How Is Rental Income Taxed? A Guide For Real Estate Investors

Real estate investors can watch relatively passive income flow into their pockets. But like other forms of income, investors must pay taxes, which may prompt them to wonder, how is rental income taxed?

The IRS treats rental income as regular income for tax purposes. This means you’ll need to add your rental income to any other income sources you may have when you file your taxes. Keep in mind that you may be able to deduct certain qualified expenses to decrease what you owe at the end of the year.

The ability to deduct qualified expenses is one of the many tax benefits that come with owning rental properties. But after the deductions are accounted for, your rental income is added to your regular income.

As of 2023, the federal tax rates on income are broken down to the following rates:

Beyond the tax rates listed above, you may also owe taxes to your state government. When determining your rental income and working through your taxes, we recommend seeking the advice of a financial advisor and tax expert.

As you tally up your rental income, you’ll need to include more than your monthly rent check. Below is a closer look at some of the things that count as rental income for tax purposes:

• Advance rent payments: If your tenant pays rent in advance, that is considered rental income. For example, if your tenant puts down the first and last month’s rent before moving in, both rental payments are considered income when you receive those funds.
• Regular rent payments: Of course, your tenant’s monthly rent check is considered rental income.
• Security deposits: If your tenant makes a security deposit, which you intend to return at the end of the lease, that’s not considered income. But if you retain some of the security deposit to cover damages, the portion you keep counts as income.
• Lease cancellation or termination payments: If a tenant has to pay a fee to cancel a lease, that fee counts as rental income.
• Property or services received instead of rent: When you receive property or services from your tenant in place of rent, the value of the rent payment must be counted as rental income. For example, if you waive your tenant’s monthly rent payment because they installed a fence, you would need to count that waived rent payment as income.
• Tenant-paid owner expenses: If the tenant covers expenses they aren’t responsible for, and deducts the expense from their rent, the covered expense must be reported as income. For example, let’s say the tenant pays the appliance repair bill that wasn’t their responsibility under the lease. When they deduct this expense from their rent, you must count the bill amount as income.
• Partial interest: If you only own a portion of the rental property, you must report your share of the profits. For example, if you own 50% of a property, you must report 50% of the rental income on your tax return.
• Lease with option to buy: If your tenant has the option to buy the property, all payments received are considered rental income.

The ample tax deduction opportunities are one thing that makes owning a rental property attractive to some. In general, the IRS allows you to deduct any ordinary and necessary expenses for managing and maintaining your rental property. Ordinary expenses include costs that most property owners face, while necessary expenses are unavoidable.

While there are many different types of rental property tax deductions, here are some of the most common.

Property Management Expenses

If you pay for property management, you can deduct this expense from your rental income. Most landlords can agree that property management is a necessary part of running your rental property. For property owners who aren’t able to commit to running the property by themselves, the cost of hiring help can add up quickly. Luckily, it’s a deductible expense.

Maintenance Costs

Property owners of all kinds can commiserate over the fact that maintaining a residence can get expensive quickly. As a real estate investor, you can deduct these maintenance costs from your taxable income.

A few kinds of maintenance costs you might encounter include materials, supplies and repairs to keep your rental property in good condition. For example, you might deduct the cost of cleaning out the gutters or paying someone to cut the grass.

Importantly, you cannot deduct the cost of improvements. If you’re making a major upgrade to the space, the costs of the improvement cannot be deducted.

Property Tax

Property tax is an unavoidable expense for landlords. Depending on the value and location of your property, the cost of property taxes can add up quickly. The good news is that real estate investors can deduct property taxes on their investment properties.

As with all of these expenses, you’ll need to keep detailed records about your property tax payments.

Utilities

If you’re paying for the utilities at your investment properties, you can deduct this necessary expense. Some landlords have their tenants pay for the utilities. But even they have gaps between tenants, which might require paying for utilities now and then.

Whenever you have utility costs tied to your rental property, you can deduct this expense from your rental income.

Advertising

Every landlord wants to find the right tenants for their property. In many cases, this involves spending money on advertising when the property is available.

Cost-effective forms of advertising might include putting a “for rent” sign in the front yard. But if you want to reach a wide audience, you might need to post the listing on multiple platforms to draw in the perfect tenant.

