Rental Income Tax Rules in California

Owning rental property in California means navigating tax rules from both the Internal Revenue Service (IRS) and the California Franchise Tax Board (FTB). All income generated from the use or occupation of a property is taxable and must be reported. This includes not just monthly rent checks but a variety of other payment types that landlords receive.

The tax framework requires careful record-keeping and a clear understanding of what constitutes income and what qualifies as a deductible expense. This guide provides an analysis for California landlords to comprehend their tax responsibilities, ensuring compliance while accurately calculating their financial position.

Identifying Taxable Rental Income

Rental income encompasses all payments received for the use or occupation of a property. Both the IRS and the California FTB define taxable income broadly, including several other types of payments that a landlord might receive. Landlords must track and report all these forms of income on their annual tax returns.

A common area of confusion involves advance rent. Any amount a landlord receives before the period it covers is considered income in the year it is received, regardless of the accounting method used. For example, if a tenant signs a lease in December and pays for both the first month’s rent and the last month’s rent of the lease term at that time, the entire amount is taxable income in that year, not split between the first and final years of the lease.

Security deposits have specific rules that distinguish them from advance rent. A security deposit, which is intended to be returned to the tenant at the end of the lease, is not included in income when received. It only becomes taxable income if and when a portion or all of the deposit is kept by the landlord. This occurs if a tenant fails to pay rent or causes damage to the property beyond normal wear and tear. The amount withheld is then reported as income in the year it is forfeited.

If a tenant pays a utility bill or for a necessary repair on the landlord’s behalf, the value of that payment is considered rental income to the landlord. The landlord would then deduct the cost of that utility or repair as a rental expense. Similarly, if a tenant provides services, such as painting or plumbing, or gives the landlord property in lieu of cash for rent, the fair market value of those services or property is taxable rental income.

Allowable Deductions for Rental Properties

Landlords can reduce their taxable rental income by deducting the ordinary and necessary expenses associated with managing and maintaining their rental property. These deductions directly lower the overall tax liability. Careful tracking of all expenditures throughout the year is necessary to accurately claim these deductions.

Landlords can deduct the interest paid on a mortgage or other loans used to acquire or improve the rental property. It is important to note that only the interest portion of the mortgage payment is deductible, not the part of the payment that reduces the principal loan balance.

Property taxes paid to state and local governments are another major deductible expense. These are the annual taxes assessed on the value of the real estate itself. Beyond property taxes, landlords can deduct various operating expenses required to keep the property in a rentable condition. These include premiums for landlord insurance policies, utilities paid by the landlord, and fees for cleaning and routine maintenance.

A distinction must be made between repairs and improvements. Repairs, which are actions that keep the property in good working order like fixing a leak or replacing a broken window, are fully deductible in the year they are paid for. Improvements, on the other hand, are expenditures that add value to the property, prolong its life, or adapt it to a new use, such as adding a new roof or remodeling a kitchen. The cost of improvements cannot be fully deducted in one year; instead, they must be capitalized and recovered over time through depreciation.

Other deductible costs include professional and legal fees. This category covers payments to accountants for tax preparation, lawyers for drafting leases or handling evictions, and fees paid to property management companies. Landlords who travel to their rental property for management or maintenance purposes can also deduct the associated travel expenses, provided the primary purpose of the trip is related to the rental activity. The costs of advertising the property for rent are also fully deductible.

Calculating and Understanding Depreciation

Depreciation is a tax deduction that allows landlords to recover the cost of their rental property over time. It accounts for the wear and tear, deterioration, or obsolescence of the asset. You can only depreciate the value of the buildings and improvements on the property; the land itself is not depreciable because it is not considered to wear out.

To calculate depreciation, a landlord must first determine the property’s basis. The basis is the amount paid for the property, including certain purchase-related costs like legal fees and recording fees, less the allocated value of the land. For example, if a property is purchased for $400,000, and an appraisal determines the land is worth $100,000, the basis for depreciation would be $300,000.

The Internal Revenue Service mandates the use of the Modified Accelerated Cost Recovery System (MACRS) for residential rental properties placed in service after 1986. Under MACRS, the cost of a residential rental building is recovered over a specific period. This recovery period for residential rental property in the United States is 27.5 years.

Using the straight-line method under MACRS, the annual depreciation deduction is calculated by dividing the depreciable basis by the recovery period. For a property with a depreciable basis of $300,000, the annual deduction would be approximately $10,909 ($300,000 / 27.5 years). This amount can be deducted from the rental income each year. The calculation may be prorated for the first year of service using a mid-month convention.

When a rental property is eventually sold, the owner may have to address depreciation recapture. This tax rule requires that the total amount of depreciation claimed over the years of ownership be “recaptured” and taxed. The recaptured amount is taxed at a maximum rate of 25%, which is different from the standard capital gains tax rates.

Reporting Rental Income and Expenses

Landlords must use Schedule E (Supplemental Income and Loss), which is filed with their annual Form 1040 tax return. This schedule is designed to calculate the net profit or loss from the rental activity by systematically listing all income and subtracting all allowable expenses.

Part I of Schedule E is where landlords report income and expenses for their rental real estate. The form provides separate lines to enter gross rental income, followed by a list of expense categories such as advertising, insurance, mortgage interest, property taxes, repairs, and utilities. There is also a specific line to enter the annual depreciation deduction. After all expenses are subtracted from the income, the resulting figure is the net rental income or loss.

This net figure from Schedule E is then transferred to the main Form 1040, where it is combined with all other sources of income to determine the taxpayer’s total adjusted gross income. For California tax purposes, the net income or loss calculated on the federal Schedule E is the starting point for the state return. California’s tax form, Schedule CA, is used to report any adjustments needed to conform the federal income amount to California’s specific tax laws.

California-Specific Tax Considerations

There are several unique state and local provisions that landlords must consider. These requirements can impact a landlord’s overall tax liability and compliance obligations.

One factor in California’s real estate landscape is Proposition 13. This state constitutional amendment limits the annual increase in a property’s assessed value for tax purposes. This can result in California landlords paying property taxes that are based on a value significantly lower than the current market value, potentially leading to a smaller property tax deduction compared to landlords in states without such limitations.

Many cities and counties in California require property owners who rent out units to obtain a business license and pay an associated local business tax. These fees are often calculated based on the gross rental receipts. This is a separate obligation from federal and state income taxes and varies widely by jurisdiction, so landlords must check the specific rules for the city or county where their property is located.

California also has specific rules regarding passive activity losses that can differ from federal law. California did not conform to the federal rule that allows certain real estate professionals to treat their rental activities as non-passive. As a result, all rental activities are considered passive for California purposes, which may limit the amount of loss that can be deducted in a given year.

Finally, there is a specific withholding requirement for landlords who do not reside in California. If a non-resident owner receives rental payments from a California property, the property manager or tenant may be required to withhold 7% of the gross payments and remit it to the Franchise Tax Board (FTB). This acts as a prepayment of California state income tax and applies when payments to a non-resident owner exceed $1,500 in a calendar year.