Posted by Tiffany Gaskin

Everything You Need to Know About Taxes on Rental Income

Everything You Need to Know About Taxes on Rental Income

What is Rental Income?

Uncle Sam defines rental income as any payment you receive for using or occupying the property. Examples are rent payments, security deposits, advance rent, fees for lease cancellation, and other services related to renting. The taxation of rental income is similar to ordinary income, even though there are some rules and deductions for rental properties you should know.


Calculation of Rental Income 

To estimate the entire taxable rental income, sum up all payments for such rental properties in the calendar year that you are filing such a return. These are:

  • Payment for rent: the summation of the entire payment, both regular and protracted, that your tenant made

  • Advance rent: For tenants that prepay for the final rent month when moving in, such amount should be reported in the year received, not when the tenant left the property 

  • Unreturned Security Deposits: This is whatever security deposits were not returned to a tenant when they leave. For the ones you returned, you need not report them. 

  • Fees: Fees paid by your tenant like lease termination fees

Adding the entire gross rental income makes it possible to subtract deductions and depreciation to get the taxable income.


Rental Income: What can you Deduct?

All expenses related to rental on your return can be deducted if they are "necessary and ordinary." Here are some deductible expenses:

  • Utilities

  • Repairs

  • Advertising

  • Property tax

  • Cleaning and maintenance

  • Homeowners insurance

  • Homeowners association fees

You, however, cannot deduct all expenses related to rental income. For example, costs associated with improvements, renovations, restoration, or adapting the house for another user cannot be deducted. You, however, can recover such improvement costs via depreciation.

 

Exploring Depreciation 

Depreciation is a deduction that stretches over a long duration. For example, if a property has a lifespan of a year or below, the business will take the deduction. In contrast, they take depreciation for items lasting over a year, like a piece of machinery. For rental properties, depreciation is handy in capturing the cost basis of such property alongside any improvement. 

Uncle Sam has a timetable for depreciation based on the form of improvement. The IRS specifies that rental properties will need 27.5 years to depreciate, making it possible to divide the cost basis of the rental property by 27.5 and removing each amount from your taxable income. This is the value of what you bought the property with, removing the cost of the land. Here are further improvements under the depreciation category:

  • Insulation 

  • Furniture 

  • Structural additions

  • Landscaping

  • Flooring

  • Heating and Air conditioning 

  • Renovations 

With the help of a tax professional, you can understand the depreciation deduction for each specific improvement. 


Selling a Rental Property: What Happens?

It is essential to pay the depreciation recapture tax on selling your rental property alongside the taxes for capital gains. The implication is that your taxes will be paid on the amount you deducted for depreciation, based on the tax rate of your income tax. 

You cannot avoid this tax by avoiding the depreciation deduction as the depreciation recapture tax is a factor of the allowable depreciation amount. However, it is possible to avoid payment of depreciation recapture tax by using a 1031 exchange for the sale of your property and have another fresh real estate investment.

 

Reporting Rental Income on Your Tax Return 

You will report your rental activities using either Form 1040 SR or Form 1040. They might need to report the rental income on their return for the specific tax year they got the income for many people. For instance, if your renter paid Jan 2020 rent in Dec 2019, such January rental income will be reported on your 2019 tax return. For renters that paid the previous month’s rent when they moved in, it is important to report it the year you got it.

For people with the above three rental properties, you can use Schedule E to highlight all the properties. Lines one and two must be filled for each property, alongside the street address. You will only fill the Total section for one form even if you use more than one Schedule E form.


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Tiffany Gaskin
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