Posted: May 27, 2021
A successful business strategy is built on more than just income generation. For landlords, knowing and understanding the tax structure used on rental income can be an important way to increase the money they take home after taxes.
Rental income is generally taxed as ordinary income and is considered to be the money a landlord receives from a property, at the time they receive it. This includes:
- Advance rent – Even if a tenant pays for rent in advance for the next year, the income is still counted in the year it is received.
- Money paid to cancel a lease – Aside from rent, other miscellaneous sources of income from the rental property, such as money a tenant pays to get out of a lease early, would be considered rental income.
- Expenses paid by tenant – If a tenant pays for expenses that they are not required to, such as paying for utilities in return for a rent deduction—the amount of the expense the landlord would have otherwise paid counts as rental income.
- Any portion of a security deposit that is kept – Landlords do not have to count security deposits that they intend to return as income. However, any part of a security deposit held to pay for damages should be counted as rental income.
Landlords can also report their expenses for managing rental property and deduct these expenses from the income they receive to reduce their overall taxable income. Some common expenses that landlords can report are:
- Mortgage Interest – If a landlord pays for a mortgage on a rental property, the portion of the payment that goes to interest, and not principal, is a deductible expense.
- Property Tax – Local property taxes can be taken as a deduction.
- Operating Expenses – Expenses for the operation of a rental property, such as the salaries of any employees, or money paid to independent contractors (groundskeepers, etc.)
Repair Costs – This includes costs that keep a rental property up and running, but which don’t add to the property’s value.
There is also a final major category of deduction called depreciation. Landlords can take a depreciation deduction for their property if: (1) they own the property, (2) use it in income-producing activity, (3) the property has a determinable useful lifespan—meaning it decays or loses value over time—and (4) the property is expected to last longer than a year.
Depreciation is essentially a method of allowing landlords to deduct the cost of a building—though not the land—used as rental property over a period of 27.5 years. To do this, a landlord would divide the cost of the building purchased (first removing the value of any land included in the purchase) by 27.5. That amount could then be taken as a reduction due to depreciation over that period of time. The deduction can only total to be as much as the original cost basis for the building or structure but will end before the total deduction has been taken if the property is retired. Retirement means that the property is sold, destroyed, or converted to another use—it does not apply if the property is only temporarily vacant.
A modified version of depreciation can be used for improvements to a property. More information can be found here: https://www.irs.gov/pub/irs-pdf/p527.pdf
Knowing the deductions available for rental property can help make landlords make future investment decisions. Always try to stay up to date on the latest IRS information, and check sources for information on local taxes.