RENTAL INCOME: Definition, Rate and Calculation

Rental Income
Photo Credit: The Economic Times

Recent census data shows that more than 50 million U.S. households are rented. Landlords use rent money to pay bills and mortgages. Many investors don’t know how rental income is taxed at tax time. To clarify, let’s look at an example and calculation of taxable rental income. At what rate is rental income taxed?

What is Rental Income (RI)?

IRS tips on RI include:

  • Applicant fees
  • Monthly rent, with late fees, included.
  • First- and last-month rent paid in advance.
  • Lease-cancellation fees.
  • Work a tenant does in exchange for free rent, such as painting a house.
  • A landlord’s use of a tenant’s refundable security deposit for unpaid rent or damage.

A refundable security deposit from a tenant isn’t RI because it’s refundable. The landlord’s security deposit is a short-term liability on the real estate balance sheet.

Defining an expense versus a liability can be tricky. That’s why so many landlords use rental property financial management software to track income, expenses, assets, and liabilities.

What Rate Is Rental Income Taxed At?

Rental income rate is taxed as ordinary income. In a 22% tax bracket, an investor with $5,000 in RI would pay $1,100. Here’s how we figured the tax payment: 5,00 x 0.22 = $1,100.

Is Rental Income Taxable?

Rental income is taxable and must be reported. RI includes rent payments, security deposits, leasing fees, and other property cash flow.  While most of the income from a property may come from rent payments, it is important to include any other income-generating sources. If a tenant pays the first and last month’s rent at move-in, both are taxable, even if the lease ends the following year. As leases tend to be multiyear, commercial property owners should be wary of “advance rent.”

When used as last month’s rent, security deposits affect RI taxes. If a property owner and tenant agree to this, the funds must be reported as RI for the year they are received. If investors don’t use the security deposit for last month’s rent, it’s not taxed as rental income.

Tenant-paid utilities are another gray area for real estate investors. The owner must include tenant-paid utilities in RI. While landlords can deduct utility costs, they must report tenant payments.

What is the Tax Rate on Rental Income?

The tax rate on rental income depends on whether your rental business is passive or non-passive. Rental properties are usually taxed as passive income. A non-passive rental business involves property development, construction, operation, or management.

Whether the owner is active affects the rental property income tax rate. It refers to management decisions. Active participants include investors who handle property management. Each qualifier affects a property owner’s deductions and tax rate.

Earned income vs. Rental income

Real estate investors can receive two main types of income: rental income (passive income) and earned income (sometimes known as active income).

Earned income

Earned income is income a taxpayer earns by working. Furthermore, earned income includes cash tips or sales commissions, casino winnings, or self-employment income from a small business or side gig. These are examples of earned income.

All of these types of earned income involve material participation in exchange for payment. Earned income is subject to payroll tax withholding, including federal income tax, state and local income tax (if applicable), Social Security and Medicare (also known as FICA), and state and local unemployment taxes.

Rental income

Most rental income is taxed as passive income. Most investors own rental property, so they don’t need to withhold or pay payroll taxes.

RI includes interest and dividends from bonds or stocks, REIT distributions, and rental income. Investors pay federal and state income taxes on RI.

Full-time real estate investors are exempt from the IR rule. Complicated situations like these may require a CPA or tax professional.

How Rental Income is Taxed

Rental income is taxed at an investor’s marginal rate. Consider a married investor with $250,000 in taxable income. IRS guidance for 2022 suggests a 24% marginal tax rate.

Rental Income Calculation

Rental Income & Tax Rate Calculation

First, investors must classify RI. The IRS defines rental income as “any payment for the use or occupation of property” (IRS). It includes tenant payments but also:

  • Advance rent
  • Retained: security deposit.
  • Non-obligated rent
  • Tenants’ services as payment.

Once an investor’s RI is totaled, they can calculate their tax rate. Unlike ordinary income, rental income isn’t taxed. Instead, it is treated as qualified business income (QBI) in some cases, allowing investors to deduct up to 20%.

Single filers need $157,500 of taxable income. Those filing jointly have a $315,000 threshold. Investors can deduct rental expenses and depreciation from their taxable income.

Calculating Tax On Rental Income Example

Here’s a basic rental income tax example. First, estimate RI. $1,000 per month in rental income equals $12,000 per year.

Calculate your depreciation basis. The purchase price, nondeductible fees, and lot value are needed to calculate this. For example, if you bought a property for $100,000 and spent $1,000 in nondeductible fees (such as title insurance and recording fees), your depreciable property basis would be $80,000.

Calculate operating and ownership costs for your rental property. Cleaning, repair, and maintenance costs; property management, leasing, and landscaping fees; pest control; property and landlord liability insurance costs; mortgage interest payments; property taxes; accountant tax preparation fees; and travel costs to visit your out-of-town property. Say operating expenses and ownership costs total $8,000 annually.

Subtract total deductible expenses ($8,000) from RI ($12,000) to find net income before depreciation ($4,000). Divide the property’s basis ($80,000) by the mortgage’s term (27) to get annual depreciation ($2,963). Then subtract your annual depreciation ($2,963) from your net income before depreciation ($4,000) to get your taxable income. An example of taxable income: is $1,037.

Calculate RI tax. Multiply annual depreciation by 22% (if married filing jointly with an $80,251-$171,050 income). $228.14 total.

I believe the above rental income example was helpful.

What Deductions are Available?

