Complete Guide On Rental Income Tax

By: Abdullah Haroon

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Taxes aren’t pleasant to think about in a capitalistic society. There are dozens of types of taxes which makes taxes pretty complicated for laypeople to understand.

A complete guide on rental income tax

Buying rental property may make things even more complicated. It’s a good idea to learn more about taxes to help avoid financial trouble later. Let’s break down the concept of rent taxation to get a better understanding.

What Type of income is Rental Income?

Rental income is simply income earned from owning your property. Rental income includes rent payments, security deposits, and any other income a property owner accepts as a result of owning their property. You are supposed to include the rent you receive from a tenant in your gross income.

Additionally, you may deduct the expenses incurred from owning the property from the rental income before paying taxes. The income that’s subject to taxation is that which is left after expenses are deducted.

  • Advance Rent:

Any payment you accept from the tenant before payment is due is considered an advance payment. You are supposed to include any advance payments in your total income for the year in which you received it.

For example, if you sign a five year lease and you received $3,000 worth of rent for the first year and $3,000 for the last year at the same time, you must include the total amount in the first year’s rental income ($6,000).

  • Security Deposits:

There are different conditions in place for security deposits. If you intend to use the security deposit against any contingency in the lease, you must include it in your rental income.

On the other hand, if you plan on returning the security deposit to the tenant towards the end of the lease, you shouldn’t include it in your income.

What type of income is rental income?

Likewise, if you have to use the security deposit as the final rent payment, you’ll also need to consider the payment as rental income and include it on your tax return.

  • Other Expenses Paid by Tenant:

Any funds your tenant spends on paying utility bills or on maintenance expenses also fall under rental income. You may deduct the amounts as expenses but you have to include it in the first place.

Is Rental Income Taxable?

There are few things in the world that aren’t taxable–rental income is no exception because it’s subject to taxation under the law just like any other income source.

There are two types of rental businesses: passive and non-passive. Rental property is normally considered a passive business. Non-passive businesses include activities such as property development, operation, or management.

Another factor that impacts rental taxation is the nature of the owner’s involvement. If the owner manages the property then the owner is an active participant, while if someone else manages the property the owner is considered a non-active participant.

This distinction It creates a difference in the tax deductions and, thus, impacts the overall tax.

Common Rental Income Deductions:

Multiple expenses can be deducted from rental income before taxes are applied. These deductions are effective in reducing income tax. Consider the following expenses as deductions to your gross rental income:

  • Depreciation:

This is the most effective deduction homeowners may make from the income. By definition, depreciation means that the property has sustained a loss of value due to normal wear and tear over the years. You need to educate yourself about how much you may deduct annually for depreciation.

  • Mortgage Payments:

If you have purchased your property with a home loan and are still paying the monthly installments, you may deduct it from your rental income. This makes a major difference when it comes to paying taxes on your rental income.

Mortgage payments

  • Maintenance:

Owners routinely have to spend money on maintenance to keep their property in good, habitable condition. The amount of money you spend for maintenance can be deducted from your gross income for tax purposes.

  • Managerial Expenses:

Employee wages are tax deductible if the owner hires someone, regardless of the person’s length of employment.

  • Insurance Premiums

Any amount of money the owner spends on insuring their property is tax deductible.

  • Legal Fees

Fees paid for an attorney, accountant, and advisor fees are also tax deductible.

  • Other Rental-Related Expenses:

If you spent money on any rental-related activity related to the property such as traveling to stores to purchase material for the property, this, too, can be deducted from your gross rental income.

Other rental-related expenses

Pro Tip: Always keep a clean and well-maintained record of the expenses you plan to deduct from your gross rental income. You’ll need to make a file with copies of all rent checks, business receipts, or other documentation of all rental-related expenses spent on the property.

Before completing and submitting your federal income taxes, double-check that all your information is accurate in case you’re selected for audit.

How to Calculate the Rental Income Tax:

Rental income tax is treated similarly to federal income tax. If you fall within the 22% marginal tax rate, you’re responsible for paying all applicable rental income tax.
Here are some steps to follow to help with that:

How to Calculate the Rental Income Tax:

Step 1: Add up all payments you’ve received while it was occupied by a tenant over the year, be it security deposits, advance payments, or monthly rent.

Step 2: Deduct all property expenses spent over the course of the year as we addressed above (i.e. depreciation, maintenance, etc.).

Step 3: The resulting amount is total income to which you’ll need to apply the 22% tax rate.

Conclusion:

Most people mistakenly only include monthly rent in their rental income. From a legal perspective, any payments received while your property was occupied fall under rental income.

If you received a security deposit or last month’s rent in advance, this should also be included in the total rental income. Try not to be intimidated by rental tax rules–you can get a sense of your tax liability using simple math.