Rental Property Tax & Deduction Guide
You don’t have to be a rich mogul to start real estate investing. Though you may wish to expand your real estate empire one day, you only need one rental property and one tenant to start earning rental income. Unfortunately, one property is also all you need for the IRS to take notice. Make sure you understand the tax implications of the choice before becoming a landlord.
How Rental Income Tax Works
You already know the drill: you made a little cash, and the IRS wants their share. The IRS classifies rental income as ordinary income and charges you tax. Because it’s considered “ordinary,” the IRS taxes this income at the same rate as your regular wages. You won’t get to pay the reduced rate enjoyed by capital gains and other investments.
Don’t fret over this, however, because you may get something that serves you even better than a preferred tax rate. There are many deductible expenses involved with owning rental property, and these can help you reduce your tax liability. You must report your rental income to the IRS, but you can offset this income with operating expenses.
What is Considered Rental Income?
Obviously, the rent payments your tenant hands you each month are income, but things are never quite that simple. Before you start counting your rent money, you need to understand what you need to count and when.
Many landlords with only one or a few real estate investments use the cash method of accounting for taxes. This means you report any rental receipts at the time you received them. Let’s say, for example, that your tenant pays her January 2022 rent on December 28 of 2021. You will report this payment as income on your 2021 taxes because that is when you received the money. It doesn’t matter that it actually covers a month in 2022. Any amount of advanced rent you receive is taxable and gets treated in this way.
The taxation of security deposits can get a little tricky. If you intend to hold the security deposit and give it back to your tenant at the end of the lease, it is not considered taxable income. But if you use the money it becomes taxable income.
For example, pretend your new tenant Bob gives you a $1,000 security deposit when he moves in. You plan to return it to him when the lease expires, so you don’t have to pay tax on the money. Unfortunately, when Bob moves out, you notice that he put a hole in the wall. It costs $300 to fix the hole, so you only give Bob $700 back. In this case, the $300 you kept becomes taxable income.
Now let’s change things up. In this example, you and Bob agree that you will use Bob’s security deposit to cover his last month of rent. Because you intend to keep the security deposit, it’s taxable income as soon you receive it.
Canceling a Lease
Sometimes circumstances change, and a tenant who signed a lease with you may have to break it and leave early. Here comes Bob again. Say Bob signed a lease with you to rent your condo for a year. Unfortunately, three months into the lease Bob’s mother falls ill and he must leave to take care of her. According to the terms of the lease, Bob must pay you a $500 early lease termination fee. If he pays you, the $500 is rental income. Of course, given the circumstances, you’ll probably be nice and waive the fee. In that case, no money changes hands and there is no income to report.
Any services you receive in lieu of rent also count as income. Pretend your rental property has some electrical issues that need fixing. As fate would have it, our man Bob is a licensed electrician. He offers to do the electrical work for you. In return, you agree not to charge him rent in January or February. If the apartment rents for $1,000 a month, you must still count $2,000 of income for those months.
Expenses Paid by Your Tenant
Like security deposits, this one gets a little tricky too. Under the simplest arrangement, your tenant will put the utilities and other expenses in their name and pay the bill when it comes. This doesn’t need to involve you at all.
In other instances, your lease may require that your tenant reimburse you for certain expenses. The water bill, for instance, often stays in the property owner’s name. In this case, your lease may include a provision that you pay the water bill and then your tenant reimburses you. This reimbursement is not taxable income.
It becomes taxable, however, if a tenant pays an expense they weren’t obligated to. Again, an example is helpful. Bob rents a house from you. Under the terms of the lease, you are responsible for the water bill. Unfortunately, you get sick and end up in the hospital for a few days. As a result, you don’t pay the water bill on time. Bob comes home to a shutoff notice from the water company. To keep his water on, Bob pays the water bill and then deducts it from his rent. In this case, Bob’s water bill payment is taxable income for you.
Rent to Own
If you’re renting a property and giving your tenant the chance to buy it, the IRS generally treats any money you receive as rent. These arrangements can become quite convoluted, however. If you have a lease-purchase agreement, it’s wise to consult both a lawyer and a CPA at tax time.
Rental Property Tax Deductions
Your rental generates income for you, but not without creating expenses as well. The IRS allows you to deduct certain expenses to reduce your rental income, and they can prove a big help. There are several deductions you don’t want to miss.
