How Much Tax Do You Pay on Rental Income?

Understanding the tax implications of rental income is crucial for managing your investment. While rental income is generally taxable, various expenses can reduce your taxable burden. This guide explores what counts as rental income and the deductions available.

What Counts as Rental Income

Rental income encompasses all payments received for the use or occupation of your property. This includes regular rent payments, the most common form, but other payments also qualify as taxable income.

Advance rent, for example, is taxable in the year it is received. If a tenant pays the first and last month’s rent upfront, both amounts are considered income in the year you receive them. Payments from a tenant for canceling a lease are also rental income and must be reported in the year received.

Payments made by a tenant for expenses that are the landlord’s responsibility are also treated as rental income. For instance, if a tenant covers a repair cost that is your obligation and deducts it from rent, that amount must be included in your rental income. Similarly, if you receive property or services instead of money for rent, their fair market value must be included as rental income.

Security deposits are generally not rental income if you intend to return them. However, if you keep all or part of a security deposit due to a lease breach, damages, or if it’s applied as a final rent payment, the retained amount becomes taxable income in the year it is forfeited or applied.

Deductible Rental Expenses

Deducting eligible expenses is a key way to reduce your taxable rental income. To be deductible, an expense must be “ordinary and necessary” for managing, conserving, and maintaining your rental property. An ordinary expense is common and generally accepted in the rental business, while a necessary expense is appropriate for that business.

Many types of costs can be deducted. Advertising expenses incurred to find tenants, such as online listings or newspaper ads, are fully deductible. Cleaning and maintenance costs, whether you hire a service or purchase supplies, are also deductible. Commissions paid to real estate agents for finding tenants are another common deduction.

Insurance premiums for property, liability, and even workers’ compensation (if you have employees) are deductible expenses. Mortgage interest is often one of the largest deductions, as you can deduct all the interest paid on a mortgage for your rental property. However, only the interest portion is deductible, not the principal payments.

Legal and professional fees paid to attorneys, accountants, or property managers are also deductible. Repairs, which keep the property in good operating condition without materially adding to its value or extending its useful life, are generally deductible in the year they occur. This differs from improvements, which are capitalized and depreciated over time.

Other deductible expenses include supplies used for the property, real estate taxes and personal property taxes, and utilities if paid by the landlord. Travel expenses directly related to the property, such as trips to collect rent or perform maintenance, can also be deducted.

Understanding Depreciation

Depreciation is a non-cash deduction allowing property owners to recover the cost of income-producing property over its useful life. It accounts for gradual wear and tear, age, and obsolescence. You cannot deduct the entire cost of a rental property in the year of acquisition.

Only certain types of property can be depreciated. Buildings, furniture, and appliances used in rental activity are depreciable, but land is not, as it does not wear out. Residential rental property has a depreciation period of 27.5 years, meaning the building’s cost is spread as a deduction over this recovery period.

To calculate depreciation, determine the property’s cost basis, generally the purchase price plus capitalized costs like closing fees and capital improvements. Subtract the land’s value, as only the building portion is depreciable. The remaining amount is your depreciable basis, divided by the useful life to determine the annual deduction.

Depreciation begins when the property is placed in service, meaning it is ready and available for rent. Even if the property is not rented for the entire year, you can still claim depreciation once it is ready for occupancy. This deduction is claimed annually on Form 4562 and reported on Schedule E.

How Rental Income is Taxed

After accounting for all eligible deductions, including depreciation, the net rental income is generally taxed as ordinary income. It is added to your other income sources, such as wages, and taxed at your marginal income tax rate.

Rental activities are typically classified as “passive activities” under Internal Revenue Code Section 469. This classification has significant implications, as losses from passive activities can generally only offset income from other passive activities. They cannot usually be used to offset active income, like salaries, or portfolio income, such as dividends or interest. This rule is a key limitation on how much rental losses can reduce your overall tax liability.

There is an exception to the passive activity rules for qualifying “real estate professionals.” If a taxpayer meets specific criteria, including spending a certain number of hours in real property trades or businesses, they can treat their rental activities as non-passive. This allows them to potentially deduct rental losses against non-passive income, offering a greater tax benefit.

Rental income is generally not subject to self-employment tax, as rental activities are typically considered investments rather than a trade or business. However, if you provide substantial services to tenants, such as operating a hotel or bed and breakfast, the activity might be considered a business subject to self-employment tax.

Rental income and expenses are typically reported on IRS Schedule E (Form 1040), Supplemental Income and Loss. Each rental property is usually listed individually on Schedule E, detailing its income, expenses, and depreciation. This form aggregates the net income or loss from all rental properties, which then flows to your main tax return, Form 1040.