If you own investment properties and are collecting rent payments from your tenants, this is important. Beginner real estate investors might find themselves asking: How is rental income taxed? Here’s what you need to know.
Real Estate Investing for Beginners- How Is Rental Income Taxed?
Running any type of business requires one to have knowledge about their federal tax responsibilities. The real estate investing business is no exception to this fact. Income generating assets are taxed in a certain way depending on their type. One type of income generating assets is a rental property. If you’re investing in rental properties and are receiving a profitable rental income (positive cash flow), this income must be reported in your tax return.
Related: Determine Your Rental Income When Investing in Rental Properties
It’s crucial for beginner real estate investors to understand the workings of real estate taxes, especially after the recently passed tax reform 2018. After all, you don’t want to get in trouble with the IRS because you didn’t know what you were doing. That’s what you want to avoid. In order to run a smooth and successful real estate investing business, you need to take on the responsibilities of that. Having an answer to the question, “How is rental income taxed?“, is one of the key real estate basics. Let’s start at the beginning.
How Is Rental Income Taxed? Part 1-What Is Considered Rental Income?
According to the IRS, rental income is any payment you receive for the use or occupation of property. If you own multiple rental properties, you must report rental income from all of them.
The way your rental income is taxed depends on the accounting method you follow. The first is the ‘cash basis method’, which is the method most people follow. The way this method works is simple. You report income as you receive it and expenses as you pay them out. Usually if you’re a private citizen who owns a rental property, you’ll use this method. The second method, ‘accrual method of accounting’, is typically used by a business. This counts income when it’s earned, not when it’s received.
How Is Rental Income Taxed? Part 2-Types of Rental Income
So you’re wondering, how is rental income taxed? In order to understand this process, you need to first understand the different types of rental income. In addition to amounts you receive as normal rent payments, there are other amounts that may be rental income and must be reported on your tax return.
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Advance Rent
Any rent payment received before the period it’s covering is referred to as advance rent. Advance rent must be included in your rental income and reported in the year you receive it, regardless of the period it’s covering or your method of accounting.
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Security Deposits
You’re also allowed to report security deposits that your tenant provides as rental income. Security deposits used as a final payment of rent are considered advance rent. This should be included as rent in the year you receive it. However, it’s important to mention that if you plan on returning this security deposit at the end the lease (when the tenant leaves), don’t include it as income.
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Payment for Cancelling a Lease
If a tenant pays you a certain amount to cancel a lease, this payment is also considered rental income. Again, regardless of the method of accounting you use, include this in your income the year you receive it.
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Expenses Paid by Tenant
This is the case when tenants pay for any building expenses when it’s not required per the lease terms. For example, a tenant pays the water or sewage bill for your rental property and then deducts that amount from the normal rent payment. The utility bill paid by your tenant should be included as income.
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Property or Services Received in Exchange for Rent
This is the case if a tenant offers to provide a service/gift instead of money for that month’s rent. According to the IRS, this exchange is still considered a form of rent payment so it must be included in your rental income.
Related: How Much Rental Income Should You Be Making?
How Is Rental Income Taxed? Part 3- Investment Property Tax Deductions
Beginner real estate investors may be overwhelmed by all the extra work required to invest in rental property; however, these rental property tax deductions might make up for that. You can’t answer “How is rental income taxed?” without talking about rental expenses. A couple of deductible rental expenses are mortgage interest, property taxes, operating expenses, depreciation, and repairs.
Related: The Best States With No Property Tax for Real Estate Investing
The IRS divides these tax deductions into two categories. All rental expenses must fall into either ‘ordinary’ or ‘necessary’ expenses in order to qualify as a tax deduction.
Ordinary Expenses
These are the expenses you would expect to come with owning a rental property. Ordinary expenses are those that are common and generally accepted in the business. For example, the cost of hiring a property manager is considered an ordinary expense and is tax-deductible.
Necessary Expenses
By the definition of the IRS, necessary expenses are those that are deemed appropriate, such as interest, taxes, advertising, maintenance, utilities, and insurance.
Other Tax-Deductible Expenses
You are also entitled to deduct the cost of materials required to maintain your investment property. You can deduct the costs of certain materials, supplies, repairs, and maintenance that you make to your rental property to keep your property in good operating condition.
We mentioned above how sometimes a tenant might pay for an expense such as the water bill, and how this would be included in your rental income. If they are deductible rental expenses, you can deduct that same amount as a rental expense.
It’s important to note the difference between a repair and an improvement. If you are fixing something and returning it to its pre-existing condition, that is a repair and is tax-deductible. However, any renovations or remodeling leading to an improvement made on the rental property cannot be deducted.
Related: The 6 Hidden Costs of Owning Rental Property
How Is Rental Income Taxed? Part 4- How to Report Rental Income
Whether you’re reporting rental income from traditional rentals or Airbnb rental income, you use the same form. To file your rental income, you’ll use Form 1040 and attach Schedule E: Supplemental Income and Loss. You start out by listing your total income, expenses, and depreciation for each rental property on the appropriate line of Schedule E.
You can use one Schedule E form to file three different rental properties. If you have more than three rental properties, complete and attach as many Schedules E forms as are needed to list the properties. In this case, you would fill out lines 1 and 2 for each property (including each property’s street address). However, you only fill in the ‘Totals’ column on one Schedule E form. The figures in the ‘Totals’ column in that Schedule E form would represent the combined totals of all Schedules E forms you file.
How is rental income taxed if you’re bad with numbers? With Mashvisor, there’s no need to worry about that. Use our investment property calculator to keep track of your rental income, rental expenses, and to view the tax history of investment properties. Do you have questions about Mashvisor? Click here to read our FAQs and learn about our tools.