Tax on rental income: Everything you need to know

According to the Internal Revenue Service (IRS), rental income is “any payment you receive for the use or occupation of property.” This includes normal rent payments, advance rent, security deposits that are not returned to renters, lease cancellation fees, and services received instead of rent. Rental income is taxed like ordinary income—at the same tax rate as your overall income tax bracket—but there are a few deductions and rules for rental real estate that you should know.

To calculate your total taxable rental income, add up the payments you received for the rental property during the calendar year for which you are filing a tax return. This includes:

• Rent payments. The total of all regular and prorated rent payments made by tenants. 

• Advance rent. If a tenant prepays for the last month of rent when they move in, this amount needs to be reported in the year you receive it, not when the tenant moves out.

• Unreturned security deposits. Any amount of a security deposit that you hold onto after a tenant departs. If you return the security deposit, you don’t need to report it. 

• Fees. Fees collected from renters, such as lease-termination fees.

• Services received in lieu of rent. Say your tenant agreed to paint their own apartment in exchange for one month of free rent—you’ll have to list that as income equivalent to one month of rent.

Once you’ve added up your gross rental income, you can start subtracting deductions and depreciation to find your taxable income.

You can deduct the costs of expenses associated with the rental on your tax return, so long as they are considered “ordinary and necessary.” Deductible expenses include:

• Mortgage interest

• Property tax

• Repairs

• Utilities

• Homeowners insurance

• Advertising

• Maintenance and cleaning

• Homeowners association or condo fees

Not all expenses related to your rental can be deducted. The cost of improvements, such as restoration, betterment, or adaptation to a different use, can not be deducted. The cost of improvements, however, can be recovered through depreciation. If you’re feeling unsure about whether or not an expense is deductible, talk to your tax preparer.

Depreciation is deduction that occurs over a longer period of time. Businesses usually take deductions for things that have a lifespan of one year or less, and depreciations for things that last more than one year, such as equipment or machinery. When it comes to rental properties, depreciation can help you recapture both the cost basis of the property itself and any improvements you make to the property. 

Depreciation happens on a timetable set by the IRS, depending on the type of improvement. According to the IRS, rental properties take 27.5 years to depreciate, so you can divide the cost basis of your rental property (the amount you paid and borrowed to buy the property, minus any surrounding land) by 27.5, and then deduct that amount each from your taxable income. 

Other improvements that fall under the depreciation category include:

• Structural additions

• Renovations 

• Insulation 

• Furniture 

• Landscaping

• Flooring

• Heating and air conditioning

A tax professional can help you understand depreciation deductions for specific improvements.

When you sell your rental property, you’ll have to pay depreciation recapture tax in addition to capital gains taxes. That means that you’ll pay taxes (at the tax rate of your income tax bracket) on the amount that you’ve deducted for depreciation. 

Deciding not to take the depreciation deduction won’t help you skip this tax since the depreciation recapture tax is based on the allowable amount of depreciation. One way that you can avoid paying depreciation recapture tax is to use a 1031 exchange to sell your property and invest in a new piece of rental real estate.

If you sometimes stay in your rental property, the tax implications depend on how much time you spend there. Here’s how the IRS categorizes three types of property.

• Primarily for personal use. If you rent out a property for less than 14 days of the year, you don’t have to report those earnings on your tax return, and you can keep the earnings tax-free.

• Primarily for renting. You can stay in your rental property for less than 14 days, or 10% of the days it was rented out (whichever is higher), and still treat the property as a rental property for tax purposes.

• Renting and personal use. If you rent your property for more than 14 days of the year but you also make personal use of the property, you can still treat the property as a rental, but your deductions will be limited by your rental income when you file your tax return. What this means is that, even if you’re operating your rental property as a loss, it won’t count as a loss for tax purposes.

Revenue from rental activity is generally considered passive income, meaning that there are limits to using loss from rental activity to offset other sources of income. But, if you can prove that you actively participate in rental activity by owning at least 10% of the property and making major management decisions (such as approving tenants and improvements), you may be able to deduct up to $25,000 of rental loss. 

You also need to meet certain income restrictions: Your modified Adjusted Gross Income (MAGI) must be under $150,000 to take the deduction, and if your income is over $100,000, you won’t be able to take the maximum deduction.

Rental activity is reported on Form 1040 or 1040-SR, Schedule E, Supplemental Income and Loss. For most people, you’ll report rental income on your return for the tax year that the income was received. For example, if your tenant paid rent for January 2021 in December 2020, you’ll report the January rental income on your 2020 tax return. If your tenant pays last month’s rent when they move in, you’ll also report that in the year it was received. 

If you have more than three rental properties, use as many Schedule E forms as needed to list every property. You’ll fill out lines 1 and 2 for each property, including each property’s street address. Even if you have more than one schedule E form, fill out the Totals section on only one form.

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