Rental Income Taxation

Buying property and renting it out is a popular investment strategy. Investors can benefit from the property’s cash flow and appreciation of the property’s value.

In this week’s post, I explain the basics of rental income taxation.

Basic formula

When the real estate is directly owned (not through a partnership or entity), rental income is reported on tax form Schedule E.

The basic formula for calculating rental income is: rents – expenses = income (loss). Rental income is taxed at regular income tax rates – it does not receive special tax treatment like capital gains and qualified dividends. However, the deductions for expenses (especially depreciation) can result in the income and taxes being low when compared to the cash flow of the property.

Expenses

To calculate income from a rental property, a variety of expenses are deducted from the rents received. These expenses include: advertising, auto and travel, cleaning and maintenance, commissions, insurance, legal and other professional fees, management fees, mortgage interest, other interest, repairs, supplies, taxes, utilities, depreciation, other.

For example, a rental property has: rents of $10,000, advertising expenses of $200, cleaning expenses of $300, taxes of $400, and depreciation of $5,200. The net income from the property is $3,900 (10,000 – 200 – 300 – 400 – 5,200 = 3,900).

Depreciation

Depreciation is an especially important expense when investing in real estate. The purchase price of a property (or major improvements to a property) cannot be claimed fully as a deduction in the year of purchase/acquisition. Rather, the purchase price is divided over a number of years. The yearly deductible expense is called “depreciation.” It is also important to know that depreciation does not apply to land, so a property’s purchase price has to be divided between the land (not depreciable) and improvements (depreciable).

Different types of property have different depreciation periods. For example, residential rental property is depreciated over 27.5 years. An investor buys a single family home for $200,000. The purchase price is divided $50,000 to the land (not depreciable) and $150,000 to the improvements (depreciable). The yearly depreciation allowed is $5,455 (150,000 / 27.5 = 5,455). Depending on the purchase date and/or when the property became a rental, the depreciation allowed in the first year will be a little different.

Other things to keep in mind

As usual, there are a lot of exceptions and complexities that we will not fully cover in this post. Here are several things to keep in mind (list is not exhaustive):

• There are special rules when a property is split between personal and rental use during the year. For example, renting out a vacation home when it is not in use.

• There are special rules concerning losses from rental activities. Certain losses cannot be deducted.

• When you take depreciation on a property, the depreciation has to be “recaptured” when the property is sold.

Example

Catherine owns a single family rental house. She collects $22,500 in rent throughout the year. The rental property has a variety of expenses: $100 for advertising to prospective tenants, $1,000 for insurance, $3,000 in taxes, and $800 in repairs. She purchased the property several years ago for $270,000. This purchase price was split between $45,000 for the land and $225,000 for the improvements. Catherine is allowed to claim yearly depreciation of $8,182 (225,000 / 27.5). The total expenses of the property are $13,082. Her net income from the rental is $9,418 (22,500 - 13,082). This income is taxed at regular income tax rates:

What about renting out a room?

It is also common for property owners to just rent out part of their property. There are several important things to keep in mind when renting out a room or some portion of a property. We will plan to cover this in our next post.

If you have any comments, questions, or ideas for future posts, please let me know

I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.