Rental Property Taxation: The Regular Annual Taxation of Rental Properties
Being a rental property owner can be exciting and financially rewarding, but also challenging. In addition to stress of managing multiple properties, screening tenants, addressing concerns, and juggling the numerous cash inflows and outflows, you have to navigate taxes…
Without an understanding of how rental property taxation works, you may be giving up valuable deductions unique to real estate investing and pay more taxes than you should.
There are three phases of owning a rental property and each has it’s own set of tax rules that you should be aware of. The three phases are:
- The Start Up Phase: When you obtain a property
- The Maintenance Phase: When you have a tenant
- The Disposition Phase: When you sell the property
This article addresses the basics of real estate income, deductions, and taxation during the Maintenance Phase.
Common Sources of Income
Income from a rental property can come from various sources, and it’s essential to understand these sources to assess the property’s profitability and financial performance. Here is a list of common sources of income for a rental property:
1. Rent Payments: The primary source of income for a rental property is the rent paid by tenants. Rent is typically collected on a monthly basis and is a significant component of the property’s revenue.
2. Late Fees: Landlords may charge late fees when tenants fail to pay their rent on time. These fees can provide additional income but should be in compliance with local laws and the terms of the lease agreement.
3. Pet Fees/Pet Rent: If tenants have pets, landlords often charge pet fees or pet rent as compensation for potential pet-related wear and tear on the property.
4. Application Fees: Some landlords charge application fees to cover the costs of screening potential tenants, including credit checks and background checks.
5. Parking Fees: If a rental property provides parking spaces, landlords may charge tenants extra for parking.
6. Laundry or Vending Machines: Income can be generated by providing coin-operated laundry machines or vending machines on the property.
7. Storage Fees: If the property offers storage units or additional storage space, landlords can charge tenants for its use.
8. Miscellaneous Fees: Landlords may charge additional fees for services or amenities, such as key replacement fees, amenity fees, or utility reimbursement fees.
9. Government Subsidies: In some cases, landlords may receive government subsidies or housing vouchers as part of affordable housing programs, which can contribute to rental income.
10. Expenses Paid by the Tenant: If your tenant pays expenses on your behalf that are not included in their monthly rent, you may have to include the cost of these expenses as income. For example, if the tenant pays for a repair on your behalf, the amount of the repair would be included as income. However, a common exception to this is utilities paid directly by the tenant. If the tenant pays for utilities directly, this amount is generally not included as income.
11. Services In Lieu of Rent: If your tenant provides services for you instead of pay rent, the fair market value of the services should be counted as income.
Security Deposits
Many landlords collect security deposits from tenants before they move in. In normal circumstances, security deposits are not counted as taxable income as this amount is considered to be held in trust for the benefit of the tenant and be returned at the end. However, if a portion of the security deposit is retained by the landlord due to damage, unpaid rent, or other lease violations, the retained amount may be considered taxable income.
Common Regular Expenses
Rental properties have many expenses they can deduct. In general, the first thing you have to figure out is if the expense is a regular expense or a capital improvement.
A regular expense is an ongoing cost incurred for the day-to-day operation and maintenance of the property and are deductible in the year incurred. A capital expense is an expense that substantially improves the value of the property and is not fully deductible in the year incurred. Rather, a capital expense is deducted over timeframes set by the IRS.
In general, both are valuable but it is better to have regular expenses you can deduct over capital expenses.
Here is a list of common regular expenses to be aware of:
Management Costs
- Advertising costs when seeking a tenant
- Expenses related to obtaining and retaining tenants
- Reasonable, travel expenses to and from your rental properties.
- Website creation & maintenance
- Employee Costs
Professional Services
- Property management
- Legal fees related to operating the property
- Accounting fees
Minor Repair Costs
- Replacing broken cabinet door
- Fixing a leaky roof
- Replacing a malfunctioning smoke detector or security camera
- Removing a dent from the garage door
- Minor electrical and plumbing repairs
- Structural repairs made to the roof or foundation of the house
- General painting
- Appliance repairs
- HVAC repairs or seasonal inspection work
- Fixing a water heater
- Replacing a small patch of carpet or having the carpet cleaned
- Refinishing a wooden floor, or replacing some cracked floor tiles
- Repairing glass in a window, or repairing a door lock
Property Maintenance
- Cleaning expenses
- Lawn Care, Landscaping, Snow Removal
- HOA Dues
- Pest Control
Utilities paid by you
- Water & Sewer
- Gas
- Electricity
- Trash
- Cable and/or Internet
- Security
• Taxes and Fees
○ Property taxes
○ Business licenses and taxes
○ Legal fees
• Financing and Insurance
○ PMI on mortgage
○ Interest paid on a mortgage on the property or improve property
○ Interest paid on credit cards used for rental property
○ Interest on auto loan if used for rental purposes
○ Construction loan interest
○ Points paid to obtain your mortgage
Insurance on the property
Depreciation
Depreciation is the annual deduction of the cost of acquiring the property and capital expenses incurred during operation. In general, depreciation will likely be one of the largest expenses a landlord writes off of income.