Investors love rental property profits until tax season. Knowing your deductions is crucial. Deductions are income-taxable expenses. Deductions can reduce taxes by lowering your taxable income.

Property owners may be eligible for several deductions, including:

  • Depreciation is a popular deduction for real estate investors. Property depreciation refers to lost value as a result of wear and tear, though determining the amount eligible for this deduction can be tricky.
  • Interest: annual mortgage or loan interest paid by property owners. Credit card interest can also be deducted. Interest is a major rental property tax income.
  • Repairs: Repairs keep a property “livable” and are income-taxable. For example, replacing broken windows, fixing plumbing issues, etc.
  • Property owners can deduct employee wages from taxable income. This includes maintenance, repair, and contract workers.
  • Insurance: Insurance premiums relating to rental activity can qualify for deductions, such as fire, flood, theft, and liability insurance.
  • Anytime investors (or landlords) travel for rental-related activities, such as property viewings or trips to the hardware store, they can deduct it. The IRS closely monitors overnight travel deductions.
  • Home office expenses are generally deductible from taxable income. Investors must prove their home office is their primary place of business to deduct home office expenses.
  • Legal Services: Attorney, property manager, accountant, and advisor fees are deductible.

How to Report RI

Form 1040 and Schedule E are required to report RI. Form 1040 is the basic income tax form for federal taxes. Filers must report their SSN and number of dependents. Investors report earnings on Form 1040.

This paper reports rental property income, expenses, and depreciation. Depending on how many properties they own and operate, investors may need multiple Schedule E forms. Even if you fill out multiple Schedule E forms, report the “totals” on one piece of paper.

Investors should keep year-round expense and income records for tax season. Keep rent checks, business receipts, and deduction paperwork. Always double-check the information. Always file paperwork cautiously.

Tips for Reducing Taxable RI

Investing in income and expenses U.S. tax laws favor real estate investors. Other ways to reduce rental property taxable income:

Owning costs

An investor may also be able to deduct owner expenses to reduce taxable net income, such as:

  • Business-related home office expenses.
  • Businesses use paper, ink, pencils, and mobile phones.
  • Real estate education
  • Investor club dues and trade publication subscriptions.
  • Rental property legal and professional fees.

Travel expenses

An investor may also deduct travel to and from a rental property. Even if a local property management company is hired, an investor may still want to visit the rental and meet with the manager.

IRS Topic 511: Business Travel Expenses explains what an investor can deduct from RI. Business expenses must be reasonable, ordinary, and necessary for the business, not personal.

Devaluation bonus

Residential property depreciation takes 27.5 years. If a home costs $140,000 (excluding land), depreciation is $5,091 per year.

A new roof must be added to a rental property’s cost basis and depreciated over the same number of years. For example, if an investor spends $10,000 to replace a roof, the additional depreciation would be $364 ($10,000/27.5 years).

Until 2022, an investor may be able to use bonus depreciation to deduct the entire cost of a capital improvement in the same tax year. If the extra deduction results in a rental real estate loss, it can be carried forward.

How does rental income get taxed in Canada?

Taxes on Rental Property

25% of gross RI must be remitted annually under the Canadian Income Tax Act. Non-residents can pay 25% of net RI (after expenses) by completing Form NR6.

What is income from rent?

Real estate investors can receive two main types of income: rental income (passive income) and earned income (sometimes known as active income).

Do I have to pay tax on rental income Ireland?

Income or other rental income is taxable. You must report this income to Revenue using a self-assessed Income Tax Return (Form 11).

What Income Category Is Rent?

The rent falls under “selling, general, and administrative accounts.” Other SG&A items include litigation, office supplies, regulatory liability payments, salaries, insurance, and depreciation.

How do I avoid paying tax on rental income?

Use a 1031 Exchange

Internal Revenue Code section 1031 allows you to defer capital gains tax on rental properties if you reinvest the proceeds.

How much rent is tax-free?

You can rent out your vacation home for up to 14 days per year, and all RI is tax-free, no matter how much you earn. The IRS isn’t even notified of the income. This rule can be a boon if you own a vacation home in a popular area where people want short-term rentals.

Conclusion

Rental property and taxes are well-documented. Why should investors ask “What rate is rental income taxed at (example)” and “is RI taxable?” Keeping organized records, researching potential deductions, and knowing the reporting process can help your business during tax season. Investors need foresight and planning to handle RI taxes.

Rental Income FAQs

What type of income is rental income?

Passive income, most RI is taxed as passive income. Most investors own rental property, so they don’t need to withhold or pay payroll taxes.

How does the IRS know if I have rental income?

The IRS can learn about rental income by conducting tax audits, reviewing public records and real estate documents, and receiving information from a whistleblower. Investors may face accuracy-related fines, civil fraud fines, and potential criminal charges if they fail to report the RI

How is Rental Income taxed Example?

Rental income is taxed at an investor’s marginal rate, for example, consider a married investor with $250,000 in taxable income. IRS guidance for 2022 suggests a 24% marginal tax rate.

References

  1. BUYING RENTAL PROPERTY: Tips For Buying Rental Properties
  2. RESIDUAL INCOME: Definition, Formula, Charts, Ideals & How-to Guide
  3. TAXABLE INCOME: Definition, Examples & Calculations
  4. BUYING A RENTAL PROPERTY: Tips on Buying a Rental Property (Updated 2022)
  5. Top 10 Rental Management Software In 2022: Features & Reviews
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