You might have heard that purchasing a rental property can muddle your taxes. While rental property taxes are more complicated than typical income taxes, the tax implications of having a rental property aren’t as daunting as you might think.
In this article we look at how rental income is taxed and also share 8 tips you can follow to simplify your tax return filing and maximize the tax advantages available to rental property investors.
Our 8 Tax Tips:
- Keep Good Records
- Know the Tax Return Deadlines
- Understand the Difference Between Improvements and Repairs
- Track Your Mileage to Deduct Travel Expenses
- Claim Home Office Deduction
- Qualified Business Income Deduction (QBI)
- Use Software Tools to Automate
What are Rental Property Taxes?
All rental income you receive as a landlord is taxable and must be reported on your taxes. Typically, your rental property income will include:
- Rental payments
- Advance rent payments
- “Security deposits” kept by the landlord. Usually, this is “prepaid rent”, where the last month’s rent is paid in advance, for example. Non-refundable deposits may also fall in this category. (Security deposits which are held in trust, to be returned at the end of a tenancy are a separate category as it is assumed that this money will not be retained by the landlord.)
- Expenses, such as repairs or materials, paid for by tenants in exchange for rent.
- Services performed by tenants in exchange for rent.
- Leasing or application fees.
- Any other cash flow generated from a given property, such as revenue from laundry machines for example.
Related Read: Cap Rate Calculator – Calculating Cap Rate
Deductions Available on Rental Property Taxes
As a landlord you may be eligible for numerous deductions in rental income taxes including:
- Maintenance, repairs, and cleaning expenses
- Landscaping or pest control expenses
- Utility costs
- Mortgage interest
- Property taxes and HOA dues
- Advertising fees
- Home office expenses
- Property management fees
- Utilities and pest control
- Legal or professional fees
- Depreciation (deduct out the value of the land from the purchase price and divide the remainder by 27.5 years)
What is the Rental Income Tax Rate?
Rental income is taxed as regular income, just the same as salary earned at a job. One important distinction, however is that investors are categorized into two types: passive and non-passive.
Almost all independent landlords fall into the passive investor category. Essentially this means that real estate investment provides a supplemental revenue stream, not the sole means of making a living. Passive investors may only apply rental losses against other passive income in order to reduce their amount of taxable income. A caveat to this is where a landlord is considered an “active participant”. Please see our description below.
A non-passive investor is a real estate professional, who might be a realtor or work in property development, construction, operation, management, etc. They can apply rental investment losses to offset income from other business activities for tax calculation purposes.
Am I an “Active Participant”?
Whether or not a landlord is considered an active participant impacts the rental income tax rate. Landlords who bear significant responsibility for the management of their rental property are considered active participants. In that case, they can deduct up to $25,000 on any rental losses. In general, landlords who meet the following you are considered to be “active participants”:
- own at least 10% of the rental property, and
- are responsible for main management decisions, like approving new renters, setting leasing terms, approving enhancements, etc.
However, as your income increases you are eligible for less and less benefit from this rule. If you have Modified Adjusted Gross Income (MAGI) over $100,000, the $25,000 exemption reduces by $0.50 for every dollar over $100,000. It completely phases out when your MAGI reaches $150,000.
8 Tax Tips for Landlords
Here are some important but often overlooked tax tips for property owners.
1. Keep Good Records
Good records help you track the financial performance of your rental investment, prepare your financial statements and tax returns, and make sure you’re prepared in case of an audit. In the unfortunate event that you are audited, if you can’t provide proof to support items reported on your tax returns, you will likely have to bear further taxes and fines.
Income: Landlords must claim all income they receive from investment properties. Examples of records to keep include:
- Rent receipts
- Bank Statements
- Payments from laundry services
- Payments for parking or other additional revenue sources associated with a rental property.
