Is Rental Income Taxable in California?

Rental income is subject to taxation at both the federal and state levels. In California, landlords must navigate regulations from the Internal Revenue Service (IRS) and the California Franchise Tax Board (FTB). The tax rate on rental income is determined by your total taxable income and filing status, as it is treated as ordinary income. California residents are taxed on all rental income, regardless of where the property is located, while nonresidents are only taxed on rental income from property within the state.

A difference between federal and state rules lies in how rental income is classified. For state tax purposes, California considers all rental income and losses to be a passive activity. Federal law, however, provides exceptions for those who actively participate in their rental activities or qualify as real estate professionals. These federal calculations are the starting point for the California tax return.

Defining Taxable Rental Income in California

Taxable rental income includes more than just the monthly rent payments. Any advance rent received is considered income in the year it is received, even if it applies to a future period. For example, if a tenant pays for the first and last month’s rent upon signing a lease, both payments are taxable in the year they are collected.

Payments received for lease cancellation also constitute taxable income. If a tenant pays a fee to terminate their lease early, that amount must be reported. Similarly, non-refundable security deposits are treated as income when received. This is distinct from a standard security deposit, which is a liability and only becomes income if it is used to cover unpaid rent or damages.

Late fees charged to tenants for overdue rent are another form of taxable income. Any services or property received in lieu of rent must also be reported. If a tenant performs a service, such as painting the rental unit, in exchange for a reduction in rent, the fair market value of that service is considered rental income.

Common Deductible Rental Expenses

Landlords can reduce their taxable rental income by deducting ordinary and necessary expenses associated with managing and maintaining their rental property.

Operating expenses form a significant category of deductions. These include the costs of advertising the property for rent, cleaning and maintenance between tenants, and insurance premiums for fire, theft, and liability. Fees paid to property managers, legal and professional fees for services like drafting lease agreements, and the cost of supplies are also deductible. If the landlord pays for utilities such as water or trash collection, these costs can be deducted as well.

Financial expenses are another major area for deductions. The interest paid on a mortgage for the rental property is a primary deduction, and property taxes paid on the rental building and land are also fully deductible. Travel expenses incurred while managing the rental property, such as trips to show the unit or perform maintenance, can also be deducted. It is important to maintain detailed records to substantiate these deductions.

A distinction must be made between repairs and improvements. Repairs, which are actions taken to maintain the property’s current condition, are currently deductible expenses. Examples include fixing a leaky faucet, patching a hole in the wall, or replacing a broken window. Improvements, on the other hand, are investments that better, restore, or adapt the property to a new use. These costs are not deducted in the current year but are recovered through depreciation.

The Role of Depreciation

Depreciation is a non-cash deduction that allows landlords to recover the cost of their rental property and its improvements over a set period. This deduction accounts for the property’s wear and tear. The building itself can be depreciated, but the land it sits on cannot. The cost of improvements made to the property, such as a new roof or a kitchen remodel, is also recovered through depreciation.

To calculate depreciation, the landlord must first determine the property’s basis. The basis is the original cost of the property, including certain settlement fees and closing costs. The basis for depreciation is the lower of the property’s adjusted basis or its fair market value at the time it is placed in service as a rental. This basis is then allocated between the land and the building, as only the building’s portion can be depreciated.

The standard recovery period for residential rental property under the Modified Accelerated Cost Recovery System (MACRS) is 27.5 years. California tax law conforms to the federal MACRS rules for assets placed in service after 1986, simplifying the calculation for landlords who must file both federal and state tax returns.

Depreciation is a required deduction, meaning that even if a landlord fails to claim it, the IRS will consider it to have been taken when calculating the property’s adjusted basis upon its sale. This has important implications for the tax consequences when the property is eventually sold.

Reporting Rental Income and Expenses

The process of reporting rental income and expenses involves specific federal tax forms, with the results carrying over to the California state return. All rental income and expenses are reported on IRS Form 1040, Schedule E (Supplemental Income and Loss). This form is used to calculate the net income or loss from the rental activity for the tax year. On Schedule E, landlords list total rental income and then itemize deductions such as advertising, insurance, mortgage interest, repairs, and property taxes.

California does not have a separate form equivalent to the federal Schedule E for reporting rental income. Instead, the net income or loss calculated on the federal Schedule E is transferred to the California Resident Income Tax Return (Form 540). For non-residents with California rental property, this amount is reported on the California Adjustments — Nonresidents or Part-Year Residents Schedule CA (540NR). The final figure from Schedule E becomes part of the taxpayer’s adjusted gross income on their federal return, which then serves as the starting point for the California return.

Tax Consequences of Selling a California Rental Property

When a rental property is sold, the tax implications are different from the annual reporting of rental income. A capital gain or loss is calculated by subtracting the property’s adjusted basis from the sale price. The adjusted basis is the original cost of the property, plus the cost of any improvements, minus the total depreciation deductions taken over the years.

Depreciation recapture is an important part of selling a rental property. The depreciation deductions that were claimed during the ownership period, which reduced ordinary taxable income, are “recaptured” at the time of sale. This recaptured amount is taxed at a maximum rate of 25 percent at the federal level.

The remaining portion of the gain, after accounting for depreciation recapture, is treated as a capital gain. This gain is subject to both federal and California state capital gains taxes. The federal rates vary depending on the taxpayer’s income, while California taxes capital gains as ordinary income.

Landlords may have options to defer the taxes on the sale of a rental property. One common strategy is a 1031 exchange, which allows an investor to sell a property and reinvest the proceeds in a new, like-kind property without immediately paying taxes on the gain.