Investing in real estate is a great way to create supplemental income. Some real estate investors are so successful that they can live off their earnings. But it’s important to consider the impact of federal taxes on your earnings.
How is rental income taxed? Read on for a guide to rental income taxes and how to plan ahead for Uncle Sam’s cut.
Yes, Rental Income Is Taxable
Whether you think of yourself as a budding real estate mogul or a casual property owner earning a little on the side, according to the federal government, your tenants’ rent is considered income and is therefore taxable.
However, this doesn’t mean you have to pay taxes on every cent you collect. You are permitted to deduct certain expenses from your rental income.
Here is a list of some—but not all—deductible expenses.
- Advertising
- Cleaning
- HOA fees
- Insurance
- Landscaping
- Management fees
- Pest control
- Pool maintenance
- Property taxes
- Repairs
- Supplies
- Travel expenses
- Utilities
For example, if your tenant moved out and you spent a month cleaning out their old belongings, steam cleaning the carpet, repainting the rooms, and patching up nail holes, you can subtract all of those costs from your gross rental income and you will only be taxed on what’s leftover.
This is one way to help maximize your profits without raising rent.
It should be noted that your deductions should be “ordinary and necessary.” Tearing up a 100-square-foot yard to install a million-dollar oasis would not be deductible.
List all income and loss (including deductible expenses) on Schedule E Form 1040 or 1040-SR.
Improvements vs. Repairs
According to the IRS, there’s a significant difference between improvements and repairs.
While both are deductible, the cost of repairs (defined as anything that maintains the operation of the property) can be deducted for the same year, while improvements (things that add value to your property) must be depreciated over multiple years.
Things like painting, replacing broken windows, and fixing appliances are “repairs.” Renovating a kitchen, installing a tankless water heater, or adding a swimming pool are “improvements.”
Calculating depreciation for your rental property improvements can be complex, as different depreciation methods apply to the land, structure, appliances, and other features of the property.
Accounting Methods
For many first-time landlords, calculating rental income seems pretty straightforward. But there are actually two accounting methods you can use: cash basis and accrual.
The cash basis method is the most common and the simplest. Under the cash basis method of accounting, you count your income and expenses at the moment you receive or spend funds. The accrual method, on the other hand, counts income and expenses when they are earned.
At first glance, these might seem like the same thing. The distinction lies in the definitions of “receive” and “earn.”
Under cash basis accounting, income is not counted until the moment the money is in your hand; expenses are not counted until you actually make the payment. For example, if your tenants’ rent is due on March 28, but they don’t pay it until April 3, you would add the rent to the books on April 3. If the landscaper mowed the lawn on July 30 but you didn’t write the check until August 1, you would subtract that expense in August.
Accrual accounting works a little differently. Using the examples above, your rental income would be counted on March 28, regardless of when you actually receive your tenants’ rent check. Similarly, your landscaping expenses would go on the books in July, when the work was done, regardless of when you sent the money.
Both of these methods have their pros and cons. Cash basis accounting is simpler and more straightforward (particularly if you have a high cash flow), while accrual accounting is generally seen as a more accurate view of a business’s finances.
Your accountant or property management company should be able to advise you on which method would be best for you.
Tax Rate
In the past, rental income was treated by the IRS like ordinary wages. The amount you earned was taxed based on what individual tax rate bracket you fell in.
The Tax Cuts and Jobs Act (TCJA) passed by the U.S. government changed the way rental income was taxed. Now, rental income can be considered qualified business income (QBI), meaning landlords can take up to a 20% deduction on QBI.
You do have to demonstrate to the IRS that you qualify for the QBI deduction. IRS policy requires that your real estate investments meet the criteria of a trade or business. In order to meet this standard, at least 250 hours per year must be dedicated to the rental property.
To receive the full QBI deduction, your total income must remain under a certain threshold—$157,500 for single filers and $315,000 for married couples. Anything below these two thresholds allows tax filers to claim the full deduction. The tax rate calculation gets more complicated when you start earning above the IRS thresholds.
If you are over the threshold, it is highly recommended to secure the services of a tax professional.
How Is Rental Income Taxed?
When done right, owning a rental property can be a great form of passive income, but “passive” doesn’t mean “hands-off.”
Just the administrative aspects of being a landlord—collecting rent checks, paying bills, bookkeeping, etc.—can easily become a full-time job. And every year, the IRS makes changes to how rental income is taxed, making it difficult to stay up-to-date.
At American Home Team Realty, our property management professionals have the knowledge and experience you can trust with your investment property. From customer service to accounting, we handle the day-to-day minutiae of property management so you don’t have to. Plus, our fees are not only affordable, they’re tax-deductible!
Stop asking yourself, “How is rental income taxed?” and let the professionals at American Home Team Realty take the stress out of being a landlord. Contact us today for efficient and professional assistance.
