Taxes aren’t exactly something that we look forward to, but for landlords and real estate investors, at least, there may be some reason to rejoice.
The tax code tends to favor real estate investors and having rental property can open the door to a tremendous number of tax deductions and credits that you could be eligible for, all of which can make a significant dent in your tax bill.
The key to maximizing your income with rental property is taking advantage of all of the tax benefits that are offered to you. Yet many landlords are unaware of just how many there are! Some deductions are more valuable than others, but overall, these write-offs can help you to increase your rental revenue considerably. Of course, how much you stand to benefit will vary widely depending on a range of factors including your filing status (married, single, joint-filing-separately?), tax status (business, investment?), tax bracket, the number of properties that you own, and how you structure your investments (LLC, sole proprietorship?).
If you’re a first-time landlord, or even an experienced investor, having a firm grasp of the tax code –as it applies to you will prove to be a tremendous advantage. It’ll help you to know how you should structure your investments, allow you to accurately calculate your taxes for prospective investments to see if a property’s worth investing in, and if you have an accountant, can help you to ensure that you both are on the same page. With this in mind, let’s take a look at the basics of the tax code, as it applies to landlords. Read on for an overview of the tenets of taxes, and to see which deductions that you may be able to claim.
Taxes Landlords Are Required to Pay
First, let’s take a look at the different types of taxes that you’re required to pay as a landlord:
- Income tax on rental income and property sales
- Social Security and Medicare taxes (some landlords)
- Net investment income taxes (some landlords)
- Property taxes
Here’s a look at each type of tax now.
Income Tax on Rental Income
Rental income that you receive is taxable and subject to federal income tax. When you file your annual tax return, you’ll add your net rental income to your other income for the year, such as income from your job or investment income.
Additionally, you may be subject to state income tax as well. Forty-three states also have income taxes, with the exceptions being Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. For more information on your state’s income tax law, visit Tax Sites, or your state tax agency’s website.
Income Tax on Property Sales
If you sell a rental property, the profit on the sale is added to your income for the year and is also subject to tax. If you’ve owned the rental for more than one year, this income will be taxed at capital gains rates, which in most cases, are lower than income tax rates. However, if you sell your property and use the proceeds to purchase a similar property, using what’s known as a like-kind exchange, or a Section 1031, you can defer the tax on your profits.
Social Security and Medicare Taxes
Many landlords are also required to pay Social Security and Medicare payroll taxes, or Federal Insurance Contributions Act (FICA). While employees pay half of these taxes and employers pay the other half, self-employed people must pay them all themselves.
These are two separate taxes. Let’s look at each now:
- Social Security Tax
Social Security tax is a flat tax of 12.4% on net self-employment income or, if you have employees, on their wages up to an annual ceiling –that’s adjusted for inflation each year. In 2017, this ceiling was $127,200.
- Medicare Payroll Tax
There are two different Medicare tax rates –2.9% tax up to an annual ceiling of $200,000 for single taxpayers and up to $250,000 for married couples filing jointly. All income above this amount is subject to tax at a 3.8% rate.
Combined Social Security and Medicare tax is 15.3%, up to the Social Security tax ceiling –whether you’re self-employed or an employee.
If you hire employees to work in your rental property business, you may have to pay and withhold Social Security and Medicare taxes. Your share of these taxes, though, as an employer is deductible.
However, income you earn from a rental property is not subject to Social Security and Medicare taxes, even if your rental activities constitute a business for tax purposes. The exception to this is if you’re a landlord who provides “substantial services” to your tenants, such as the services provided by hotels or bed and breakfasts.
Net Investment Income Taxes
Net investment income tax is a 3.8% tax that affects many higher-income landlords. This is a tax on unearned income including rental income and gains from selling property. If your adjusted gross income exceeds $200,000 if you’re single, or $250,000 if you’re married filing jointly, you will be subject to this tax.
Finally, if you own property, you’ll have to pay property tax. These are taxes imposed by cities, counties, or other jurisdictions, and are a tax on the value of your rental.
What Is Considered Rental Income?
Of course, your rental income includes the rent that your tenants pay, but it can also include other payments as well.
- Security Deposits
Security deposits that you plan to apply to the tenant’s final rent payment must be claimed as income in the year that you receive them. However, if you plan to return the deposit to your tenant at the end of their rental term, then do not include it as income. If you end up keeping some of the money because your tenant doesn’t live up to the terms of the rental agreement, you should include the amount that you keep in your income for the year.
- Interest on Security Deposits
Any interest earned on security deposits should also be included in your income unless your state requires landlords to credit that interest to tenants.
