Rental real estate can be a lucrative investment and a reliable vehicle for wealth building. But any active investor will tell you that you need to be thoroughly educated about real estate or you’ll lose money faster than you can ever make it.
One of the aspects of learning the real estate business is knowing how to file taxes on your real estate investments. Rental property taxes are complex and even if you know what you’re doing you can still benefit from having a tax attorney or CPA on your team.
But where do you start? Every investor’s portfolio is unique and there are dozens of questions to ask when you’re filing taxes on long-term rentals, vacation homes, crowdfunded real estate and when you sell a rental.
Here are some of the most frequently asked questions to get you started.
Do I Have to Report Rental Income?
You do. All rental income must be reported on your tax return. Failure to do so is a felony and can result in fines, interest payments, a lien on your property or even jail time.
But what’s considered rental income? It’s defined by the IRS as any payment you receive for the use or occupation of a property. This includes:
- Advanced rent payments. If a renter pays for a year upfront you have to report the entire payment when you receive it even if the lease agreement extends into the following tax year.
- Security deposits you intend to keep. If you charge first and last months’ rent upfront, the last month’s rent is considered an advanced payment. If you plan to return the entire security deposit after the lease is over you don’t have to report it as income.
- Fines for early lease termination. Consider it as rent in the year you receive it regardless of when the tenant is breaking the lease.
- Any expenses your renter pays for you. If the renter pays you a flat rate of $50 per month for utilities, you have to include that as rental income. You can still deduct the expenses if they’re deductible rental expenses but you must report the income.
- Services in exchange for rent. If your tenant provides you a good or service as payment for rent you must report the value of the good or service in the year you receive it.
Even if you’re part-owner of a rental property, you still have to report your part of the rental income from the property in proportion to the amount you own.
Do I Have to Pay Taxes on Rental Income?
Yep, your rental income is subject to taxes just like your regular income. Whether you have a W-2 or rental real estate is your full-time business, your rental income and all other income is taxed at your marginal tax rate.
That doesn’t mean you’ll have to pay taxes on every dollar you get from renters. You can subtract the total amount of expenses related to maintaining the property from your income and pay taxes on that amount.
How Can I Avoid Paying Tax on Rental Income?
The best way to avoid paying taxes on your rental income is through tax deductions. Tax deductions reduce the income you’re able to be taxed on and are commonly a result of expenses, especially those incurred to produce income. That means most expenses associated with a rental property are deductible from rental income.
Some of the most commonly used deductions on rental properties include:
- Mortgage interest
- Travel to, from, and for the property
- Your home office
- Contractors and employees
Some expenses are so large the government won’t let you deduct them all in one tax year. The value of appliances, renovations and anything in a property that can be used for multiple years must be deducted over the lifespan of the item.
This is referred to as depreciation, it’s often the biggest deduction for rental properties and the reason why profitable real estate businesses can show a negative income on their property year over year.
For example, say you purchase an investment property for $100,000 through a real estate marketplace service like Roofstock and you put $50,000 into renovating it. You can deduct closing costs, travel to and from the property, and Roofstock’s $500 listing fee in the year you buy the property.
Read More: Roofstock review
The purchase price of the home and the cost of renovations must be depreciated. The standard depreciation rate for residential rental properties is 27.5 years so if you want to know how much you can deduct for structural renovations simply divide $50,000 by 27.5 and get your annual deduction of $1,818.
In addition to the property purchase and structural renovations, furnaces and water pipes are also depreciated over 27.5 years. Items that aren’t structural have varying depreciation schedules:
- Appliances, carpeting & furniture: 5 years
- Office furniture & equipment: 7 years
- Fences & roads: 15 years
Unfortunately, you can’t claim depreciation on personal residences, only if the property is considered a rental for tax purposes and only if you’re not selling it in the same year you depreciate it.
How Do Residential Real Estate Tax and Rental Property Taxes Differ?
If you have a property that you rent out 100% of the time then you know to report its expenses and income in your taxes. But what if you have a single-family home, townhouse, apartment, condominium unit, duplex, mobile home or even a boat, that you use for both renting and personal use?
If you rent your property out for fewer than 14 days per year then it’s considered a residential property. That means you don’t have to pay any tax on rental income but you can only deduct up to a certain amount of expenses.
To claim the property as a rental property, you can’t use it more than 14 days out of the year or 10% of the days it was rented, whichever is greater. So if you want to live in the house for the month of July, 31 days, you’ll have to have it rented for 310 days of the calendar year.
If you use the property for more days than the rule allows, like in single-family house hacking or renting a room on Airbnb, it’s taxed like a residential property. You can still deduct expenses but only up to the amount of rental income produced. That just means you cant produce a loss for tax purposes regardless of whether you made a profit.
Speaking of house hacking, if you own a multifamily property like a duplex or triplex and live in one unit, the IRS treats the other units like separate investment properties so you can depreciate expenses for that portion of the residence.
How Are You Taxed When You Sell a Rental Property?
When you sell an income property, all profit is considered capital gains and is taxed separately from other income. If you lose money, you can deduct the loss up to certain limitations.
The capital gains tax you’ll pay depends on how long you owned the home. If you’ve owned the home for one year or less, you’ll be taxed based on the current short-term capital gains rate.
