Real Estate Investing
Tax Rates on Rental Income: What You Need to Know
Belong on Aug 1, 2022
Rental property is defined by the IRS as a property you own and rent to tenants for 15 days or more each year. It is critical to understand how taxes are calculated as they relate to your rental property. This also allows you to plan accordingly and consider implementing tax strategies for real estate investors.
How tax rates work
The United States has a progressive tax system which means your tax rate increases as your income grows. Tax rates in the United States range from 10% to 37%. Importantly, each person is charged at multiple rates as your income rises, rather than just at the rate of the bracket into which you fall for the total amount of your income. You can also lower your tax burden or the amount of money you will owe at the end of the year by claiming certain deductions on your tax return.
Federal Rental Real Estate Taxes
There are both federal and state taxes related to your real estate rental income, but at the federal level, your net rental income is taxed as ordinary income according to your IRS tax bracket. Essentially, the rental income you collect, minus your expenses, will contribute to your total income, which is progressively taxed.
To calculate your federal income tax from rental incomes, you’ll need to use two IRS forms:
- Schedule E: Supplemental Income and Loss, Form 1040 or 1040-SR
- Form 4562 to report depreciation
How to calculate your rental income
To determine your rental property income, you’ll need to subtract any rental property expenses from the total income generated from your rental property. This number becomes your total taxable income before depreciation. Once you calculate and deduct depreciation from that number, you will add the remaining amount to any other taxable income.
Rental property income
Rental property income is primarily the rent you collect from your residents. However, there are several other potential sources of income that you will need to include. If your residents have pre-paid some or all of their future rent, you’ll need to include this as part of your rental property income. Security deposits that were not returned to a resident should also be included. If you are still in possession of a security deposit and the lease has not expired, you should categorize those amounts as a short-term liability on your balance sheet, so they are not included in your income.
Any additional fees, such as pet or lease cancellation fees, will also contribute to your total rental property income. Finally, you’ll need to include tenant-paid owner expenses in calculating your rental property income. These types of expenses can occur if your resident is not obligated to pay for utilities, like water or electricity, as part of their lease but they make a payment and are not reimbursed. We recommend that you keep a careful record of all income to ensure that your tax return is accurate.
Rental property tax deductions
Rental property tax deductions come in the form of expenses related to the operation and management of your property. These deductions work by lowering the overall taxable income at the end of the year.
Common rental property tax deductions include:
- HOA fees
- Advertising and marketing
- Cleaning, maintenance
- Legal or professional fees - hiring an attorney to create a lease, accounting services
- Property management
- Mortgage interest
- Property taxes
- Utilities, pest control, and other services
You can reduce your total taxable income by keeping careful records of your expenses. If you are not a meticulous record keeper, you should consider using accounting software for landlords to ensure accuracy.
Rental property depreciation
The final piece of information needed to calculate your taxable rental property income relates to the depreciation of your property. This is an essential step, as depreciation lowers your taxable income over a period of time.
You can deduct the costs of buying and improving a rental over its useful life through a process called depreciation. Depreciation is calculated using a modified accelerated cost recovery system (MACRS). Essentially, this allows you to depreciate your property over the course of 27.5 years, which is considered the useful life of your property. This equates to 3.636% each year. Keep in mind that depreciation does not include the value of the land because land does not become less useful over time. Therefore, land does not depreciate.
We recommend you engage a tax professional to assist in identifying the correct depreciation amount. You can estimate your depreciation by taking the amount you paid for the property, minus the value of the land and dividing by 27.5. This should give you an estimated amount for your yearly depreciation deduction.
As you make capital improvements to your property, you can add this amount to the property's value and recalculate your depreciation. Again, this is best done with consultation from a tax professional. For more detailed information, you can review IRS Publication 946: How to depreciate property.
Other types of rental property taxes
While your federal taxable rental property income will account for the major portion of your tax burden, there are several additional taxes related to owning a rental property.
State real estate taxes
In most instances, the tax rate on rental income is based on federal standards. However, each state has its own guidelines regarding taxable rental income. You should familiarize yourself with these guidelines or engage the services of a tax professional in your state or the state where your property is located.
It’s likely that you are already familiar with property taxes. This is the amount you pay monthly, along with your mortgage payments. This amount is based on the assessed value of your home and varies depending on your state’s property tax rate.
Capital Gains Tax
The capital gains tax is related to selling and buying real estate. Even if you have no plans to sell your rental property, you should familiarize yourself with this tax to plan appropriately for the future. If you sell a property at a profit after owning it for at least one year, you will owe a capital gains tax. The IRS provides detailed information regarding the capital gains tax: Internal Revenue Service. “Tax Forms and Instructions,” Pages 8–9. The capital gains tax exists to ensure that property owners are taxed in accordance with how their property appreciates or increases in value.
Depreciation Recapture Tax
Rental property owners must also understand how the depreciation recapture tax can impact their tax returns. If and when you sell your rental property, the IRS will collect a certain amount of the depreciation deductions you have taken on the property. This amount is calculated not by how much of a deduction you have taken in the past but by the
depreciation deduction you should have taken. If you failed to take a depreciation dedication, you would still own the depreciation recapture tax. The depreciation recapture tax is based on your ordinary income tax rate and is capped at 25%.
Preparing for rental property taxes
You'll need to keep careful, accurate records to avoid potential penalties and ensure your taxes are correct. Consider working with an accountant or property manager if this sounds challenging. Some property management companies offer record keeping and reports that may assist you in preparing your taxes. Most importantly, we recommend that you find a tax professional who can ensure you take advantage of any deductions and guarantee that your taxes are filed correctly.
Belong supports homeowners through all the stages of owning rental property
Belong makes managing taxes a breeze because you always know where you stand. Your rent is guaranteed so you always know exactly what your rental income will be, regardless of when residents pay. You won't be stung with hidden fees or expenses either.
Because Belong homeowners can also manage all maintenance and repairs through the Belong app, you have full visibility on your income and expenses in the one place. Each year we'll send you a statement for you or your accountant to work through, plus your concierge is on hand to assist if you need to clarify any information around earnings or charges. And did we mention that Belong fees are tax deductible?
To learn more, contact us to speak with a Belong advisor.