Expenses: The rule of thumb we’d suggest when it comes to keeping records is “if you want to deduct it from your taxes, keep the records”. Examples include:
- Documentation of mileage and travel expenses
- Receipts for meals associated with travel (50% may be deducted)
- Invoices for repair work, landscaping, and any other upkeep services you’ve paid for
- Payment for professional services
- Office expenses
- Mortgage, Tax, and Insurance statements
- Utility bills
- Advertising receipts
Manually keeping track of your rental properties’ finances is a laborious task. You may want to check out some popular reporting and accounting tools to automate the record-keeping process.
Related Read: The Best Online Rent Payment Service for Small Landlords
2. Know the Tax Return Deadlines
Tax season doesn’t start and end on Tax Day every year. Throughout the year, it is important to keep an eye on key tax deadlines that could apply to you and impact how you file your taxes.
For the 2021 tax season, these are the tax return deadlines:
|Partnerships (Form 1065)||March 15, 2021|
|Individual (Form 1040)||April 15, 2021|
|Partnership Extension (Form 1065)||September 15, 2021|
|Individual Extension (Form 1040)||September 15, 2021|
For quarterly 2021 tax deadlines and checklists, check out Stessa’s tax deadline calendar here.
3. Understand the Difference Between Improvements and Repairs
There’s a big difference between improvements and repairs. The expense of property improvements (IE remodeling, alterations, additions, upgrades) must be capitalized and depreciated over several years instead of deducted in the year paid. On the other hand, repairs are treated as maintenance expenses and deducted from the year’s income.
Improvements are actions that materially add to the property’s value or considerably extend its life. For example:
- Structural additions
- Addition of a swimming pool
- Installation of a water filtration system
- Kitchen modernization
- Insulation installation
- Window replacement
Repairs just keep the building in good operating condition. For example:
- Painting a unit
- Appliance repair
- Fixing plumbing problems
- Broken windows or doors replacement
Horse’s Mouth: Here’s an IRS article on allowable deductions.
4. Track Your Mileage to Deduct Travel Expenses
According to IRS (warning: mind-boggling detail), you can deduct the ordinary and necessary expenses of traveling if you incur them to collect rental income or to manage, protect, or maintain your rental property. However, you can’t deduct the cost if the main purpose of traveling is to improve the property. The costs of improvements are deducted over time in the form of depreciation.
Here are two methods to deduct travel expenses.
For actual expenses, you need to document the following information for each trip to qualify for a tax deduction for mileage.
- The date of the trip
- The address of the starting point and destination
- The vehicle’s mileage at the beginning and end of the trip
- Tolls, parking, and other trip-related costs
You must keep these records for three years from the date your return is filed.
Standard Mileage Rate
The standard mileage rate for business use is 56 cents per mile for 2021. To figure out your deduction, multiply your business miles by the applicable standard mileage rate. You only have to keep track of how many miles you drive for business, the date of the trip, your business destination, and your purpose.
If you select the standard mileage rate, you can’t deduct actual car operating expenses. This means you can’t deduct vehicle maintenance and repairs, fuel, insurance, or car registration fees. The standard mileage rate includes all these items, as well as depreciation. It is a simpler way to calculate travel expenses instead of tracking and itemizing all mileage and travel expenses.
Depreciation allocates the cost of a tangible or physical asset over its useful life. It represents how much of an asset’s value has been consumed. For example, if a business spends $10,000 on machinery with a useful life of 5 years, they can take a $2,000 depreciation deduction annually for the next 5 years to deduct the cost.
The same goes for real estate, however, the useful life of a property is much longer. Residential rental properties depreciated over a 27.5-year period, while commercial properties are deductible over 39 years.
Rental Real Estate Depreciation In A Nutshell:
No matter what the condition of a building is, and how it deteriorates, for tax purposes the IRS allows you to take the value of a structure and act like it’s usefulness will erode to nothing over 27.5 years. If your building is worth $200,000 when you buy it, you can reduce your taxable income by $7273 each year. If you’re in the 22% tax bracket, for example, this would save you $1600 in tax each year. You cannot depreciate the value of land.
Although depreciation can help you save a lot of money each year on taxes, the downside is that you have to pay back a certain amount to IRS when you sell the property. This is called depreciation recapture tax.
