Rental Real Estate Taxes

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Rental Real Estate Taxes
2022 Tax Brackets
2022 Tax RateSingle FilersMarried Filing JointlyHeads of Households
10%$0 to $10,275$0 to $20,550$0 to $14,650
12%$10,276 to $41,775$20,551 to $83,550$14,651 to $55,900
22%$41,776 to $89,075$83,551 to $178,150$55,901 to $89,050
24%$89,076 to $170,050$178,151 to $340,100$89,051 to $170,050
32%$170,051 to $215,950$340,101 to $431,900$170,051 to $215,950
35%$215,951 to $539,900$431,901 to $647,850$215,951 to $539,900
37%More than $539,900More than $647,850More than $539,900

For example, if you earn $10,000 in rental revenue and are in the 22% tax rate, you will owe $2,200 in taxes.

How to Calculate Rental Income

Rental income is defined by the IRS as “any payment you receive for the use or possession of property.” Rental revenue comprises, in addition to normal rent payments:

  • Rent is paid in advance. This is any money received prior to the time covered. If you collect a tenant’s first and final month’s rent in advance, both payments are considered revenue when you get the money.
  • Deposits for security. It does not qualify as rental revenue if you intend to refund a tenant’s security deposit at the conclusion of the lease. If, on the other hand, you retain a part of the deposit to pay damages, that amount is deemed income. Security deposits are considered advance rent when utilized as a final rent payment.
  • Payments for lease termination. If a renter pays you to terminate a lease, the money is deemed rent and is considered revenue.
  • Tenant pays the owner’s expenditures. If a renter pays for any of your expenditures, the money is deducted from your rental revenue. Assume, for example, that a renter pays the rental property’s water and sewage bills and deducts the amount from their monthly payment. If the renter is not required to pay the bill, the amount paid by the tenant is considered rental income.
  • Instead of rent, property or services are received. Assume your renter is a painter and offers to paint the house for two months’ rent. The rent the renter would have paid for those two months is considered rental revenue.
  • Lease with the opportunity to purchase If your rental agreement includes the opportunity for your renter to purchase the property, the payments you receive are considered rental revenue.
  • Partial enthusiasm. You must disclose your share of rental revenue if you own a portion of a rental property.

Rental Property Tax Deductions

While rental income is taxed like regular income, you may minimize it – and hence your tax burden – by deducting permitted costs. As a landlord, you may normally deduct your expenditures for managing and maintaining the property, including payments made to the property for:

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  • Advertising
  • Auto and travel expenses
  • Cleaning and maintenance
  • Dues for a homeowners association (HOA)
  • Insurance
  • Legal and professional fees
  • Mortgage interest
  • Property management
  • Property taxes
  • Utilities, pest treatment, and other services are available.

These deductions are often taken in the same year that the money is spent. You may also deduct the expense of purchasing and developing your rental property, albeit the rules are different. Instead of taking a single large deduction, you recoup these expenditures over time via depreciation.

Rental Property Depreciation

One of the most significant tax benefits that rental property owners get is depreciation. It lets you to deduct the expenditures of purchasing and developing a rental property throughout its useful life, decreasing your taxable income.

After 1986, residential rental property is depreciated using the modified accelerated cost recovery approach (MACRS).This accounting approach distributes expenditures over 27.5 years, which is the IRS’s definition of the “useful life” of a residential rental property. Commercial properties depreciate over a 39-year period.

Which Property Is Depreciable?

Not surprise, the IRS has strict depreciation requirements. Only if all of the following things are true may you depreciate a rental property:

  • You own the land. Even though the property is subject to a debt, you are the owner in the eyes of the IRS.
  • You utilize the property in your company or as a source of revenue (e.g., as a rental).
  • The property has a determinable useful life, which means it wears out, decays, is used up, becomes outdated, or loses value due to natural causes.
  • The property should endure at least a year.

A rental property cannot be depreciated if it was put in service and then disposed of (or no longer utilized for business) in the same year.

Land is not depreciable since it is never “depleted.” Similarly, the expenditures of clearing, planting, and landscaping cannot be depreciated since they are related to land, not structures.