All of these advertising opportunities come with a cost. As long as you track these expenses, the IRS allows you to write off advertising costs.

Insurance

If you don’t have a mortgage on the property, you might not be required to get landlord insurance. But getting an appropriate amount of insurance is usually the right move. The only downside of getting insurance is the premium payments.

As a real estate investor, you can deduct these sometimes expensive premium payments from your rental income.

Homeowners Association Fees

If the property you own is within the jurisdiction of a homeowners association (HOA) or condominium, you’ll likely get stuck with an HOA or condo fee. Depending on the situation, this fee could eat away at a significant portion of your profits.

As an investor, you can deduct the HOA fee or condo fee from your rental income.

Travel

If you travel to and from the property, you have an opportunity to deduct your travel expenses. While the deduction might not be very large if you live in town, it’s always worthwhile to write off any deductions you qualify for.

Start by tracking your mileage when traveling to your properties. The IRS allows you to write off a standard mileage rate, which was 62.5 cents per mile in the second half of 2022.

For investors who live farther away from their properties, the travel expenses might add up faster. After all, getting on a plane to look at your rental properties will likely involve a significant expense.

Be careful about mixing business with pleasure. If you make a business trip to your property but spend double the amount of days visiting family, then you might not be able to deduct the costs of this trip. Always ask a tax professional when you have questions about potential deductions.

Legal And Professional Services

Most real estate investors build a network of professionals to help them manage their rental property business effectively. For example, you might hire a lawyer or CPA along the way. In fact, working with these professionals can help you save time and hassle in the long run.

Depreciation offers another tax benefit for real estate investors. For many investors, depreciation offers the biggest perks. Essentially, depreciation allows you to deduct the cost of buying and improving a rental property for the course of its useful life. Since you can deduct the cost of depreciation, you can lower your taxable income in the process.

As an investor, you can deduct the cost of buying and improving a rental property over 27.5 years, which is what the IRS considers the “useful life” of residential rental properties. If you’re investing in commercial property, the depreciation timeline is 39 years.

Here’s how to calculate depreciation for residential real estate.

• Determine the property’s cost basis: The property’s cost basis is the amount that you paid to acquire the property. This can include the amount you put into the property, the amount you borrowed to buy the property and the expenses related to rehabbing the property.
• Separate the land cost from the building: Unlike the rental house, the land isn’t a depreciable asset. A portion of the acquisition costs must be allocated toward the land where the building sits.
• Straight-line depreciation: If using straight-line depreciation, you spread the cost basis evenly over 27.5 years.

For example, let’s say that you acquired a rental property with a cost basis of $100,000. That would generate a depreciation of $3,636 per year. But you cannot start this depreciation deduction until the property is placed into service, which means the amount is prorated on a monthly basis.

Ultimately, depreciation can lower your taxable income for the year. But keep in mind that the IRS will use depreciation recapture when you sell the property. In other words, the IRS will expect something back from your tax write-offs when you sell the property.

If you want to pursue this deduction, it’s a good idea to consult a tax professional.

When it is time to report your rental property income on your taxes, you’ll need to list it on the appropriate tax form.

If you have less than three properties, you can list your rental income and expenses on a Form 1040 or 1040-S, Schedule E, Part 1. Be prepared to list the income and expenses on a Schedule E tax form. If you have more than three properties, you’ll need to fill out as many of these forms as necessary to list all of the properties.

When reporting rental income and taking deductions, be sure to keep detailed records of your cash flow. You must be able to provide evidence to the IRS that you did receive that amount of income or qualify for the deductions you are claiming.

It gets a bit more complex if you use the property for any personal use. In many cases, using the property for a vacation home or primary residence will limit your rental deductions.

Real estate investors can tap into a wide range of real estate deductions. But, like everyone else, they still have to pay taxes on their rental income. As a real estate investor, keep detailed records of your rental income and expenses to create a smooth tax filing experience. And, of course, it’s always best to speak with a financial advisor and tax professional when it comes to your finances.

If you’re interested in growing your real estate investment portfolio, apply for a mortgage with Rocket Mortgage^®.