If you’re renting out space in your home, leasing a summer home for the season, or even considering investing in real estate, you’re probably asking a crucial financial question: Is rental income taxable? In other words, if you make money renting a residential property out to tenants, do you have to report that money to the IRS and pay income taxes on it?
First, a disclaimer: We are not your accountants, and this is not property tax advice! This is general information for educational purposes. If you’re unsure about your individual financial situation, ask an accountant or a tax attorney. Tax law is famously complicated, and making a mistake can land you in serious trouble with the big guy.
All of that said, this property tax question has a simpler answer than most. So, is rental income taxable? Generally speaking, yes, you must pay income tax on your rental income. Of course, there are many interesting exceptions and wrinkles here, which we’ll get into below. Let’s dig into some nitty-gritty.
What counts as rental income?
According to the IRS, “Rental income is any payment you receive for the use or occupation of property.” Naturally, that means rent payments count as rental income, regardless of how much those payments are for or how frequently you collect them.
Rental income also includes advance rent. The IRS offers this example: Imagine you sign a multi-year lease with a tenant for $5,000 per year. The tenant agrees to pay you both the first and last year’s rent upfront when the lease is signed. You, therefore, have to report $10,000 in rental income for the current tax year.
Lease-escape payments are also rental income. Say your tenant signed a one-year lease to rent your property, but unexpectedly needs to move at the six-month mark. As per the agreement they signed, they pay you a one-time lease-cancellation fee to be released from their financial obligation to you. That fee is rental income and you have to report it.
Also included as rental income are any expenses the tenant covers on your behalf. Sometimes, for instance, landlords allow tenants to pay the water and electrical utility bills for their property and then deduct these costs from their total monthly rent payment. In the eyes of the IRS, this is still taxable rental income you’re receiving.
If a resident pays you in property or services, rather than cash, that’s rental income as well. For example, say you rent out a room in your house to a dentist. You agree to let them perform dental work for your family instead of paying you for the first three month’s rent. However much money they would have paid you, that’s the rental income you must report.
And finally, if you own a percentage of a property, you have to report as rental income that percentage the rent. So if you own a one-third stake in a beach cabin that you share with some friends, a third of the cabin’s monthly rental cost is your taxable income.
What about security deposits?
Security deposits are an interesting case. Generally speaking, they don’t count as rental income – but there are two exceptions.
First, if you plan to keep some or all of a tenant’s security deposit in exchange for the last month’s rent, it becomes a form of rental income. This is considered a form of advanced rent, and you have to report it.
Second, if you end up withholding and using a portion of the security deposit, it becomes rental income. Imagine that a tenant gives you a $2,000 security deposit upon move-in. When their lease ends and they vacate the rental property, you determine that $500 damage was done. You withhold this amount to make repairs, and return $1,500 of the tenant’s deposit. In this case, you count $500 as rental income from the vacancy property.
Types of Rental Income
To sum up, you must report all forms of rental income, including:
- Rent payments
- Advance rent payments
- Lease cancellation payments
- Expenses the tenant covers on your behalf
- Property or services a tenant trades for rent
- Your ownership percentage of a shared property
- Security deposits you keep or withhold
What deductions can property owners take?
Having come this far, real estate taxes might seem like a raw deal for you as the landlord or rental property owner. But don’t worry – the IRS also allows you to take a wide range of deductions that can offset some of your tax liability. Just like a small business owner, you don’t owe taxes on expenses needed to maintain and operate your rental business.
Need to perform service and maintenance to keep your property in good condition? That’s a deductible rental expense. Everything from yard maintenance and pool cleaning to pest control and basic plumbing is included. Materials and professional services count, too.
Then there’s taxes, advertising, utilities, and insurance for your property – all the high-level business expenses you need to keep your investment functional. These are deductible expenses as well. As long as it’s what the IRS calls “ordinary and necessary,” it’s fair game.
Note, however, that the IRS makes a sharp distinction between maintaining and improving a property. If you’re making basic repairs and doing routine service, that’s considered a maintenance rental expense, and it’s deductible. This includes: fixing leaks, replacing broken doors or windows, repairing appliances, and painting. On the other hand, if you renovate, remodel, or add a bunch of fancy new utilities to your property, that’s considered an improvement. It’s not deductible. This includes: upgrading a kitchen, installing a swimming pool, installing insulation, and water filtration.
How does depreciation affect my taxes?
When it comes to real estate, depreciation is complex and takes a little unpacking. But the short story is that residential real estate depreciation benefits you greatly as a taxpayer and owner/landlord.
When you own a major asset over a long period of time, it loses value… at least in principle. We see this clearly with cars, which are only worth about ten percent of their original price a decade after purchase. In the eyes of the government, loss of investment value is a cost of operating a rental business, and therefore deductible. In reality, of course, real estate may retain its value or even grow over time. Nevertheless, you can take a depreciation deduction on your property.
There are a few different ways to calculate depreciation, but the simplest is called “straight line depreciation.” Imagine you purchase and rent out a $200,000 home. To calculate the annual depreciation, you divide $200,000 by 27.5 – the number of years that the building loses value until it bottoms out. That gives you $7,273, which is the annual depreciation deduction you can take on your new property for as long as you rent it out.
What’s a qualified business income deduction?
According to the IRS, the Qualified Business Income Deduction (QBI) allows non-corporate taxpayers to deduct up to 20 percent, plus 20% of qualified real estate investment trust dividends and qualified publicly traded partnership income.
This includes income they receive from a pass-through entity such as an LLC or S-Corporation. Pass through entities include rental income from an investment property. Because this is a complex deduction, you should consult a tax professional to determine if you qualify or not.
How are recent legal changes affecting property owners?
The recently passed Tax Cuts and Jobs Act (TCJA) has been an enormous boon to real estate investors and landlords. Thanks to a new deduction called the “pass-through,” owners are able to count profit from their rental income as personal income, and pay taxes at individual income rates.
The new law had a range of other impacts on property owners, as well. Read more about it here. The key thing to understand is that it’s now easier and more profitable than ever to invest in real estate. So while rental income is taxable, residential rental property is still a powerful financial strategy for many investors.
Plus, many investors are choosing to outsource their rental property management responsibilities to maximize their rental income. With property management in St. Louis, MO to property management in Gainesville, FL, and more, Great Jones handles rent collection, tenant selection, and more so you don’t have to. For more advice on getting the most out of your rental property, reach out today to consult with our experienced team.