Things You Should Know About Rental Income and Taxes

Property management can be a lucrative industry for landlords. It is a fast-paced industry with many moving parts, such as interviewing potential tenants, managing current tenants, and maintaining property quality. Income tax and deductions for rental properties may not be top of mind, but there are certain things about rental income and taxes every landlord should know about.

In this article, we’ll dive into 5 key things every landlord or property manager should know about rental income tax and potential tax deductions. Keep reading to learn everything you need to know about how to navigate the complex world of rental income and taxes.

1. What Is Rental Income? 

Rental income is a broad term that includes four sections:

• Amounts paid to cancel a lease
• Advance rent
• Expenses paid by a tenant
• Security deposits

First, money that comes from a lease cancellation is considered rental income. You need to report this for the tax year in which you received it. Advance rent paid in the tax year in which you receive it is rental income. Expenses paid by tenants are also rental income; however, this form of rental income may be deductible.

There are several components to security deposits:

• Security deposits that will be returned to your tenant after their lease does not count as rental income.
• If your tenant broke the lease early or moved out of the property early, you must include the amount of income that you kept as income for the tax year.
• If you kept part or all of the tenant's security deposit because of damaged property to make repairs, you will include the amount you kept as rental income if you deduct the cost of repairs as expenses.
• The security deposit applied to your tenant's last month of their lease is advance rent. Upon receiving the money, it can be considered rental income.

2. How Much Tax Do You Pay on Rental Income?

Rental income is reported and taxed just like any other source of income. Therefore, the tax rate on your rental income is largely dependent on your tax bracket. The IRS’s marginal rate for the tax year 2023 breaks down as follows based on filed income:

Remember, if you own more than three rental properties, you will file a Schedule E (Form 1040) for each property.

3. How Is Rental Income Tax Calculated?

To calculate your rental income tax, add up all the rent that you've received. Include any expenses from your property. You should also include the fair market value of any merchandise or services you received. If you are planning to return security deposits at the end of the lease, don't include that amount in your gross income total.   

Next, add the amounts of property-related costs such as advertising, depreciation, insurance, maintenance, and taxes. Finally, subtract the expenses from your gross income. This amount is your taxable income. 

There are three possible results:

• For a total greater than zero, this is the amount of your taxable rental income.
• For a total that is less than zero, this is the amount that you can deduct from other income sources, such as lost business revenue.
• A total of zero doesn't affect your income.

4. Is Rental Income Earned Income?

Rental income is typically considered unearned income by tax authorities like the Internal Revenue Service (IRS). Unlike earned income, which primarily includes wages, salaries, or business income from active participation, unearned income typically includes sources such as interest, dividends, and rental income from real estate.

There are a few exceptions where your rental income is not considered earned income. Therefore, it's not subject to taxation. For instance, if you use a dwelling unit as a personal residence and rent it for fewer than 15 days in a year, you do not have to report the rental income and you cannot deduct any expenses as rental expenses. If the property serves both rental and personal purposes, expenses need to be split between the two uses based on the number of days used for each. Only the rental portion of allowable expenses can be deducted from your tax return. This is similar to how you file business and personal deductions separately.

5. What is Tax Deductible From Rental Income? 

As a landlord, you can deduct numerous expenses from your rental income to reduce your tax liability. These expenses must be ordinary, necessary, and directly related to managing, conserving, or maintaining your rental property. Below we've listed some common tax deductions related to rental income:

• Depreciation 
• Operating Expenses 
• Repair
• Property Tax
• Mortgage Interest

It's possible to take advantage of several deductions to avoid paying higher taxes. Expenses such as ordinary expenses and necessary expenses can reduce your tax liability or the amount you owe in taxes. 

Ordinary expenses include everyday payments that you make to maintain your property. Necessary expenses include advertising, insurance, maintenance expenses, and utility costs. 

Costs of maintenance, materials, repairs, and supplies are eligible for deductibles. You can also deduct expenses paid by a tenant if they are deductible rental expenses. However, you can't deduct the cost of improvements to your rental property.

Rental Income and Taxes FAQs

How does the IRS know if I have rental income?

The IRS has a number of ways to determine whether or not you have rental income. A few of these include reporting by third parties, reported income and expense discrepancies, audits and reviews, and public records. As a business owner, you need to remember that the IRS is dedicated to ensuring all taxable income is reported. It's very important to report honestly and accurately, if you're confused about your responsibilities, don't hesitate to seek professional advice.

Do you pay taxes on rental income?

Yes, you do pay taxes on rental income in the United States. Rental income is generally considered taxable income and needs to be reported on your federal income tax return. This includes rent payments and any advance rents, security deposits used as a final payment of rent, and expenses paid by a tenant for you. However, you may also deduct rental expenses to reduce your tax liability.

Do I pay taxes on rental income from another state?

You must file a tax return in the state where your property is located, even if you maintain residence in another state. You might be required to file a 1040 or similar return type. Be sure to keep up with state and local tax laws applicable to your properties. 

What is the tax rate on rental income?

Since rental income is taxed just like any other form of income, your tax rate is dependent upon tax bracket based on annual income. Tax rates, deductions, and other aspects will vary by state and other local regulations. 

How do I avoid paying taxes on rental income?

Various deductions are available to lessen your financial burden when filing your tax return. Ordinary and necessary expenses for maintaining your property, material costs, and expenses paid from your tenants are a few examples of deductions to potentially include on your tax return.

Will rental income affect my taxes?

Yes. Rental income should be treated just like any other form of income when you file your tax return. If your combined incomes exceed a certain amount, you could be bumped to the next tax bracket and be subject to a high tax rate. Consult with an experienced tax professional to ensure yours are filed properly and you get the best return available.

What happens if I don't pay taxes on my rental income?

Not claiming rental income on taxes can lead to significant consequences. Rental income is considered taxable income and must be reported on your tax return. If unreported it can lead to penalties and interest, audits, criminal charges, or in extreme cases liens and levies.

Work with a Professional

Potential deductions on rental income can help landlords save money by reducing their tax liability. Work with an accounting professional who specializes in rental income and taxes to ensure you take advantage of as many tax deductions as possible. Don't hesitate to seek expert advice to maximize your rental property income!