Everything You Need to Know About Taxes on Rental Income

Investing in rental properties is an exciting venture that can generate consistent passive income streams for savvy investors. It's important to know not just how to manage your rental business but also how to calculate and report your rental income.

Like all income generated in the U.S., rental income is subject to taxation, meaning that at least some of the money you make from your investment properties will go towards taxes. Luckily, there are several ways real estate investors can minimize their tax liability.

In this article, we’ll discuss everything you need to know about rental income tax, including how rental income is taxed, what counts as rental income, and how to save on rental income tax. We’ll also introduce income tax brackets for 2024 and how to report rental income tax to the IRS accurately. 

How is rental income taxed?

Rental income is taxed in the same way regular income is taxed, which is based on your marginal tax bracket. The tax bracket you belong to is determined by the amount of money you make in a given year. Your tax bracket can vary, depending on how much money your rental business generates that year — it'll typically range from 10% to 37%.

The U.S. operates on a progressive tax system, which means the amount of taxes you owe increases as your income grows. The more rental income you produce, the higher your tax bracket. However, not all of your income is subject to taxation. You only have to pay rental income taxes on your taxable income, which is the amount of money you’ve made in a year minus any qualifying deductions and exemptions. As a result, real estate investors need to understand what deductions and exemptions they qualify for to minimize their taxable rental income and ultimately keep more of their rental income.

What counts as rental income?

Before you can determine your taxable rental income, you need to take stock of all the rental income you produced in a given tax year. Any payment received for the use or occupation of your rental property is considered rental income. This includes regular, monthly rent payments, rent advances, lease cancellation fees, and pet fees.

The following payments may also be considered rental income:

• Security deposits: While security deposits are usually returned to the tenant after their lease is up, all or some of a security deposit may be kept to cover repairs. When this happens, rental owners need to report the amount that they kept as rental income.
  However, if you return a security deposit in full to your tenant, there’s no need to document this as rental income. Make sure to label security deposits as short-term liabilities on your balance sheets so they are not accidentally included in your rental income for the year. 
• Property services: Depending on how familiar you are with your tenant, you might accept property services in exchange for discounted or free rent. Tenants often provide landlords with landscaping, painting, or property management services to save on rent.
  Rental owners are responsible for paying taxes on the amount that is deducted from a tenant’s monthly rent as a result of these services. Keep in mind that the amount deducted should represent fair market value for the services provided.
• Tenant expenses: Some tenants are willing to cover expenses beyond their obligations as renters. This includes basic utility bills, such as water, electricity, and sewage services, as well as minor home repairs, such as unclogging the sink, patching up a hole in the wall, or replacing a shower head.
  If you and your tenant have agreed that they're responsible for such expenses, you may need to report these expenses as rental income. Consult your accountant to see what tenant-paid owner expenses should be reported to the IRS.

How to save money on rental income taxes

As you can see from the information mentioned above, monthly rent payments aren't the only form of rental income you'll need to report to the IRS. Factoring in multiple streams of rental income can push you into a higher tax bracket and raise your tax liability, which is why rental owners need to minimize their taxable rental property income through deductions and property depreciation.

Deductions are expenses subtracted from a real estate investor’s rental income to reduce the amount of rental income that is taxed. Property depreciation is a type of deduction that allows property owners to recover the cost associated with owning a property. Depreciation essentially works as an allowance for the deterioration or lack of use of a property over an extended period.

Here’s what you need to know about both tax-saving methods:

Claiming deductions

The IRS provides property owners with multiple rental property tax deductions. As a rule of thumb, rental owners can deduct any ordinary and necessary expense related to the management and maintenance of a property.

Here are 5 of the most common tax deductions available to property owners:

1. Property management, tax, and legal services

Hiring a property manager, tax accountant, or real estate lawyer is considered a necessary expense, as it allows property owners to run their rental businesses smoothly. However, the cost of these services can quickly add up and eat away at your overall earnings. As a result, the IRS allows you to deduct these expenses from your rental income.

2. Maintenance costs

Keeping your property in good condition is also a necessary and ordinary component of any successful rental. Rental owners are allowed to deduct all materials, supplies, and repairs used to maintain their property. This includes the cost of landscaping, cleaning, and other necessary home repairs, as well as HOA and condo fees. However, major home improvements, such as kitchen renovations, bathroom additions, or roof replacements, are not considered necessary and cannot be deducted.

3. Property insurance

Failure to protect your assets could significantly impact your rental business. As a result, property insurance becomes obligatory when running a rental business. The IRS permits property owners to subtract monthly insurance premium payments from their rental income.

4. Property taxes

Paying property taxes on your investment properties is also mandatory. Since property taxes are a necessary and ordinary expense, the IRS allows for property tax deductions to be made.

