How to Calculate Tax on Rental Income

Calculating tax on rental income is an important aspect of property ownership. This process involves identifying rental income and accounting for deductions. Property owners must determine their taxable net income to comply with federal tax regulations. This article guides individuals through the steps to calculate and report rental earnings, covering income types, deductible expenses, calculation methodology, and filing procedures.

Understanding What Counts as Rental Income

Rental income includes any payment received for the use or occupancy of property, such as regular monthly rent from tenants. Advance rent, like a payment for the last month’s rent at the beginning of a lease, must be included in income in the year it is received.

Payments tenants make for expenses that are the property owner’s responsibility are also considered rental income. For example, if a tenant pays for repairs or utilities that the lease states are the landlord’s obligation, these payments are treated as additional rent. Payments received from a tenant to cancel a lease are also taxable rental income in the year received.

A security deposit is not included in income when received if it is refundable. It becomes taxable income only if withheld because the tenant breached the lease or caused damage, and the property owner keeps it. The value of services received from a tenant in place of rent, such as repairs, must also be included in rental income.

Identifying Your Deductible Expenses

Property owners can reduce their taxable rental income by deducting ordinary and necessary expenses. An ordinary expense is common in the rental business, and a necessary expense is helpful for maintaining the property. These expenses lower the net income subject to tax.

Mortgage interest is one of the largest deductions for rental property owners. Interest paid on a loan used to acquire or improve rental property is fully deductible, including interest on a mortgage, second mortgage, or line of credit. Lenders report the amount of interest paid during the year on Form 1098, Mortgage Interest Statement.

Property taxes assessed on the rental property by state or local governments are also deductible. These taxes are paid annually or semi-annually and are a direct cost of owning the property. Owners should deduct only the portion of taxes attributable to the rental period if the property was not rented for the entire year.

Operating expenses cover costs of day-to-day property management. This includes utility payments like electricity, gas, water, and sewer if the owner is responsible. Insurance premiums for policies covering fire, theft, liability, and other risks are also deductible. Advertising costs, cleaning and maintenance services, and supplies used for the property are examples of deductible operating expenses.

Repairs to keep the property in good condition are deductible expenses, such as fixing a leaky faucet, patching a roof, or repainting a room. Repairs maintain the property’s current condition and do not add to its value or extend its useful life. In contrast, improvements, like adding a new room or replacing an entire roof, are not deductible. Their cost is recovered through depreciation over several years.

Depreciation allows property owners to recover the cost of the property and certain improvements over a specific period. This deduction accounts for wear and tear, deterioration, or obsolescence. For residential rental property, the recovery period is 27.5 years under the Modified Accelerated Cost Recovery System (MACRS). A portion of the property’s cost, excluding land value, is expensed each year.

Professional fees related to rental property are also deductible. This includes fees for property managers, legal services (like drafting leases or handling evictions), and accounting or tax preparation. Travel expenses incurred solely for collecting rent or managing, conserving, or maintaining the rental property are deductible, such as driving for repairs. Owners should maintain detailed records for claimed expenses.

Performing the Income Calculation

After identifying sources of rental income and documenting expenses, calculate the net taxable rental income. Subtract total deductions from gross rental income. The formula is: Gross Rental Income minus Allowable Deductions equals Net Rental Income.

For example, if a property owner received $25,000 in gross rental income and incurred $10,000 in deductible expenses, the calculation is $25,000 – $10,000, resulting in $15,000 net rental income. This $15,000 is added to the property owner’s other income, such as wages or business profits. If expenses exceed income, the result is a net rental loss, which can offset other income, subject to passive activity loss rules. Performing this calculation accurately determines the correct tax liability.

Filing Your Rental Income

The calculated net rental income or loss is reported to the Internal Revenue Service (IRS) on Schedule E, Supplemental Income and Loss. This form is used for reporting rental real estate income or loss. Owners enter gross rental income and list deductible expenses on Schedule E.

Schedule E provides lines for deductions like advertising, cleaning and maintenance, insurance, legal and professional fees, management fees, mortgage interest, repairs, and taxes. The final net income or loss from Schedule E is transferred to Form 1040, U.S. Individual Income Tax Return.

Property owners claiming depreciation must complete and attach Form 4562, Depreciation and Amortization. This form calculates and reports the depreciation deduction and is referenced on Schedule E. Attaching Schedule E and Form 4562 to Form 1040 ensures rental income and expense information is submitted to the IRS.

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References:

IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes), Chapter 1, Rental Income.
IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes), Chapter 2, Rental Expenses.
IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes), Chapter 3, Depreciation.
IRS Schedule E (Form 1040), Supplemental Income and Loss.