Rental Property Depreciation has many facets to it but the most common treatment breaks it down into two parts: Acquisition Depreciation and Subsequent Capital Improvement Depreciation.
Acquisition Depreciation is depreciation related to the costs of acquiring the property. The value of the land is not depreciable, but most everything else related to the cost to purchase a property is. For example:
Purchase Price: $300,000
Land Value Allocation: In real estate, the value of the land itself cannot be depreciated because land doesn’t wear out. You need to allocate a portion of the purchase price to the land. Let’s say you allocate $50,000 to the land, leaving $250,000 as the depreciable basis.
Depreciation Method: Most residential rental properties in the United States are depreciated over 27.5 years using the Modified Accelerated Cost Recovery System (MACRS).
Annual Depreciation Deduction: To calculate the annual depreciation, you divide the depreciable basis by the useful life (27.5 years): Annual Depreciation = $250,000 / 27.5 = $9,090.91 per year
This means you can deduct $9,090.91 from your taxable income each year for the next 27.5 years due to the acquisition depreciation.
Subsequent Capital Improvement Depreciation occurs when you incur an expense that substantially increases the value of the property. For example, installing a new roof, new deck, or attached garage, are all examples that fall in this category. These capital improvements are depreciated separately from the Acquisition Depreciation. For example: let’s assume you make $50,000 worth of capital improvements to the rental property three years after the acquisition. These improvements extend the property’s useful life.
New Depreciable Basis: To calculate the new depreciable basis after the capital improvements, you add the cost of improvements to the existing depreciable basis:
New Depreciable Basis = Original Depreciable Basis + Cost of Improvements
New Depreciable Basis = $250,000 + $50,000 = $300,000
Updated Annual Depreciation Deduction: With the new depreciable basis, you can recalculate the annual depreciation using the same method:
Updated Annual Depreciation = $300,000 / 27.5 = $10,909.09 per year
Now, you can deduct $10,909.09 from your taxable income each year for the remaining 27.5 years.
There are different depreciation schedules for different sorts of capital improvements so you may have depreciation over a shorter period of time as well.
While you can write depreciation off as an expense against income each year, it is important to note that depreciation does not negatively impact your annual cash flow but rather improves it as it lowers taxable income.
Common Capital Improvements
Appliances
- Refrigerator
- Washer
- Dryer
Home Structure
- Attic, wall, and floor insulation
- Wiring upgrades
- New roof
- Storm windows and doors
- Installing a new garage door
- New Windows
Heating and air conditioning
- New HVAC
- Central air conditioning
- A furnace
- Duct work
- A central humidifier
- A filtration system
Plumbing improvements
- Septic system
- Water heater
- Soft water system
- Filtration system
- Major pipe replacements
Property Additions
- Shed
- Deck or patio
- Swimming pool
- Additional Room
Additions and interior improvements
- Built-in appliances
- Room Renovations (Kitchen Remodel, Finishing a Basement, etc)
- Flooring
- Central Vacuum
- Wall-to-wall carpeting
- Security system
- Major Painting
Improvements to your lawn and grounds
- Landscaping
- Driveway
- Walkway
- Fence
- Retaining wall
- Sprinkler system
Tax Documents and Documentation
Schedule E
In most cases, rental property income and expenses will be reported on Form 1040, Schedule E (Supplemental Income and Loss From rental real estate, royalties, partnerships, S corporations, estates, trusts, REMICs, etc.). This forms helps calculate your taxable income or loss on the property which flows through to your main tax return.
About Schedule E (Form 1040), Supplemental Income and Loss | Internal Revenue Service (irs.gov)
Form 1098
Form 1098 is a mortgage tax report that shows how much interest you paid on any loans for the property. Keep this as documentation to deduct your interest expense.
Document, Document, Document!
Maintaining proper documentation is critical in the case of an audit from the IRS. If you don’t document, you may have to go back and adjust your expenses resulting in higher taxes and potential late penalties or interest! Keep receipts and invoices, rental agreements, bank and financial statements credit card statements, mileage logs, and depreciation records.
Publication 527 (2022), Residential Rental Property | Internal Revenue Service (irs.gov)
Other Rules To Be Aware OF
There are some additional rules to be aware of on a regular basis that are beyond the scope of this article. They are:
- Passive Loss Rules,
- Real Estate Professional Status (REPS),
- Safe Harbor for Small Taxpayers,
- Routine Maintenance Safe Harbor,
- De Minimus Safe Harbor, and
- Section 179 Expensing