Buying property with the intention to rent is a great way to generate cash flow and protect your money from inflation. An added bonus to rental income is the appreciation of the property over time.
So, how much tax do you have to pay on rental income? Rental income is taxed the same as ordinary income. Therefore, if your marginal tax rate is 24% and your annual rental income is $100,000, you would owe $24,000 in taxes on your rental income.
However, you can significantly reduce the amount of taxes you owe on your rental income by reporting things like deductions and depreciation of property value. Read on if you would like to learn how to pay less rental income tax.
How Can I Lower the Amount of Taxes I Pay on Rental Income?
There is nothing shady about lowering the amount of taxes you pay on rental income. The following tips are completely legal and enumerated on the official IRS website. An added bonus is that you don’t have to be a tax expert to employ these simple methods.
It is extremely important that you keep a detailed record of expenses associated with your property and the rental income you generate from it. Like any business, there are numerous things that the IRS determines as deductible.
“If you receive rental income from the rental of a dwelling unit, there are certain rental expenses you may deduct on your tax return. These expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs.”
From the official IRS website.
Here is a simplified list of common deductibles associated with rental income:
- Mortgage Interest
- Property Tax
- Repairs and General Maintenance (+ cost of materials)
- Homeowners association dues or condo fees
- Legal fees related to the property
Something to note concerning repairs and maintenance is that the IRS states that you can’t deduct the cost of improvements made to the property. Rather, depreciation, which we will discuss later, recovers the cost of improvements. In the words of the IRS:
“A rental property is improved only if the amounts paid are for a betterment or restoration or adaptation to a new or different use.”
From the official IRS website.
By adding together, the tax deductibles above with depreciation, many property owners are able to have almost $0 taxable rental income.
The depreciation of your rental property works like depreciation for business assets that have a longevity of usefulness.
For example, say your business spends $50 on paper clips and staples annually. You can deduct that cost as a business expense on your tax return.
Now let’s say that you made a purchase for a non-consumable item, like an industrial printer. This printer costs your business $7,000, but the printer is not ‘used up’ in a year like your paper clips and staples.
Rather than deducting the printer, you deduct the depreciation of the printer each year. Therefore, if the $7,000 printer your purchased depreciates by 10% each year, you will deduct $700 annually for the depreciation of that printer.
So, how does this translate to your rental property? Well, like an industrial printer, you are not going to throw your property away in a year. Instead, the IRS calculates the depreciation of the property and allows you to deduct it from your taxable rental income annually.
However, you cannot deduct depreciation indefinitely. There are limits for commercial and residential properties.
- Residential = 27.5-year period
- Commercial = 39-year period
Let’s break down how to calculate the depreciation value of your rental property. First, you take the amount you paid for the property and subtract the value of the land. Next, divide that number by 27.5 (for residential properties) or 39 (for commercial properties).
I have simplified the process in the following formula:
(Amount paid for the property) – (Value of land) / (27.5 or 39) = Annual depreciation value
If you bought a condo, which is a residential property, for $300,000 and the land is worth $75,000, you could calculate the annual depreciation value like this:
300,000 – 75,000 = 225,000 / 27.5 = 8,182
Therefore, in this particular example, you could deduct $8,182 as a depreciation expense on your tax return on top of your other deductibles.
Qualified Business Income Deduction (QBI)
If your taxable income falls below $157,000 and you are single, or your taxable income falls below $315,000 and you are married, you may qualify for a 20% deductible with QBI! Even if you are over the threshold, you may still qualify for a deduction.
QBI works for those receiving pass-through income through an LLC or S-Corporation. With QBI you can deduct an additional 20% of your taxable ‘pass-through’ business income (like rental income).
QBI is a bit more complicating than the other deductions discussed in this article. You can read more about it here on the official IRS website, or speak to a tax professional.
Rental Income Tax Example
If you feel at all confused by this, perhaps a hypothetical example will help to clear things up.
Meet Susan. Susan decided to buy a rental property in San Diego County in 2018 for $250,000. The land value of Susan’s condo is $75,000 and the property nets her $3,000 per month in rental revenue.
Susan has been diligent about keeping records of her taxable expenses and she has made the following list:
- Mortgage Interest = $10,000
- Insurance = $1,500
- Property Management = $2,500
- Real estate taxes = $4,000
- Other deductible expenses = $1,000
- Tenant paid utilities = $1,500
(Note: This is only an example, obviously your list will be longer and more complex than this!)
These deductible expenses add up to a total of $20,500. Remember that Susan nets $3,000 per month in rental income, which comes out to $36,000 per year. However, Susan won’t be taxed on the $36,000 if she includes these deductibles.
Now, Susan subtracts $20,500 from $36,000 to get her new taxable income figure of $15,500. But wait! Susan still has to deduct for depreciation.
250,000 – 75,000 = 175,000 / 27.5 = 6,364
Now Susan can deduct another $6,364 from her taxable income on top of the $15,500 she has already deducted. A total of $21,864 in deductions. Subtracting that from the $36,000 of income her rental property generates, that leaves $14,136 of taxable income.
But wait, there’s more!
Susan is single and makes $70,000 a year, well below the QBI threshold of $157,000. That means she can deduct 20% from her taxable income (after the above deductions). Let’s clarify Susan’s deductible with a list.
- Deductibles = $15,500
- Depreciation deductible = $6,364
- QBI deductible = $2,827 (20% of the remaining $14,136)
After these deductibles, Susan only has to pay taxes on $11,309 of the $36,000 her rental property generates!
Since Susan is single and makes about $70,000 a year, her federal marginal tax rate is 22%. That means that Susan will pay 22% in taxes on her remaining $11,309 taxable rental income, or $2,488.
If Susan had made no deductions to her $36,000, she would have had to pay $7,920 in taxes on her rental income!
Of course, your situation will differ from Susan’s. You may end up owing more, or you might be closer to 0!
Again, make sure to keep accurate and complete records of expenses related to your rental property, and don’t forget to file using the tax form 1040, Schedule E. If you have more than one rental property, you will need multiple Schedule E forms.
You can retrieve these forms from the IRS website.
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