If you’re still paying for your rental, the IRS allows you to deduct the amount of mortgage interest you pay. The IRS counts the mortgage interest you pay on your rental unit as a business expense. Your mortgage company will send you a statement at the end of the year outlining how much interest you paid, so don’t sweat it if you haven’t kept the best records of your interest.
The Depreciation Expense
Unfortunately, the things you buy wear out over time and they sometimes lose value as they do. As such the IRS allows rental property owners to depreciate their residential property over 27.5 years. To keep things simple, it’s generally helpful to use the simple, straight-line deprecation method. Simply divide the value of the property by 27.5 and deduct that amount for deprecation every year.
It’s easy to overlook at tax time, but you likely pay property taxes on your rental unit. If so, you can deduct them from your income at the end of the year. Just like mortgage interest, you can treat your property taxes as a business expense. If you have a mortgage, the taxes may be part of what you pay every month. If so, they will appear on the form your mortgage company sends at year-end. If not, you’ll have to track this expense yourself.
Repairs – Sometimes
Generally, you may deduct expenses you incurred to repair your rental property. If you fixed a garbage disposal, replaced a washing machine, or fixed a plumbing leak, the amount you paid for the repair counts as an expense. This is true whether you handled the repairs directly or paid a property management company to do or oversee the work for you. If you use a property management company, the fees you pay them are also a deduction.
Note that the IRS distinguishes between repairs and capital improvements. Repairs you make to keep the property in good working order are expenses. Renovations and improvements, however, are capital investments that increase the value of the property. When you make improvements, they get added to the overall value of your property and then worked into a new depreciti9on schedule. You can’t just count them as an expense.
For example, say you buy a rental property for $200,000. It needed a new dishwasher so you put one in for $300. This $300 is a deductible business expense. After replacing the dishwasher, you decide the property needs a second bathroom. You install one for a cost of $20,000. You cannot deduct the $20,000 as an expense. Instead, the IRS now views your cost basis in the property as $220,000. This is the figure you will use to calculate future depreciation.
Examples of items the IRS counts as capital improvements include:
- Sprinkler systems
- New roofs
- Security systems
- HVAC systems
The Qualified Business Income Deduction
Under the tax law changes of 2017, you may be able to take the qualified business income deduction (QBI). The QBI allows pass-through entities to deduct up to 20 percent of their income before paying taxes. Income from renting out a property is a pass-through situation if you are personally liable for the rental business’ income taxes. This is a deduction you don’t want to miss, but it does phase out as your income increases. This is another good one to discuss with a CPA to make sure you get the biggest deduction you can without taking too much.
There are several other deductions you can take for your rental property as well, and taxpayers overlook many of them. You can, for example, deduct the cost of advertising your property in the rental market. You can also deduct insurance premiums you pay for the property as well as HOA or condo fees. Legal expenses, like the cost of having an attorney draft a lease, are also deductible. Pest control, trash removal fees, and cleaning costs also count as business expenses.
A very frequently overlooked rental expense is travel. Pretend for a moment that you live in Pennsylvania but own a home in Florida. You have a property management company oversee the rental of and basic maintenance on the property — an expense you remember to deduct on your taxes. They call you one day and tell you that you’ve had a serious plumbing issue and you need to come to inspect the situation and advise them on how to proceed. The money you pay for the plane ticket and other travel expenses are tax-deductible since this trip is all about dealing with an issue and not taken for pleasure.
Reporting Rental Income on Your Tax Return
Come tax time, you will report rental income on a Form 1040 Schedule E. This form provides ample space to report your income and any expense you’re using to offset it. Note that if you have multiple rental properties, the IRS will want to see the accounting for each one separately. You can add additional sheets of paper if you need more room to list them all.
This form itself is not complicated, but knowing exactly what you can deduct sometimes is. The Schedule E comes with detailed instructions, of course, but the wording in IRS instruction manuals isn’t always clear. If you have questions, a CPA can help.
Being a landlord has its ups and downs, but it’s often a good way to supplement your income. If you’re new to the game, however, it’s a good idea to let the CPAs at Picnic Tax help you adjust to your new tax picture. We can help you make sure you’re reporting your income properly while getting every deduction and tax break you’re entitled to. We want your landlord experience to be a positive one that moves you toward your financial goals rather than frustrating you. Reach out today and let us know how we can help.