How to Calculate Depreciation on a Rental Property

It’s not as simple as dividing your purchase price by 27.5 to figure out how much to depreciate each year. Instead, there are a few simple measures to take:

  1. Determine the property’s foundation. This is the amount you spent for the property (in cash, with a mortgage, or in some other way). Certain settlement fees and closing expenses might be included in the basis.
  2. Calculate the cost of land and structures separately. Because land is not depreciable (it never gets used up), you can only discount the cost of structures. Use the fair market value of the building and land when you purchased the property to establish the value, or base the amount on assessed real estate tax values. Assume you spend $300,000 to purchase a rental property. The most recent real estate tax assessment values the property at $280,000, with the residence valued at $252,000 and the land valued at $28,000. As a result, you may dedicate 90% of the purchase price ($252,000 $280,000) to the home. The land is represented by the remaining 10% ($28,000 $280,000).
  3. Determine your home’s foundation. You can compute your basis in the home now that you know the basis in the property (house + land) and the value of the structures. In the above case, your basis is $270,000 (90% of $300,000). That is the maximum amount you may depreciate.
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Qualified Business Income Deduction

Property owners may deduct their costs and depreciation, but the benefits don’t stop there.

Another tax advantage provided by Section 199A of the Internal Revenue Code (IRC) is the QBI deduction, which enables pass-through businesses to lower their qualifying business income (QBI).While there are income limits, qualified taxpayers may deduct up to 20% of their pass-through company income, which includes rental income from an investment property. Keep in mind, however, that QBI is only applicable if you are actively managing your property.

The 14-Day or 10% Rule

The tax advantages to which you are eligible are determined by the number of days the property is leased out each year and the amount of time you spend in the residence. The three major categories are as follows:

  1. Every year, I rent for 14 days or less. You do not have to record the rental revenue in this scenario. The home is deemed a personal residence, and you may deduct mortgage interest and property taxes—but not any rental expenditures. When you sell the property, it is recognized as a personal home rather than an investment.
  2. Rented for more than 15 days but only utilized for 14 days. The property is classified as a rental property under these circumstances. Based on the proportion of days the residence was leased out, you report the rental revenue and deduct specific rental charges.
  3. Used for more than 14 days, or 10% of the total number of days the residence was leased. In this case, the property is deemed a personal home, and you may deduct mortgage interest and property taxes. Rental expenditures may also be deducted, but only up to the amount of rental revenue.

Taxes When Selling a Rental Property

When you sell a rental property, you may be subject to capital gains and depreciation recapture taxes.

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Capital Gains Tax

Any earnings from the sale of a property held for more than a year are taxed at the long-term capital gains rate. The following are the capital gains tax rates for 2022:

Capital Gains Tax Brackets for 2022
RateSingle FilersMarried Filing JointlyHeads of Households
0%$0 to $41,675$0 to $83,350$0 to $55,800
15%$41,676 to $459,750$83,351 to $517,200$55,801 to $488,500
20%More than $459,750More than $517,200More than $488,500

If you sell after less than a year, the profit is considered a short-term capital gain and is taxed as ordinary income at your marginal tax rate.

Depreciation Recapture Tax

When you sell your rental property, the IRS will remember your depreciation deductions and will want part of your money back. This is referred to as depreciation recapture, and it may be financially devastating to unprepared property owners.

Depreciation recapture pertains to the part of the gain related to previously taken depreciation deductions. So, if you depreciated $6,000 every year for ten years, you’d incur depreciation recapture tax on $60,000 when you sold it.

Think again if you believe you can escape the depreciation recapture tax by not depreciating your rental property. The IRS estimates depreciation recapture based on what you should have depreciated, regardless of whether you did.

The tax is calculated using your regular income tax rate and is limited at 25%. Form 4797, Sales of Business Property, is used to report it.

What is a 1031 exchange?

A 1031 exchange allows you to trade one investment property for another while delaying capital gains and depreciation recapture taxes. The characteristics being exchanged must be “like-kind,” but this does not imply that they must be identical. According to the IRS, properties are like-kind “if they’re of the same sort or character, even if they vary in grade or quality.” In general, whether developed or unimproved, real estate is considered like-kind.

What deductions can I claim for a rental property?

If you own rental property, you may use many deductions to offset rental revenue and reduce your taxes. Qualified rental expenditures (e.g., mortgage interest, property taxes, interest, and utilities), operation expenses, maintenance charges, and depreciation are all deductible. You may also be eligible to deduct 20% of your qualifying company income (QBI).

How do you report rental income?

Rental income and costs are reported on Form 1040, U.S. Individual Income Tax Return, or Form 1040-SR, U.S. Tax Return for Seniors, as well as Schedule E (Form 1040), Supplemental Income and Loss.

The Bottom Line

Rental properties are a popular option for investors to get into the real estate industry. You may make money as a rental property owner by collecting rentals and appreciating your property. While you will have to pay taxes on the revenue generated by your rental property, you may lower your income (and hence your tax burden) by claiming certain deductions.

Taxes may have a huge influence on your financial situation. Working with a skilled tax consultant may assist guarantee that you understand the regulations and apply them in the most advantageous manner for your case.

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