- Advance Rent Payments
Any rent that you receive in advance, before the period that it covers should be included in your rental income for the year that it was received.
- Property or Services Paid in Lieu of Rent
Property or services that you receive from a tenant as rent must also be included as rental income.
- Rental Expenses Paid for by Tenant
Any rental expenses that a tenant pays to you are also considered rental income. This includes utilities, repairs, and more. These expenses can then be deducted by you.
- Fees or Charges Paid by Tenant
Any fees that tenants pay are also considered rental income. This includes charges for paying late rent, parking fees, storage facility fees, or even laundry income.
- Lease Cancellations
Payments for lease cancellations are also considered rental income.
- Leases With an Option to Buy
If your rental agreement gives your tenant the right to buy your rental property, the payments you receive under the agreement are usually considered rental income.
One of the great things about owning investment property is the wealth of tax deductions that are available for landlords.
The law allows you to subtract operating expenses for your rental –including repairs and maintenance, as well as other expenses including mortgage interest and depreciation from your gross rental income, to determine your taxable income.
Here’s a look at some of the deductions that landlords are able to take:
- Mortgage Interest
- Interest on Other Loans
- Repairs and Maintenance
- Professional Services
- City and State Taxes
- Travel Costs
- Operating Expenses
In many cases, landlords end up with so many deductions that they show a net loss when calculating their gross rental income. In these cases, you’ll owe no tax on your rental income. This tends to be more common during the first few years of owning rental property, when your rents that you’re charging may be lower, and you may be claiming more for depreciation.
In fact, in some cases, you may show a loss for tax purposes, even if you’ve actually earned more income than you’ve paid in expenses –due to the often-significant deductions of mortgage interest and depreciation.
Your Tax Status Affects Your Deductions
Rental properties can be considered a business, an investment –or in rare cases, a not-for-profit activity.
If your rental activities qualify as a business, you’re entitled to all the tax deductions listed above, however, if your rentals are considered an investment –you’ll lose certain deductions. Of course, tax deductions for not-for-profits are extremely limited.
Your tax status will be determined by how much time and effort you put into your rental activities, and whether you earn profits each year.
Property Ownership Affects Taxes
Keep in mind that how you structure your rental property purchases will affect the type of tax returns that you must file.
The main ownership options for most landlords are:
- Sole proprietorship
- General partnership
- Limited partnership
- Limited liability company (LLC)
- Tenancy in common
- Joint tenancy
These different types of ownership can be divided into two main categories; individual ownership and ownership through a business entity.
Small landlords, those who own one to ten residential rentals, generally own their properties as individuals. In fact, according to one government survey, individuals owned 83% of the 15.7 million rental housing properties with fewer than 50 units. (Department of Housing and Urban Development and Department of Commerce, U.S. Census Bureau, Residential Finance Survey: 2001 (Washington, DC: 2005).)
Partnerships, limited partnerships, LLCs, and S corporations, on the other hand, are all “pass-through” entities. This means that the entity itself doesn’t pay taxes, but the profits or losses are passed through to the owners who include them on their tax returns. Because pass-through taxation permits property owners to deduct losses from their personal taxes, it’s generally considered the best form of taxation for real estate ownership. And with the new Tax Cuts and Jobs Act, there may be even more incentive for investors to structure their purchases this way. Pass through entities with “qualified business income” are now eligible for a 20% deduction.
Sure, it’s not our favorite topic, but since taxes often one of the single biggest outgoing expenses that we have each year, aside from the mortgage itself, looking for ways to reduce your tax bill can often result in significant savings.
If you’re a landlord, it’s worth spending some time familiarizing yourself with the tax code, to find out if you’re saving as much in tax as you could be. It’s also a good idea to consult with a qualified CPA, to ensure that you’re structuring your purchases in a way that’ll be most beneficial for your tax situation, and to make sure you’re not missing out on any valuable tax deductions that could make a big difference in the amount of tax that you owe.
Many thanks to Stephen Fishman's Every Landlord's Tax Deduction Guide, for providing clear, concise information on taxes as they pertain to landlords. See Every Landlord’s Tax Guide to learn more about taxes for landlords.
Please Note: While this article contains information that we’ve learned from classes and from working with our clients over the years, please keep in mind that we are not tax professionals. This information is intended to inform and to guide only, and it is not meant to serve in place of tax advice from a licensed tax professional. These principles should only be applied in conjunction with a CPA. To learn more about depreciation as it applies to your own financial situation, please consult a tax professional.