and cleaning
  • Dues to a homeowners’ association (HOA)
  • Insurance
  • Fees for legal and professional services
  • Interest on a mortgage
  • Management of real estate by a third-party
  • Property taxes
  • Services such as utilities, pest management, and others

These deductions are usually taken in the same year that the money is spent. You can also deduct the expense of purchasing and developing your rental property, although the rules are a little different there. Instead of claiming a significant deduction all at once, depreciation allows you to recover these expenses.

Understanding Depreciation

One of the most significant tax benefits regarding rental income taxes is depreciation. It lets you deduct the costs of purchasing and improving a rental property throughout the course of its useful life, decreasing your taxable income.

Depreciation is a method for real estate investors to recover the initial cost of their property over time. They deduct it from their annual income tax. This depreciation allowance is based on the premise that the value of a property depreciates over time. This is attributable to wear and tear, degradation, or obsolescence.

A residential rental property depreciates over the course of 27.5 years, or 3.636 percent per year. So this omits the value of the lot or land, which does not depreciate because land does not wear out.

If you are unsure whether your rental income includes depreciation, consider these factors determined by IRS regarding depreciation:

  • You own the property. As far as the IRS is concerned, you are the owner even if the property is subject to a debt.
  • You use the property in your business or as an income-producing activity.
  • The property has a determinable useful life. That means it’s something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
  • The property is expected to last at least one year

Reporting Rental Income

Property owners must file 1040 Tax Return and a Schedule E for their rental income taxes. The basic income tax form that anyone paying federal taxes must file is Form 1040. It requires filers to provide personal information such as social security numbers and the number of dependents. Rental owners will also need to fill out Form Schedule E and a deprecation schedule 4562 to declare their rental activity.

When determining how rental income is taxed, the Schedule E form is critical. This document will detail the entire revenue, expenses, and depreciation for each investment property. Based on the number of properties they own and operate; investors may need to file multiple Schedule E forms. It’s crucial to note, though, that even if you complete many Schedule E forms, you should only record the “totals” on one page. Gathering up all your data can be a real chore, we have a Rental Information Form to assist you.

Investors should keep exact cost and income records throughout the year to guarantee a simple tax filing process. In addition, it’s a good idea to maintain track of rent checks, company receipts, and any other papers pertaining to potential deductions. Finally, when reporting rental income, always double-check the information provided. When filing paperwork, it’s usually a good idea to be as cautious as possible.

Rental Income Taxes When Selling a Property

The tax ramifications of selling your rental property should be considered. Long-term capital gains will be taxed on any profits gained on the sale of a rental property. As a result, the amount of money you’ll have to pay will differ based on how much money you made. This tax applies only if you have owned the property for more than a year, which is the case with most rental properties.

Also, keep in mind that there is a depreciation recapture tax. You may have benefited from the property’s depreciation, which reduces the rental’s taxable income while holding a rental property. You will, however, owe taxes on the entire value of depreciation charges claimed for the course of your possession of the property.

The IRS will notice the depreciation deductions you took when you sell your rental property, and it will want part of that money back. Depreciation recapture is what it’s called, and it might be a costly shock to unsuspecting property owners. The longer you own the property the more depreciation you have used.

Final Thoughts

Real estate rentals are a common way for investors to get into the market. You may make money as a rental property owner by collecting rents and appreciating your property. While you will have to pay taxes on the revenue generated by your rental property, you can lower your income—and hence your tax burden—by taking advantage of several deductions.

Taxes can have a big impact on your financial situation. Working with a trained tax specialist can assist in ensuring that you know the rules. Also, that you implement them in the most advantageous way feasible for your circumstances.

When beginning the process of rental income taxes, it is incredibly easy to become overwhelmed. Or you can make a mistake – which can lead to fines, audits, and possibly charges. For those who are new to this business venture and handling rental income, it may be best to hire a tax specialist. A tax specialist that can walk you through the filing process while ensuring all of your submitted information is accurate.

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