If you own an investment property and collect rent from your tenants, it's important to declare that rental income on your taxes. You can, however, deduct expenses you incur to maintain your rental property. In other words, becoming a landlord for the first time will make filing your taxes more complex. Planning ahead for these taxes can have many benefits. If you need help with taxes, a financial advisor can help you create a tax strategy.
Taxes on Rental Income: What to Declare
The rental income you declare on your income taxes will depend on your method of accounting. Most individuals use the “cash basis method.” This method requires you to report income as you receive it and expenses as you pay them out. But some businesses use the “accrual” method of accounting. This counts income when it's earned, not when it's received.
If you're just a private citizen with a rental property, you'll probably use the cash basis method. That means you'll count rent money that you receive as income in the relevant tax year. The IRS also says that you can also include advance rent, which the agency defines as any amount that you get from a tenant before the period that it covers, when using this method. So if you sign a two-year lease with a tenant, and you get the first-year rent payments with some payments for the following year, then you would report all of these payments as rental income in the tax year that your received them.
You may also be able to count the security deposit that your tenant provides. You can do so if you use the security deposit as a final rent payment or you take all or part of it as compensation for damage done by tenants. But if you take a security deposit with the intention of returning that deposit when the tenant leaves, don't count the deposit as income.
When a tenant makes an in-kind payment, you can also report as income according to the number of months it covers. For example, let's say you agree with a tenant to accept a good or service from them in exchange for one month's rent. In the eyes of the IRS, you have still received a month's rent. This means you'll need to report that month's rent as income when you file your taxes.
There are some other forms of rental income landlords should report. For example, if a tenant pays you to get out of a lease, that payment counts as rental income for tax purposes. You'll need to report that payment in the year you receive it, no matter your method of accounting. If your tenant pays any building expenses not required per the lease terms, those payments count as income for you. It will also count as income if a tenant pays for a repair or utility not required in the lease and then deducts that payment from his or her rent payment.
What is the Tax Rate on Rental Income?
The tax rate on rental income will vary depending on whether your rental business is classified as passive or non-passive. In most cases, rental properties will be classified as passive income and taxed accordingly. A non-passive rental business involves property development, construction, operation, management, or leading activities.
A further distinction necessary to determine the rental property income tax rate is whether or not the property owner is an active participant. This refers to the type of management decisions being made. If an investor is the one handling property management responsibilities, they may be considered an active participant. Each of these qualifiers is important because they can also impact the deductions a property owner may be eligible for in addition to determining the tax rate.
How is rental income calculated?
To calculate your total taxable rental income, add up the payments you received for the rental property during the calendar year for which you are filing a tax return. This includes:
- Rent payments. The total of all regular and prorated rent payments made by tenants.
- Advance rent. If a tenant prepays for the last month of rent when they move in, this amount needs to be reported in the year you receive it, not when the tenant moves out.
- Unreturned security deposits. Any amount of a security deposit that you hold onto after a tenant departs. If you return the security deposit, you don't need to report it.
- Fees. Fees collected from renters, such as lease-termination fees.
- Services received in lieu of rent. Say your tenant agreed to paint their own apartment in exchange for one month of free rent—you'll have to list that as income equivalent to one month of rent.
Once you've added up your gross rental income, you can start subtracting deductions and depreciation to find your taxable income.
What can you deduct from rental income?
You can deduct the costs of expenses associated with the rental on your tax return, so long as they are considered “ordinary and necessary.” Deductible expenses include:
- Mortgage interest
- Property tax
- Homeowners insurance
- Maintenance and cleaning
- Homeowners association or condo fees
Not all expenses related to your rental can be deducted. The cost of improvements, such as restoration, betterment, or adaptation to a different use, can not be deducted. The cost of improvements, however, can be recovered through depreciation. If you're feeling unsure about whether or not an expense is deductible, talk to your tax preparer.
How do I report a rental activity on my tax return?
As an individual, you report the income and deductions for rental properties on Schedule E: Supplemental Income and Loss. The total income or loss computed on Schedule E carries to page 1 of your Form 1040.
Report the depreciation of rentals on Form 4562: Depreciation and Amortization.
What are passive activities and how do they affect me?
As a general rule, rental properties are, by definition, passive activities and are subject to the passive activity loss rules. These rules are quite complex. In general, the passive activity rules limit your ability to offset other types of income with net passive losses.
But the good news is there is an exception: If you actively participate in a rental real estate activity, you can deduct up to $25,000 of your rental loss even though it's passive. To actively participate means that you:
- own at least 10% of the property, and
- make major management decisions, such as approving new tenants, setting rental terms, approving improvements and so forth. (No, you don't have to mow the lawn or answer middle-of-the-night phone calls from tenants about a backed-up toilet.)
But this exception phases out as your income rises.
- If you have modified Adjusted Gross Income over $100,000, the $25,000 rental real estate exception decreases by $0.50 for every dollar over $100,000.
- The exception is completely phased out when your modified adjusted gross income reaches $150,000.
Phil and Mary have modified Adjusted Gross Income of $90,000 and a rental loss for the year of $21,000. They actively participated in the rental. Since their modified Adjusted Gross Income is below the $100,000 phase-out threshold, their entire rental loss is deductible even though it is a passive loss.
- If their loss had risen to $28,000, they would have been limited to a deductible loss of $25,000 for the year.
- The nondeductible balance of $3,000 is a passive loss that is carried over to future years until the passive loss tax rules allow it to be deducted.
If you're married and you file a separate tax return from your spouse, and if you lived apart from your spouse at all times during the year, the maximum rental real estate loss exception for you is $12,500, and the exception begins to phase out at modified Adjusted Gross Income of $50,000 instead of $100,000.
If you're married and file separately but you did not live apart from your spouse at all times during the year, the exception for active rental real estate losses is completely disallowed.
To calculate your deductible loss, you may need to complete Form 8582: Passive Activity Loss Limitations according to the IRS instructions.
If you spend considerable time in real estate activities during the year, you may be eligible for a favorable special rule.
- For so-called real estate professionals (as defined by IRS guidelines), the passive activity rules don't apply to losses from certain rental real estate activities, which means the losses can usually be fully deducted in the year they occur.
- For more information on this beneficial special rule, consult IRS Publication 527: Residential Rental Property (Including Rental of Vacation Homes).