If you’ve held it for more than a year you’ll pay a much lower long-term capital gains rate. Those rates are based on your income and are 0%, 15%, or 20%. And if your total income for the year was less than $41,675 in 2022, you won’t pay any tax at all on your capital gains.
And unless you owned the home for 27.5 years, you’ll have to pay depreciation recapture. The tax rate for depreciation deductions is 25% but you can offset that by documenting any improvements you’ve made to the property.
You can postpone paying capital gains tax on the sale of a property with a 1031 exchange. Real estate investors can reinvest proceeds of a sale in a similar property within 45 days and defer paying capital gains tax in the year they sold.
If you can’t find a property that fast, RealtyMogul is one of the only real estate crowdfunding platforms that offer 1031 exchanges. You can roll over your gains into a RealtyMogul investment and get all the tax benefits with no agents, escrow, or closing costs involved.
How is Crowdfunded Real Estate Taxed?
Real estate crowdfunding has become a popular way for investors large and small to easily get into real estate without a lot of upfront capital or maintenance worries. With that comes the question of how you pay taxes on your gains.
First, you have to know what type of deal you’ve invested in. There are two main types, equity and debt.
In a debt deal, you act as the lender to the property owner or deal sponsor. There’s a set hold period, usually, 6-24 months and you get regular distributions over that time.
In an equity deal, the investor typically owns shares in a company that invests in another company that holds the title to the real property. As a shareholder, you get a proportionate piece of the property, or portfolio of properties, equity and share in the profits as the property is developed and sold or managed for rental income.
EquityMultiple, for example, offers debt and equity deals. On its debt deals, it works with experienced lenders, rather than operating as a lender itself. For equity deals, EquityMultiple receives a 10% participation share in project profits, which the company receives only after the full initial investment has been returned to all investors.
Learn More: EquityMultiple Review
Because a debt deal is essentially loaning money versus owning a property, there are no tax benefits to it. As an equity investor, you own a part of a property and can deduct depreciation to reduce the taxes you owe on your income. Not all platforms offer this option but EquityMultiple does.
A Real Estate Investment Trust, REITs for short, is a more common and easier way to invest in crowdfunded real estate. A REIT is a company that owns, operates, or finances, income-producing real estate.
REITs are similar to index funds. They’re publicly traded and instead of choosing a property or group of properties to invest in, you’re a shareholder in a pool of real estate assets chosen by the company.
Most REITs are equity but you can also invest in mortgage REITs that act just like debt deals. Fundrise offers REIT portfolios with several different REITs designed to tailor returns for investors.
Learn More: Fundrise Review
Dividend payments made by the REIT are typically taxed to the shareholder as ordinary income at their top marginal rate. A portion of the dividends paid by REITs may also be considered a nontaxable return of capital, which reduces taxable income in the year the dividend is received.
How to Deduct Real Estate Taxes Using Form 1040
You're legally allowed to deduct real estate taxes from your federal income taxes. However, for the real estate tax to be deductible, it has to be local, state, or foreign real estate taxes. And those taxes have to be equally imposed on all the properties within that jurisdiction.
How much tax you'll pay depends on the value of the property itself. As a taxpayer, you will have to itemize all your deductions to deduct local, state, and foreign real estate taxes in that current tax year. You'll also file these deductions on Form 1040 (Schedule A). If you're doing this for an estate, you will use Schedule K instead of A.
The first step is to fill in all required information on Form 1040. This includes your name, address, Social Security number, your filing status, and any exemptions. Then, you’ll input your income information and work through any adjustments.
This gives you your AGI (adjusted gross income). Note: If you’re using one of the tax software programs we’ve recommended in this article, the software will do this automatically for you.
Related: Best Tax Software for Investors
Next, you'll deduct any itemized deductions from your AGI. This will show up (in total) on line 40 of Form 1040.
After that, you'll add in any other needed information for Schedule A. This consists of deductions other than your real estate tax deduction.
Then, input the real estate taxes you paid on line 6 of Schedule A.
From there, you'll finish up with Schedule A and see the total dollar amount of your itemized deductions. Once you have that number, it will go on line 40 of Form 1040.
And lastly, you will file Schedule A along with your income tax return. Make sure to include any validating documents with your return, too. This might consist of any tax statements you got from the local, state, or foreign government, for instance.
This will help verify the total amount you paid in real estate taxes. This isn't always necessary, but I recommend it if you're manually filing your taxes.
What is Deductible?
Currently, you can deduct up to $10,000 (if you’re filing jointly; otherwise, it’s $5,000) for real estate taxes. This total is a combination of both property taxes and state and local income taxes (including sales taxes). In most cases, you can deduct real estate taxes on:
- Your primary residence
- A vacation home
- A co-op apartment
- Property owned outside of the U.S.
- Cars and other vehicles
It’s best to check with a tax professional before deducting something if you’re unsure. And don’t forget, a program like TurboTax will help guide you through this AND offer you live professional support when you need it.
Bottom Line - Rental Real Estate Tax Rules Can Get Complicated
Even with a knowledge of the rules, every case is unique. If you’re not confident with filing taxes for your rental property income then don’t hesitate to hire a professional. A tax attorney or CPA can answer questions specific to your property and state and give you peace of mind.
Don’t let the complexity of rental property taxes deter you from investing in real estate. With a little research and a good team of professionals by your side, you can make real estate investing work for you at tax time and throughout the rest of the year.
Related: Best Tax Software Compared