Luckily for both current and aspiring landlords, owning a rental property faces favorable tax rules that aren’t available for other types of investments. These favorable rules related to rental income tax are a major reason why so many people get rich in real estate investing. Any pain of putting up with tenants is offset by tax regulations that make the financial potential of your real estate investment so great. So let’s talk about your rental income tax.
How many rental income tax reductions you get depends on what kind of real estate investor you are. Your classification as either a passive investor or a real estate professional makes a big difference in the number of tax breaks you get. The IRS defines a real estate professional as someone who spends more than half of his/her working time in the rental business – including property development, construction, management, etc. If you are a professional, your rental losses are not passive, which means that your losses are fully deductible against all income. If you are a passive investor and spend less of your time dealing with your rental properties, then your losses will be passive and only deductible up to $25,000 against your rental income.
In case you didn’t already know, you can deduct mortgage interest and property taxes on investment properties. However, if you pay mortgage points, you must pay those off over the term of the loan. This is unlike points on a mortgage to purchase a principal residence, of which you can deduct immediately. You can also write off all other standard operating expenses that come with owning a rental property such as repairs, maintenance, utilities, insurance, association fees, etc. All of these are included in your rental income tax reductions.
At a certain point, your rental properties should start producing positive taxable income instead of losses – escalating rents will surpass your deductible expenses. Obviously, you have to pay rental income tax on these earnings, but don’t stress – if you have piled up suspended passive losses in earlier years, you can now use them to make up for your passive profits.
Other good news: positive taxable income from rental real estate isn’t hit with the self-employment (SE) tax, which applies to other unincorporated profit ventures. The SE tax can be as high as 15.3%, so it’s great that you don’t have to pay it as a landlord. However, due to a provision in the 2010 healthcare legislation, positive passive income from rental real estate can get subjected to the new 3.8% Medicare surtax on net investment income – but only for upper-income landlords. Talk with your own rental income tax advisor to be sure of this new healthcare tax.
Related: Everything Real Estate Investors Should Know About Tax Season
Beware of Passive Activity Loss
If your rental property throws off a tax loss as most do, things get complicated. Beware of the so-called passive activity loss (PAL) rules that will usually apply. Generally, PAL rules only allow you to deduct passive losses to the extent that you have other passive income sources (for example, positive income from other rental properties or the money from selling them). Passive losses that exceed passive income are suspended until you either have more passive income or you sell the income property that generated the losses. Long story short: PAL rules can postpone your rental property loss deductions, sometimes for years. However, there are several exceptions that can allow you to deduct losses sooner rather than later, so make sure you research your state’s rules on PAL rules and rental income tax.
Different Income Sources
As a property owner, you have several different income sources – and they are all taxed differently. Let’s go through a few of the most common ones and discuss the rental income tax and deductions for each:
Rental Income Tax: The money you get from rent is generally considered taxable in the year you receive it, not when it’s due or earned. This means you must advance payments as income. For example, imagine you rent out a house for $1,000 per month and you require new tenants to pay first and last months’ rent when they sign a lease. You would have to declare the $2,000 you receive as income, even though a $1,000 of that $2,000 covers a period that might be several years in the future.
Tenant-Paid Expenses: Expenses your tenant pays for you are considered income – these include, for example, emergency repair on a water heater that a tenant needed to do while you were out of town. You simply deduct the repair payment as an expense.
Related: 6 Better Ways To Spend Rental Income
Security Deposits: Security deposits are not taxable when you receive them as long as the intent is to return the money to the tenant at the end of the lease. If you have a trouble tenant whose security deposit you must keep to repair the things he/she broke, you must still declare the amount that you used for the repairs and pay taxes on that amount.
While we are talking about repairs, remember that repairs are deductible expenses, while renovations are not deductible. So, from a rental income tax standpoint, it is better to make repairs as the problems arise instead of waiting until they multiply and you require renovations.
- Mortgage – not all payment is deductible, but the interest you pay on it each year is.
- Travel expenses – money you spend on travel to collect rent or maintain your rental property is deductible; you can deduct on the actual expenses or the standard mileage rate.
- Lawn care
- Tax return preparation fee
- Losses from causalities: hurricane, earthquake, flood, etc – or theft
Related: All You Need to Know About a Mortgage for Rental Property
When You Sell
When you sell a real estate property that you’ve owned for more than one year, the price difference is generally considered as a long-term capital gain. Because of this, it will be taxed at no more than a federal rate of 20%. However, part of the gain will be subject to a maximum rate of 25%. Like every rule in real estate, there are variances from state to state, so check up on additional state income taxes on your real estate gains. New York City even has its own tax for properties in the city.
When it comes to rental income tax, remember that rental property appreciation isn’t taxed until you actually sell the property. And you can even pocket part of your real estate appreciation in advance by taking out a second mortgage against your property or refinancing it with a bigger first mortgage. A cash-out deal like this is legal and tax free.
Before you decide to go for real estate investing, make sure to familiarize yourself with the above-listed main rules for rental income tax. For more tips on becoming a successful real estate investor, check up Mashvisor daily.