How is Rental Property Taxed?

While owning a rental property is a good investment and income stream, many choose to refrain from it mainly for complex tax issues. It is undeniable that rental income taxes are quite complicated compared to regular income taxes. Nonetheless, the complications are not as many might think.

When it comes to taxing rental property or income, there are two tax implications that apply. The first involves the way the IRS treats the rental income a property generates. While the second has to do with the way the IRS treats the eventual sale of a rental property.

Classifying rental properties

It is important to classify rental properties. You can start by answering this question: Is your property officially a rental property or a personal residence that you often rent out?

• Tax-Free Rental: This concern individuals who rent out a property for 14 days or less in a year. The IRS makes provision for this category by allowing short-term rentals with a specific break. As long as you rent the property at a fair market rate, you don’t have to claim the income on your taxes.

• Personal Residence: This category, of rental property, requires that you use the property for 14 days or 10% of all the days it was rented, whichever applies best to you. If you own a house and would like to rent it out, the IRS requires that you spend at least 14 days or 10% of the total time it is rented. That is, if you rent out a property for 150 days, you will have to spend 15 days (i.e. 150 / 10 = 15) before your property can be classified as a personal residence. Some exceptions can be made to rental income when filing tax returns.

• Rental Property: This category includes properties that are up for “full-time” rent. As the owner, you are not mandated to use the property at all or abide by the IRS residency cutoff of 14 days or 10% of total rent days. All rental income must be reported and you can deduct all related expenses related to the property. In the event where you lose money on a rental property, you can carry over those losses to your personal income.

‘What is rental income and how is it taxed?’

As the name implies, rental income is simply income generated from rental properties. The IRS properly defines rental income as “any payment you receive for the use or occupation of the property.” For example, if a tenant writes you a check of $500 per month as their rent, it is referred to as rental income. Rental income can also include the following:

• Services received from a tenant instead of monetary rental payment

• The parts of security deposits that are kept by you

• Advanced rental payment that you receive

• Other expenses paid by tenants if it is not their duty to pay them

Rental income is usually taxed as ordinary income. That is, if you belong to the 22% marginal tax bracket earning $5,000 in rental income to report, you will pay $1,100. The tax burden on rental property owners can be lessened in several ways. It is possible to have a rental property that shows no income or loss for tax purposes.

‘When to pay rental income’

Expenses are not included (i.e. expenses associated with a property). They are rather deductible against rental income. There are two main ways businesses can deduct their expenses when they spend money. They can deduct expenses from smaller purchases and immediately consumable items at once. For example, if a business spends $500 to restock office supplies, it can be deducted as ‘business expense’ on your tax return form. Also, assets that will still be in use over the cause of one year or more like machinery, can be deducted over time through depreciation. For example, if your business owns a piece of equipment with a 2-year life span, if you spend $5,000 on the equipment, you can take a depreciation deduction of $1,000 each year, lasting through the two years to deduct the cost.

It is assumed that real estate can effectively serve its purpose for a year or more (i.e. it has a life span of more than a year), the cost of deducting rental property may occur in two ways. First, residential rental properties have a 27.5-year deductible period. Second, commercial properties depreciate over 39 years.

Other allowable expense deductions are:

• Mortgage interest

• Insurance costs

• Property taxes

• Legal and other professional fees associated with owning a property

• Cost of property maintenance

• Condo fees or HOA dues

• Cost of services you pay for

Thanks to depreciation there are more tax deductions available to property owners. Many consider depreciation as a great advantage for real estate investors. It can be said to be a major reason why a lot of profitable rental properties show no income for tax purposes.

Qualified Business Income (QBI) on Rental Property

The Qualified Business Income (QBI) deduction is yet another tax break offered by the IRS for deducting a property’s expenses and depreciation. The QBI is also known as “pass-through” income deduction.

The QBI allows a 20% deduction of income from a qualified business on your taxable income. It includes income received from a pass-through entity like an S- Corporation or LLC. This is also applicable to businesses such as sole proprietorships. It is common to find real estate and rentals under this category.

There are also taxable income thresholds for individual taxpayers ($157,500) and married taxpayers ($315,000). Anyone under the threshold can take up the entire 20% deduction. There is also a provision for those that earn substantially more income to get a deduction. You can hire the services of a professional if you aren’t sure which category you fall under.

Rental Property Depreciation

Depreciation is a loss on the value of a building over time due to factors such as deterioration, age, wear, and tear. Land improvements and other purchased items that are not part of the building like household appliances can be included.

Rental property depreciation occurs when investors write off the structure and improvements to a property over a period of time. This reflects as “expense” and can be used to write off on your rental income tax. Only improvements to the structure can be depreciated and not the land itself.

Depreciation holds a major advantage for property owners and real estate investing at large. It can reduce reportable net income, and by extension, your taxes.

How to Calculate Depreciation

Usually, the IRS grants property owners permission to take tax deductions based on the estimated decrease in value within a timeframe of 27.5 years. Depreciation deductions stretch over the “useful life” of a property. As permitted by the IRS, owners can depreciate the value of a property over a 27.5 year period.

Thus, depreciation is calculated with this formula:

Cost of the Building – Value of the Land = Building Value

Building value / 27.5 = Yearly allowable depreciation deduction

Example:

If a property worth $65,000 and the land worth $20,000, applying the depreciation formula will look something like this:

$65,000 - $20,000 = $45,000

$45,000 / 27.5 = $1,636