How Are Taxes on Rental Income Calculated?

Taxes on rental income are a small price to pay for the additional cash flow an investment property brings. You must pay taxes on all rental income. Your ​rental income tax rate is generally the same as your personal income tax. If you have a tax rate of 25% and make $10,000 in rental income, you’ll pay $2,500 in ​rental income tax. The good news is that you may be able to deduct expenses, depreciation and passive activity losses. Read on to understand taxes on rental income.  

The IRS taxes rental income as regular personal income. You may be able to deduct certain qualified expenses to decrease what you owe. Is rental income taxable? Yes. Here’s a detailed list of what to consider:

The first step to determining tax liability for rental income is to record the total gross rental income. Sources of rental income include various types of rental properties, from commercial retail space to long-term rental properties, multifamily housing, vacation rentals or properties used for Airbnb. It can also include rental income from farmland, parking lots or spaces and any other income sources related to physical property or buildings. 

The IRS defines taxable rental income as “any payment you receive for the use or occupation of the property.” This can include advanced rent, security deposits and any expenses paid by the tenant. You can deduct operating expenses, depreciation and repair costs from that income. 

Depreciation refers to the accounting method used to allocate the cost of a tangible or physical asset over its useful life. The IRS allows depreciation on a rental property, assuming it will lose a certain amount of value each year. Typically, this is 3.6%. You may subtract depreciation from your taxable income for as long as you own a property. 

How to Calculate Rental Property Depreciation

To calculate a rental property’s depreciation, start with the property’s cost basis (typically how much you paid). Add property tax, abstract fees, transfer tax, legal fees and other closing costs to that. Under gross debt service (GDS) guidelines, which the IRS uses for depreciation, you can calculate a property’s useful life as 27.5 years. Divide the cost basis plus expenses by 27.5 to calculate annual depreciation. 

Rental property depreciation = (Cost basis + closing costs) / useful life (27.5) 

Generally, anything directly related to maintaining, repairing or managing a rental property is considered a deductible expense. Common deductible expenses include:

• Mortgage interest
• Property tax
• Operating expenses
• Depreciation
• Repairs
• Maintenance
• Improvements
• Insurance 
• Lawn care
• Travel expenses related to collecting rent
• Advertising
• Employees and independent contractors related to running the rental
• Home office expenses
• Losses from casualties such as hurricanes, earthquakes, floods or thefts
• Professional services such as accountants, tax preparers, property managers and attorneys
• Utilities

The passive activity loss rules prevent taxpayers from using passive losses to offset earned or ordinary income. Essentially, passive losses can only be used to offset passive income. Rental activity is considered passive even if you materially participated in it unless you’re a real estate professional. See full IRS qualifications of passive and active participation. This means you’re allowed to deduct passive losses on real estate properties. 

You are allowed to deduct passive losses from rental real estate as long as it meets passive activity requirements. According to the IRS, to qualify as passive, a rental dwelling unit can’t be used for personal purposes for more than 14 days or 10% of the number of days during the year that the home was rented at a fair rental.

In most cases, you do not have to pay self-employment tax on rental income. The IRS considers rental income passive income and usually taxes it at the same rate you’ll pay on income from a job. 

If you’re self-employed, net earnings from self-employment are taxed with self-employment tax. You may still be able to report rental income as passive income and not pay self-employment tax on this portion of your income. Speak with a certified public accountant to understand your situation.  

Capital gains taxes are paid on profits when they sell an asset like a rental property. There are both short-term and long-term capital gains taxes, depending on how long you have held the asset.

Short-term capital gains taxes are paid on assets held for less than a year. Short-term capital gains are taxed at the same rate as your regular income, usually from 10% to 37%.

You’ll only need to pay long-term capital gains if you hold a property for more than one year and then sell it. Long-term capital gains tax rates depend on your taxable income and range from 0% to 20%. 

Be sure to also account for variations in state and local tax regulations and additional regional rental income taxation considerations. For example, you might be able to take additional deductions for solar installations on rental properties or a new pool in certain states. 

Practical strategies for reducing tax liability include carefully tracking all income and expenses to maximize deductions. In addition, look for possible tax credits for qualified renovations or upgrades and effectively use tax deductions and credits. A certified public accountant may be able to help you maximize deductions to reduce rental income taxes for your individual situation.  

To accurately report income and deductions, be sure to keep accurate records and receipts of all rental income and expenses. There are apps to track rental income and expenses. Also, check out more tips for managing rental properties. 

As part of a diversified investment portfolio, investment properties can offer stable returns and long-term appreciation. Taxes on rental property are relatively simple, as long as you plan ahead and carefully track all income and expenses. With the possibility to deduct normal operating expenses, you could potentially increase returns on rental investments. If you’re looking for other ways to invest in real estate, consider the best real estate investing apps or fractional real estate ownership.