Rental Real Estate Taxes
What’s the tax bite when you own—or sell—a rental property?
Whether you already own a rental property or are thinking about buying your first investment, it’s essential to understand how real estate taxes work. After all, taxes can mean the difference between earning a profit and losing money on a rental property. In general, rental property owners need to be aware of two sets of taxes: those that relate to their rental income and those that relate to the eventual sale of their property.
- Rental income is taxed as ordinary income, but you may be able to lower your tax burden by claiming certain deductions on your tax return.
- You can deduct expenses related to owning and maintaining a rental property, such as mortgage interest, insurance, and utilities.
- Residential real estate is depreciated at a rate of 3.636% each year for 27.5 years.
- When you sell a rental property, you may be liable for capital gains and depreciation recapture taxes.
How Is Rental Income Taxed?
Rental income is taxed as ordinary income according to your Internal Revenue Service (IRS) tax bracket. Here’s a look at the 2023 tax brackets for single filers, married couples filing jointly, and heads of households:
2023 Tax Brackets
|2023 Tax Rate||Single Filers||Married Filing Jointly||Heads of Households|
|10%||$0 to $11,000||$0 to $22,000||$0 to $15,700|
|12%||$11,000 to $44,725||$22,000 to $89,450||$15,700 to $59,850|
|22%||$44,725 to $95,375||$89,450 to $190,750||$59,850 to $95,350|
|24%||$95,375 to $182,100||$190,750 to $364,200||$95,350 to $182,100|
|32%||$182,100 to $231,250||$364,200 to $462,500||$182,100 to $231,250|
|35%||$231,250 to $578,125||$462,500 to $693,750||$231,250 to $578,100|
|37%||More than $578,125||More than $693,750||More than $578,100|
For example, if you have $10,000 in rental income and you’re in the 22% tax bracket, you will owe $2,200 in taxes on that rental income.
How to Calculate Rental Income
The IRS describes rental income as “any payment you receive for the use or occupation of the property” and in addition to regular rent payments, rental income includes:
- Advance rent payments. This is any amount you receive before the period it covers. If you collect a tenant’s first and last month’s rent upfront, both payments count as income when you receive the money.
- Security deposits. If you plan to return a tenant’s security deposit at the end of the lease, it does not count as rental income. However, if you keep some of the deposit to cover damages, that portion is considered income. Security deposits used as a final rent payment are regarded as advance rent.
- Lease cancellation payments. If a tenant pays you to cancel a lease, the amount that you receive is considered rent and counts as income.
- Tenant-paid owner expenses. If a tenant pays any of your expenses, the amount is included in your rental income. If a tenant pays the water and sewage bill for the rental property and deducts the amount from their rent payment and if the tenant isn’t obligated to pay that bill, then the amount paid by the tenant counts as rental income.
- Property or services received instead of rent. If your tenant is a painter and offers to paint the property in exchange for two months’ rent, the amount that the tenant would have paid for those two months counts as rental income.
- Lease with an option to buy. If the rental agreement gives your tenant the option to buy the property, the payments that you receive are considered rental income.
- Partial interest. If you own part of a rental property, you must report your share of the rental income.
Considering a 1031 Exchange?
Speak with the experts at 1031 Capital Solutions first.
Rental Property Tax Deductions
While rental income is taxed as ordinary income, you can reduce that income and lower your tax bill by deducting allowable expenses. As a rental property owner, you can generally deduct your expenses for managing and maintaining the property, including payments that you make related to the property for:
- Auto and travel expenses
- Cleaning and maintenance
- Homeowners association (HOA) dues
- Legal and professional fees
- Mortgage interest
- Property management
- Property taxes
- Utilities and other services
These deductions are generally taken in the same year when you spend the money. You can also deduct the cost of buying and improving your rental property, but that works differently. Instead of claiming one big deduction all at once, you recover these costs over time through depreciation.
Rental Property Depreciation
Depreciation is one of the biggest tax perks that rental property owners get. It allows you to deduct the costs of buying and improving a rental over its useful life, lowering your taxable income in the process.
Residential rental property placed in service after 1986 is depreciated using the modified accelerated cost recovery system (MACRS). This accounting method spreads costs over 27.5 years—the length of time considered the “useful life” of a residential rental property by the IRS. Commercial properties are depreciated over 39 years.
Which Property Is Depreciable?
Not surprisingly, the IRS has specific rules regarding depreciation. You can depreciate a rental property only if all of the following statements are true:
- You own the property. As far as the IRS is concerned, you are the owner even if the property is subject to a debt.
- You use the property in your business or as an income-producing activity (e.g., as a rental).
- The property has a determinable useful life, meaning it’s something that wears out, decays, gets used up, becomes obsolete, or loses its value from natural causes.
- The property is expected to last at least one year.
You can’t depreciate a rental property if you placed it in service and disposed of it (or no longer used it for business) in the same year.
Land is not depreciable because it never gets “used up.” Similarly, you can’t depreciate the costs of clearing, planting, and landscaping, as these costs are tied to the land, not to buildings.
