Investing in rental real estate can be a great way to diversify your investment portfolio and generate wealth.
In this article, we will guide you through the intricacies of rental real estate taxation.
How Does Rental Real Estate Income Work?
Rental income is any payment you receive for the use or occupation of property, and this income must be reported for all your properties. This includes any money you receive as monthly rent from a tenant as well as advanced payment of rent (e.g., first and last month’s rent), security deposits that you keep, expenses paid by your tenant that they deduct from their rent, and services done by the tenant that is deducted from their monthly rent.
Rental income in most cases is considered passive income by the IRS. Passive losses can only be deducted against passive income or if your AGI is below certain thresholds you may be able to deduct up to $25,000 in net rental losses (i.e., the special allowance).
Rental real estate professionals, however, are permitted to treat rental income as ordinary income. Rental real estate activities in which real estate professionals materially participate are required to be treated nonpassive activities for income tax purposes.
As a result of this requirement, net rental losses from rental losses can be deducted against other nonpassive income (such as W-2 wages). The $25,000 special allowance limitation does not apply to real estate professionals. Several conditions must be met to make this classification.
Losses not allowed under passive activity loss rules are carried forward until subsequent tax years where they are either offset by passive income or the property that generated the losses is disposed. Tracking these losses can be very important as these losses are often helpful in offsetting capital gains generated from the sale of the property.
Calculating Rental Income
It’s important to note that you don’t have to pay tax on all of the rental income you collect. Numerous expenses are deductible against your rental income. Some of the expenses that you can deduct include:
- Costs of cleaning and maintaining property
- Interest on mortgage
- Insurance costs
- Money spent on advertising the property
- HOA or condo fees
- Property taxes
- Services such as utilities and pest control
- Legal fees related to owning the property
Perhaps the most important deduction for a rental property owner is depreciation. Depreciation deductions allow a property owner to deduct the costs of buying and improving a property over its useful life, and thus, can significantly reduce taxable income.
The Qualified Business Income Deduction
Owners of rental real estate should be particularly concerned about whether their real estate activities can be considered a Section 162 trade or business and, therefore, treated as a trade or business for the purposes of the Qualified Trade Income (QBI) deduction. This deduction can be significant for any business owner, including owners of rental real estate. Certain taxpayers with taxable income less than $163,300 ($326,600 if married filing jointly) as of 2020 can deduct 20% of qualified business income. Rental properties often generate losses, but this deduction can be very valuable to property owners that generate profits.
A Sample Tax Bill
Now, let us put this knowledge into practice to illustrate how deductions can help save you money. Let us take a look at this scenario:
You own a duplex that you purchased for $300,000 and the land’s value is $75,000. Both units are occupied, and each generate $1,300 a month in rental income. Your year’s total in rental income is $31,200. For the year, you have accumulated the following expenses on the property:
- Mortgage interest: $10,000
- Insurance: $2,000
- Tenant-Paid Utilities: $1,000
- Property Management: $3,120
- Real Estate Taxes: $4,000
- Other Deductible Expenses: $500
This brings you to a total of $20,620 in expenses. Additionally, there is an $8,182 annual depreciation dedication based on the property and land value. This brings your overall taxable income to $2,398.
In this example, let us say you’re under the income threshold for the QBI deduction, which means you can tax advantage of the QBI deduction and an additional reduction in your taxable income.
How to Report Your Rental Income
According to the IRS, if you have rental property such as buildings, rooms or apartments, you normally report your rental income and expenses on Form 1040 or 1040-SR, Schedule E, Part I. On this form you will list your total income, expenses, and depreciation for each rental property on the appropriate line.
If you have more than three rental properties, complete and attach as many Schedules E as are needed to list the properties. However, your totals for all your properties only need to appear on one of these Schedules E.
Should your return be audited by the IRS, you will be required to thoroughly document that rental income you’ve received as well as every dollar of expenses you claim on your tax return. Documentation can include copies of cancelled checks, receipts or other appropriate forms of documentation. As a rule of thumb, you should keep this type of documentation for three years after filing your taxes.
If you are looking for professional assistance, the dedicated professionals at the firm of Cooke, Lavender, Massey, & Company P.C. have over 80 years of combined experience when it comes to helping their clients report their taxes. Whether you own rental property or have other tax situations that need a professional eye, contact us to speak with one of our certified public accountants about how we can assist you.