For landlords, property management may be a very profitable business. Interviewing possible tenants, managing existing tenants, and maintaining property quality are just a few of the many moving components in this fast-paced market. There are some aspects concerning rental income and taxes that every landlord should be aware of, even though income tax and deductions for rental properties may not be the first things that come to mind.

1. What Is Rental Income? 

Rental income is a broad term that includes four sections:

• Amounts paid to cancel a lease
• Advance rent
• Expenses paid by a tenant
• Security deposits

First, money that comes from a lease cancellation is considered rental income. You need to report this for the tax year in which you received it. Advance rent paid in the tax year in which you receive it is rental income. Expenses paid by tenants are also rental income; however, this form of rental income may be deductible.

There are several components to security deposits:

• Security deposits that will be returned to your tenant after their lease does not count as rental income.
• If your tenant broke the lease early or moved out of the property early, you must include the amount of income that you kept as income for the tax year.
• If you kept part or all of the tenant’s security deposit because of damaged property to make repairs, you will include the amount you kept as rental income if you deduct the cost of repairs as expenses.
• The security deposit applied to your tenant’s last month of their lease is advance rent. Upon receiving the money, it can be considered rental income.

2. How Much Tax Do You Pay on Rental Income?

Rental income is reported and taxed just like any other source of income. Therefore, the tax rate on your rental income is largely dependent on your tax bracket. The IRS’s marginal rate for the tax year 2023 breaks down as follows based on filed income:

37%	$578,125 or more	$693,750 or more
35%	$231,250 to $578,125	$462,500 to $693,759
32%	$182,100 to $231,250	$364,200 to $462,500
24%	$95,375 to $182,100	$190,750 to $364,200
22%	$44,725 to $95,375	$89,450 to $190,750
12%	$11,000 to $44,725	$22,000 to $89,450
10%	$0 to $11,000	$0 to $22,000

Remember, if you own more than three rental properties, you will file a Schedule E (Form 1040) for each property.

3. How Is Rental Income Tax Calculated?

To calculate your rental income tax, add up all the rent that you’ve received. Include any expenses from your property. You should also include the fair market value of any merchandise or services you received. If you are planning to return security deposits at the end of the lease, don’t include that amount in your gross income total.   

Next, add the amounts of property-related costs such as advertising, depreciation, insurance, maintenance, and taxes. Finally, subtract the expenses from your gross income. This amount is your taxable income. 

There are three possible results:For a total greater than zero, this is the amount of your taxable rental income.For a total that is less than zero, this is the amount that you can deduct from other income sources, such as lost business revenue.A total of zero doesn’t affect your income.

4. Is Rental Income Earned Income?

Rental income is typically considered unearned income by tax authorities like the Internal Revenue Service (IRS). Unlike earned income, which primarily includes wages, salaries, or business income from active participation, unearned income typically includes sources such as interest, dividends, and rental income from real estate.

There are a few exceptions where your rental income is not considered earned income. Therefore, it’s not subject to taxation. For instance, if you use a dwelling unit as a personal residence and rent it for fewer than 15 days in a year, you do not have to report the rental income and you cannot deduct any expenses as rental expenses. If the property serves both rental and personal purposes, expenses need to be split between the two uses based on the number of days used for each. Only the rental portion of allowable expenses can be deducted from your tax return. This is similar to how you file business and personal deductions separately.

5. What is Tax Deductible From Rental Income? 

As a landlord, you can deduct numerous expenses from your rental income to reduce your tax liability. These expenses must be ordinary, necessary, and directly related to managing, conserving, or maintaining your rental property.

Below we’ve listed some common tax deductions related to rental income:

• Depreciation 
• Operating Expenses 
• Repair
• Property Tax
• Mortgage Interest

It’s possible to take advantage of several deductions to avoid paying higher taxes. Expenses such as ordinary expenses and necessary expenses can reduce your tax liability or the amount you owe in taxes. 

Ordinary expenses include everyday payments that you make to maintain your property. Necessary expenses include advertising, insurance, maintenance expenses, and utility costs. 

Costs of maintenance, materials, repairs, and supplies are eligible for deductibles. You can also deduct expenses paid by a tenant if they are deductible rental expenses. However, you can’t deduct the cost of improvements to your rental property.

Ordinary Income vs. Capital Gains

To comprehend the taxation of rental income, it’s essential to distinguish between ordinary income and capital gains. Rental income falls under the category of ordinary income, which means it’s taxed at your regular income tax rate. On the other hand, capital gains come into play when you sell a property at a profit.

Read Also: The Top Rental Websites for Finding Apartments

“While rental income is considered ordinary income and is taxed annually, capital gains come into play when you sell a property, and they may be taxed at a different rate,” Christanne said.

Capital gains is taxed at either long term or short term capital gains rate and only needs to be considered upon the sale of the property. It’s advisable to talk to your tax advisor or CPA to discuss potential strategies for mitigating capital gains tax, such as a 1031 exchange.

What Counts As Taxable Rental Income?

Obviously, any rent the tenant pays is counted as taxable income. However, as well as this you also have to report other forms of income as rental income including the following:

• Advance rent payments. For example, if a tenant pays for the last month of the lease as well as the first month.
• Any of the security deposit you end up keeping (such as to cover repairs) counts as taxable income rent payments. However, any you return to the tenant is not. You should make sure to carefully track how much deposit was collected, where it was kept, how much you kept, and how much was returned on your property balance sheet.
• Expenses your tenant covered that a landlord would typically pay. This includes repairs as well as any agreements for payments you have, such as if the tenant pays utilities and subtracts the amount from the rent.
• Property services in lieu of rent. You may ask a tenant to maintain the property (for instance, through landscaping or painting) in exchange for a discount on rent. You’ll need to pay for rental income tax on the amount you deduct from the service — and the amount should be the fair market value.
• Fees for early lease termination.
• Payments you receive through a lease-with-option-to-buy agreement.