Rental Real Estate Depreciation Recapture In a Nutshell:
When you sell an investment property the IRS requires you to pay the taxes you saved by deducting depreciation. Taking the example we used above, if you’d depreciated your $200,000 building for 5 years and then sold it, the IRS would charge you tax on that $36,365 you’d deducted. If you’re still at the 22% tax bracket (notice, this is your regular income tax rate not the capital gains rate) you’d owe $8000 out of the proceeds of your sale. So, if you’re going to sell this is just a deferral of taxes, not avoidance. This is why so many people use the 1031 exchange, where they keep their money in real estate and postpone paying those taxes indefinitely.
Keep in mind that we didn’t talk about any increase in value on your property. That portion of the sale is a capital gain… a topic for another day. Also, the IRS assesses depreciation recapture whether you’ve deducted it or not. This is above our pay grade to explain, we suggest you talk to a tax professional if you have questions.
6. Claim Home Office Deduction
Another tax benefit is that you can claim a home office deduction if you use a part of your property solely as a business space. The amount you can deduct depends on the percentage of your property that is used as your home office.
To qualify for this deduction, you have to fulfill both of the following conditions.
The part of the house must be:
- Solely and regularly used for a trade or business; or
- Used to store inventory or product samples.
The business portion of the property must be:
- The main place of business;
- A place where the taxpayer meets or deals with patients, clients, or consumers; or
- A separate structure (detached from the house) that is used for business.
There are two ways to calculate the home office deduction.
The Actual Expense Method
You can deduct direct expenses in full such as painting or repairs only in the home office. Indirect expenses such as mortgage interest, insurance, home utilities, property taxes, and general home repairs are deductible based on the percentage of your property used for trade or business. In general this method works better if the business takes up a larger part of the property.
The Simplified Method
If your home office is 300 sq. ft. or less you can take the simplified deduction of $5 per square foot of the property that’s used for business. It’s an easier way than documenting actual expenses and can work well for single-room offices and small setups.
Keep in mind that home office deduction can make things more complicated when you sell the property. You may have to recapture any depreciation you claimed depending on the method you used each year to claim home office expenses.
- The actual expense method of claiming a home office deduction requires that the percentage of the home you’re using for business be depreciated.
- Using the simple method of calculating the home office deduction may help you avoid having to recapture depreciation.
Due to the strict requirements relating to the home office deduction, we suggest consulting a tax specialist.
7. Qualified Business Income Deduction (QBI)
You may also qualify for a Qualified Business Income (QBI) deduction that allows you to deduct as much as 20% of your pass-through business income. This includes income you receive from a pass-through entity such as an LLC or S-Corporation. Here is a resource to help you figure out whether you’re eligible.
In 2021, the QBI threshold has increased to $164,900 for single filers and $329,800 for joint filers. This threshold is the maximum income level you can have and still be eligible for the full QBI. However, people who earn more than these amounts may be able to get partial benefit from the QBI. We advise you to contact a tax professional to find out whether you are eligible.
8. Use Software Tools to Automate
Filing your tax return involves a lot of steps. You have to track income and expenses, create schedule E for 1040, create and send 1099 to contractors, fill out IRS Form 4562 to claim depreciation, and much more.
To simplify the process, here are a few resources that can automate reporting:
- Asset management and accounting software for real estate investors, including smart money management, automated income and expense tracking, personalized reporting and more.
- Strength: Accounting and Financial Tracking
- Accounting and property management tools to save time and money while managing your rentals. Track income and expenses, screen tenants, collect rent, and more.
- Strength: Accounting and Financial Tracking
- Designed to address the needs of DIY landlords as well as property management companies, Rentec Direct includes all the tools necessary to manage and rent your properties
- Strength: Complete Solution
As a landlord, it is important to understand the rental property taxes and the expenses you’re allowed to deduct on your taxes. These 8 tips can help you manage the tax side of your rental property.
However, we still recommend you to consult a tax professional as they’ll be able to better guide you about tax opportunities available to rental property owners.
Learn More: Rental Property Tax Resource Guide for Landlords
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