5. Utilities

Lastly, you can deduct utilities from your rental income. In most cases, landlords are responsible for a tenant’s access to water, electricity, and sewage lines. In some cases, a landlord will even supply wifi. If you pay for your tenants' utilities, you can deduct these expenses from your rental income. However, if they pay for their utilities themselves, make sure to categorize this as a rental income on your end.

Calculating property depreciation 

Property depreciation is a special kind of tax deduction allowing rental owners to subtract the cost of buying and improving their property from their rental income. Unfortunately, calculating your property depreciation isn’t as simple as subtracting one of the deductions mentioned above from your total annual rental income. You’ll need to follow a certain set of rules imposed by the IRS to accurately depreciate your investment property.

Once you’ve subtracted all qualifying deductions from your total rental income for the year, you can take that number (ie: taxable income) and use it to calculate property depreciation. To maximize your tax savings, it’s important to first subtract rental property expenses from your rental income and then calculate property depreciation.

Property depreciation can significantly reduce your tax liability. As a result, the IRS has strict rules regarding who can and cannot depreciate a rental property for tax purposes. You can only depreciate a rental property if the following is true:

• The property title belongs to you.
• It’s used as an income-producing asset.
• It has a determinable useful life, which means it is a piece of real estate that wears out, decays, or loses its value over time.
• It has a determinable use of life of at least one year. 
• It hasn’t been disposed of or halted income-producing activity in the same year in which depreciation is calculated. 
• It is not a piece of land. 

Once you have verified that your property meets all of the criteria mentioned above, you can go ahead and calculate property depreciation. It’s best to employ a real estate accountant in this process to make sure you are accurately calculating property depreciation.

Here are the three steps you'll need to follow when determining depreciation:

1. Determine the basis of the property: The basis of a property is the amount of money you paid in cash, through a mortgage, or some other financial vehicle to acquire the property. Settlement fees and closing costs can be included in the basis of the property. 
2. Separate the cost of land and buildings: When calculating property depreciation, you’ll need to separate the cost of land and physical real estate. Land isn’t a depreciable asset, because it doesn’t have a determinable useful life, but rather an indefinite useful life. In other words, it never gets used up. You’ll need to subtract the cost of land from the value of the actual property.
3. Determine your basis in the home: Once you’ve completed the first two steps, you’ll be able to determine your basis in the home. This includes the basis of the property plus any improvements you've made to the property since acquiring it. This is the number you can depreciate from your total annual rental income.

What is a qualified business deduction?

When working with a real estate accountant, they may suggest taking advantage of a qualified business income deduction, also known as the pass-through deduction or Section 199A deduction. The QBI deduction allows for an additional deduction of 20% after standard deductions and property depreciation are accounted for.

The rules for this deduction tend to be complex and require the assistance of a certified CPA with real estate tax knowledge. It's always best to calculate rental income tax with an experienced tax professional to maximize your rental income tax savings.

How much rental income tax do I need to pay in 2024?

Taxes paid in April 2024 will be based on 2023 tax brackets. The tax bracket that applies to you will depend on how you choose to file; however, most property owners file as single filers.

Here are the 2023 tax brackets for single filers:

• If taxable income is not over $11,000, your tax liability is 10%.
• If taxable income is between $11,001 and $44,725, your tax liability is $1,100 plus 12% of the excess over $11,000.
• If taxable income is between $44,726 and $95,375, your tax liability is $5,147 plus 22% of the excess over $44,725.
• If taxable income is between $95,376 and $182,100, your tax liability is $16,290 plus 24% of the excess over $95,375.
• If taxable income is between $182,101 and $231,250, your tax liability is $37,104 plus 32% of the excess over $182,100.
• If your taxable income is between $231,251 and $578,125, your tax liability is $52,832 plus 35% of the excess over $231,250.
• If your taxable income is over $578,125, your tax liability is $174,238.25 plus 37% of the excess over $578,125.

How do you report rental income to the IRS?

Now that you’re aware of the three major ways to save on rental income tax, you should know how to report it. Reporting rental income requires real estate investors to submit Form 1040 and Schedule E documentation.

Form 1040 is a basic income tax form applicable to anyone filing federal taxes. Schedule E is a supplemental form applicable to property owners that reveals total income, expenses, and depreciation for each rental property in a real estate investor’s possession.

Depending on the number of properties you have in your portfolio, you’ll need to submit multiple Schedule E forms. Every real estate investor will need to submit at least one of each.

The bottom line on rental income tax

Investing in residential rental property can be a lucrative investment that generates consistent, passive income streams. However, as your rental income grows, so does your tax liability. This makes it crucial for real estate investors to understand how rental income tax works and what they can do to minimize their taxable income.

The IRS acknowledges that owning real estate can be expensive, which is why they allow property owners to claim several deductions. Deductions lower your taxable income, which puts you in a lower tax bracket. You're therefore responsible for paying less taxes on the rental income you generate.

Some deductions are easy to calculate, while others require specific real estate tax knowledge. Consult with a real estate tax professional to make sure you're taking advantage of all deductions available to you.