Essentially, if you collect a payment, in either money or services from a tenant you need to report it as taxable income. However, it’s also worth noting that many of these are also deductible expenses. For example, if you keep $300 of your tenant’s deposit to cover repairs you would also report $300 of deductible expense for those repairs.

If you are a cash basis taxpayer (most people are), you’ll need to pay rental income tax for the year that you receive the payments, no matter when the amount is actually owed to you. This includes all the income you receive constructively, meaning it’s the full amount available to you by the end of the year, even if you haven’t yet taken possession of the funds — such as a check that you haven’t yet cashed.

If you use the accrual method of accounting, you should report income as you earn it — and expenses for tax deductions as you incur them.

Rental Income Tax and Depreciation

One major way to manage your tax liability as a real estate investor is by taking advantage of rental depreciation. Depreciation is a tax benefit that sets real estate investing apart from many other types of investments.

Christanne explained that depreciation is the allocation of the cost of your property over a set number of years. For residential rental properties, this typically spans 27.5 years, while commercial properties have a 39-year depreciation schedule.

“What makes depreciation valuable to real estate investors is that it allows them to deduct a portion of the property’s cost each year, even though it’s not an actual cash expense. This can result in substantial tax savings.”

For example, if you had a residential rental property worth $100,000 with a land value of $20,000 you would be able to deduct $2,900 per year in depreciation, which is a sizeable amount.

5 Rental Property Tax Deductions Landlords Need To Know About

Investing in rental properties offers a number of tax advantages. This includes a variety of tax-deductible charges, depreciation, which lets you deduct the cost of the property from your income over 27.5 years, and 1031 exchanges, which let you postpone capital gains tax indefinitely. The primary tax-deductible expenses are listed below.

1. Interest

Interest is often a big deductible expense. For example:

• Mortgage payment interest
• Interest on loans for improving the property
• Credit card interest for payments towards goods and services used in a rental activity.

These interest payments can quickly add up which makes the ability to offset these payments back against your taxes very valuable.

2. Depreciation

Depreciation is one of the major tax benefits of rental property. According to the IRS, the property has a useful life. As such, over the time you own the asset the cost of the property – though not the land can be depreciated and the depreciation makes up a large rental property tax deduction. the useful lifetime of a property according to the IRS is 27.5 years. This means you can claim the full value of the purchase price of the property back over this period.

You should also be aware that the IRS will claim a portion of the depreciated value back upon the sale of the property in a process called depreciation recapture.

Additionally, any capital improvements (this is work on the property that adds to or increases the property’s value and is generally a permanent fixture), or costs, such as replacing appliances, cannot be deducted as rental property expenses but must be added to the cost basis of the property and depreciated.

3. Repairs & Maintenance

Repairs and maintenance often come unexpectedly and can quickly add up affecting the cash flow and overall profitability of your rentals. Thankfully, the cost of maintenance and repairs qualify as rental property tax deductions and can be fully reclaimed at the end of the tax year.

It should be noted that repairs and maintenance costs do not include expenses or costs for improving the property.

Repairs are defined as any effort to maintain the current condition of the property and provided they are “reasonable, necessary, and ordinary” they can be fully deducted in the year which they occurred.

Examples of repairs include:

• Painting
• Plumbing Repairs
• Air conditioning repairs
• Fixing guttering
• Replacing broken windows
• Labor costs
• Rental of necessary tools etc.

Maintenance costs are a little different. These are necessary expenses related to maintaining the property’s current condition – not fixing things that are broken.

A few examples of claimable maintenance expenses:

• Pool maintenance and cleaning
• Pest control
• Gardening/landscaping or tree trimming
• Machinery maintenance eg. chain saw sharpening
• HVAC filters.

4. Personal Property used in the Rental

You can deduct the expense of any property owned by the landlord used in the property. For example, any furnishings supplied by the landlord, appliances, or gardening equipment.

The cost of personal property used in a rental activity can usually be deducted in one year using the de minimis safe harbor deduction (for property costing up to $2,000) or 100% bonus depreciation which will remain in effect for 2018 through 2022.

5. Pass-Through Tax Deduction

Formally known as the Section 199a Qualified Business Income Deduction, and also called the QBI deduction, the pass-through tax deduction is designed to encourage Americans to start small businesses and engage in other entrepreneurial ventures.

In a nutshell, it treats income that comes from certain non-employer sources in a favorable manner.

This was part of the Tax Cuts and Jobs Act, which went into effect in the 2018 tax year. Like most of the provisions in this tax reform bill that affect individuals, it’s scheduled to end after the 2025 tax year.

Specifically, the pass-through tax deduction lets U.S. taxpayers deduct as much as 20% of their business income that comes from “pass-through” entities such as:

• LLC’s;
• Sole Proprietor;
• S Corporations;
• C Corporations.

This deduction is scheduled to expire after 2025.

Finally

It can be costly to operate a rental. Numerous ancillary expenditures and expenses can mount up rapidly and become uncontrollable. Making a property cash-flow positive can sometimes seem unattainable.

This is the reason it’s so crucial to benefit from rental property’s tax advantages. You must maintain accurate records of all your rental property tax income and deductions, as well as any necessary supporting documentation, in order to accomplish this.