How to Calculate Depreciation on a Rental Property
Determining how much to depreciate each year isn’t as easy as dividing your purchase price by 27.5. Instead, there are a few basic steps to follow:
- Determine the basis of the property. This is the amount that you paid (in cash, with a mortgage, or some other manner) to acquire the property. You can include certain settlement fees and closing costs in the basis.
- Separate the cost of land and buildings. Land isn’t depreciable (as noted, it never gets used up), so you can only depreciate the cost of buildings. To determine the value, either use the fair market value of the building and the land when you bought the property or base the number on assessed real estate tax values. For example, assume you buy a rental property for $300,000. The most recent real estate tax assessment values the property at $280,000, of which $252,000 is for the home and $28,000 is for the land. Therefore, you can allocate 90% ($252,000 ÷ $280,000) of the purchase price to the house. The remaining 10% ($28,000 ÷ $280,000) represents the land.
- Determine your basis in the home. Now that you know the basis of the property (house plus land) and the value of the buildings, you can calculate your basis in the home. Using the above example, your basis would be $270,000 (90% of $300,000). That’s the amount that you can depreciate.
Qualified Business Income Deduction
Section 199A of the Internal Revenue Code (IRC) provides another tax break called the QBI deduction, which allows pass-through entities to reduce their qualified business income (QBI). While there are income thresholds, eligible taxpayers can deduct up to 20% of their pass-through business income—including rental income from an investment property. However, keep in mind that QBI only qualifies if you are actively managing your property.
The 14-Day or 10% Rule
The tax benefits to which you’re entitled depend on how many days the property is rented out each year and how much time you spend in the home. Here are the three main categories:
- Rented for 14 days or fewer each year. In this case, you don’t have to report the rental income. The house is considered a personal residence, and you can deduct mortgage interest and property taxes, but you can’t deduct any expenses as rental expenses. When you sell the property, it’s treated as a personal residence, not an investment property.
- Rented for more than 15 days and used for fewer than 14 days. Under these conditions, the property is considered a rental property. You report the rental income and deduct certain rental expenses based on the percentage of days when the home was rented out.
- Used for more than 14 days or 10% of the total days when the home was rented. The property is considered a personal residence in this instance, and you can deduct mortgage interest and property taxes. You can also deduct rental expenses, but only up to the level of rental income.
Taxes When Selling a Rental Property
When you sell a rental property, you may be liable for two types of taxes: capital gains and depreciation recapture.
Capital Gains Tax
If you hold a property for more than a year, any profits from the sale are taxed at the long-term capital gains rate. Here’s a look at the capital gains tax brackets for 2023:
Capital Gains Tax Brackets for 2023
|Rate||Single Filers||Married Filing Jointly||Heads of Households|
|0%||$0 to $44,625||$0 to $89,250||$0 to $59,750|
|15%||$44,625 to $492,300||$89,250 to $553,850||$59,750 to $523,050|
|20%||Over $492,300||Over $553,850||Over $523,050|
Higher-income taxpayers may owe an extra 3.8% net investment income tax.
Conversely, if you sell after owning for less than a year, the profit is a short-term capital gain, taxed as ordinary income at your marginal tax rate.
Depreciation Recapture Tax
When you sell your rental property, the IRS will remember the depreciation deductions you took and it will want some of that money back. This is known as depreciation recapture, and it can come as a financial shock to unprepared property owners.
Depreciation recapture applies to the portion of the gain attributable to the depreciation deductions you have already taken. If you depreciated $6,000 a year for 10 years, you would owe depreciation recapture tax on $60,000 when you sell.
If you think you can avoid the depreciation recapture tax by not depreciating your rental property, think again. The IRS calculates depreciation recapture based on what you should have depreciated whether or not you did.
The tax is based on your ordinary income tax rate and is capped at 25%.14 You report it on Form 4797, Sales of Business Property.
What is a 1031 exchange?
A 1031 exchange lets you swap one investment property for another, deferring capital gains and depreciation recapture taxes in the process. The properties being exchanged must be “like-kind,” though that doesn’t mean the properties need to be identical. Instead, properties are like-kind “if they’re of the same nature or character, even if they differ in grade or quality,” according to the IRS. In general, real properties are considered like-kind whether they’re improved or unimproved.
What deductions can I claim for a rental property?
If you own rental property, you can take advantage of several deductions to offset rental income and lower taxes. Broadly, you can deduct qualified rental expenses (e.g., mortgage interest, property taxes, interest, and utilities), operating expenses, repair costs, and depreciation. You also may be able to deduct an additional 20% of your qualified business income (QBI).
How do you report rental income?
You report rental property income and expenses on Form 1040, U.S. Individual Income Tax Return, or Form 1040-SR, U.S. Tax Return for Seniors, and on Schedule E (Form 1040), Supplemental Income and Loss.
The Bottom Line
Real estate rentals are a popular way for investors to tap into the real estate market. As a rental property owner, you have the potential to earn money by collecting rent and through appreciation. While you will owe taxes on the income that your rental property generates, you can reduce your income—and thus your tax burden—by claiming various deductions.
Taxes can have a significant impact on your bottom line. It’s a good idea to work with a qualified tax specialist who can help ensure that you understand the rules—and that you apply them in the most favorable way possible for your situation.