Rental property and taxes: How is rental income taxed?

Congrats! You’ve bought some residential real estate and will rent it out. You are a landlord now!

Qualified tenants? Check.

Maintenance budget and go-to contractor? Check.

A landlord-tenant rental agreement? Check.

The one thing many new rental property owners don’t know enough about to have a solid plan is rental property taxes.

Rental property taxes can be daunting. Many property owners find themselves wondering:

• What is the best way to calculate rental income?
• Am I more likely to be audited? What will the IRS find?
• Did I use the right number of years in my depreciation calculation?
• Can I use rental losses to reduce my other taxable income?
• Are there any rental property tax deductions I should know about?
• And… what are the things I don’t know that I don’t know?

The first important thing to know as a rental property owner is that making the wrong decisions in the first year of renting out property can cause headaches down the road.

How is rental income taxed?

Rental property income is taxed as ordinary income, with the tax rate determined by your tax bracket. You can, however, reduce your taxable income by deducting allowable expenses you incur to maintain the property. Deductible expenses include things like cleaning and maintenance, HOA dues, insurance, mortgage interest, utilities, and property taxes.

You will generally report rental real estate income and related expenses on Schedule E, Supplemental Income and Loss. On Schedule E you’ll list your total rents received, expenses, and depreciation for each rental property then file this form with your Form 1040.

Now that we’ve covered reporting rental income and how rental income is taxed, here are three more major tax concepts regarding rental income tax and rental real estate you need to understand.

Depreciation: What it is and how it applies to you

When property deteriorates over time, it may decrease in value. That’s what “depreciate” means.

This often reflects what it would cost you to restore the property to a high level of functionality. Tax law allows (and requires) property owners to account for the expected deterioration of their property by taking periodic deductions to reduce the income produced by that property. Those periodic deductions are called “depreciation.”

The law assigns different periods of time for depreciating different types of property. The time periods are mostly based on the life expectancy of the property. For example, you’d expect a refrigerator to last less time (five-year depreciation schedule) than a corporate headquarters building (39-year depreciation schedule).

Rental real estate depreciation can be advantageous as a rental property owner because it allows you to deduct the costs associated with buying and improving your rental over its useful life on your tax return. This, in turn, lowers your taxable income.

What about residential buildings used for rentals?

Residential landlords have 27.5 years to depreciate a building and its integrated systems (HVAC, plumbing, electrical, etc.).

Depreciation begins when you make the property available for rent by advertising or searching for a tenant.

Remember that you don’t have to depreciate items you buy for your rental property if they cost less than $2,500. You can choose to adopt an accounting method to expense those (or “write them off”) on your tax return for the year you purchase them. You can also deduct the full cost of routine repair and maintenance expenses.

Rental property depreciation can create losses for tax purposes

Depreciation deductions often mean landlords run their rental activity at a loss for tax purposes, even though they have positive cash flow for the year. You may be able to use that loss to reduce other income (and reduce your tax liability). The answer depends on several factors including your level of involvement with the activity and on the other types of income you make.

You can only reduce some types of other income with your rental losses

Why? This issue all boils down to passive versus nonpassive activity.

Here’s how it works: If you earn income from a business or rental but don’t regularly manage or work in the business or rental, the IRS considers that a passive activity. Any money you earn from the activity is passive income.

You can only reduce passive income with the same type of loss: passive losses. For example, you can’t use your passive rental losses to reduce your wage income. Because they’re not the same type of income.

The good news is you can take advantage of “carryovers,” which allow you to “save” the loss to use in future years, when you might have more passive income to absorb the loss, or when you sell your rental property.

There is an exception

Certain residential rental property owners can deduct up to $25,000 of passive losses from nonpassive income, like wages. This is called the “special allowance for active participation.”

You could qualify to use the full amount of this exception if:

• You make less than $100,000 ($50,000 if married filing separately) in income per year, and
• You make management decisions, such as approving new tenants and rental expenditures.

Airbnb hosts should be aware that they may not qualify for the special allowance if their average visitor stays for seven days or less. Special rules apply in this situation. It’s a good idea to see a tax and accounting professional for help navigating passive income and loss limitations.

Even if you are a real estate professional, the IRS probably won’t treat you like one

The Internal Revenue Service (IRS) assumes that all residential rental activity is passive. And most of it is unless you can prove that you are a real estate professional (as defined by the tax code) and that you materially participated in the rental activity. If you can prove that, you’ll get to use your rental losses to reduce other types of income you make.

While many landlords think of themselves as real estate professionals, especially if they make a living as real estate agents, they still have to meet strict requirements that the IRS uses to decide who gets this special treatment under the tax code.

For the IRS to consider you a real estate professional for tax purposes, you must:

• Spend more than half of all your working hours materially participating in real property trades or businesses (which includes any real property development, renovation, management, leasing, or brokerage business), and
• Work more than 750 hours yearly materially participating in real property trades or businesses. Keep in mind that if you’re a real estate agent who is paid as an employee, you can’t count those hours toward the total.

Even if you meet those tests, you still have to prove that you materially participated in the rental activity to be able to use your losses to reduce your other types of income. Material participation means “regular, continuous, and substantial participation” in the activity.

One of seven tests the IRS uses to measure material participation is whether you spent 500 hours or more per year working in the rental activity. This is a difficult threshold for most landlords to meet, so most are subject to the passive-loss limitations.

How a tax professional can help with rental income taxation

Now you know a little bit about taxable rental income, depreciation, and passive loss limitations, all of which are important for rental property owners to understand. It’s also important that you make good tax decisions now so that you won’t get hit with expensive compliance costs later.

For example, if you used the wrong class life for your depreciation schedule in Year 1, you may have to file special forms to correct for over- or under-depreciation in later years.

Your Block Advisors tax professional  can help you set up your depreciation schedule and determine how passive activity loss rules may affect your rental activity. They can also help you decide how to structure your business for tax purposes and talk to you about your new recordkeeping responsibilities.

Your new role as a property owner and landlord comes with opportunities and complexities. Starting out in compliance with tax law and understanding rental property taxes will save you headaches down the road and could maximize your benefits along the way.

This article is for informational purposes only. The content may not constitute the most up-to-date information and should not be construed as legal advice. 

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