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ContinueDiscover key tax implications when buying a rental property, from income tax to deductions, depreciation, and 1031 exchanges. Maximize returns with smart strategies.
Head of Content, Landlord Studio
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When it comes to understanding the tax implications of buying and owning a rental property, landlords should, at a minimum, familiarize themselves with how rental income is taxed, the nature of deductible expenses and depreciation, and the intricacies of capital gains and 1031 exchanges.
Having a solid understanding of these elements can significantly influence your financial strategy and enhance your overall investment returns.
That’s why we’ve created this article—to provide comprehensive insights into everything aspiring property owners need to know about rental taxes, from the tax benefits of rental property to real estate tax deductions.
The IRS categorizes rental income as normal income, meaning it is subject to both federal and state income taxes.
It's important to note that landlords need to report not just their rental income but all income received through their rental business, this includes regular rent payments, advance rent, lease cancellation payments, security deposit deductions, and even expenses covered by tenants.
If you've recently rented out your property you might be wondering, "How does the IRS know I have rental income?", especially if you're collecting rent payments in cash. The answer to that question is more complex than you might imagine.
The IRS employs several strategies to ensure real estate investors are reporting all of their rental income. And whilst you might be able to fly under the radar for a while, not reporting or innaccurately reporting your rental income is very likely to raise a red flag with the IRS audit office.
Here are some key methods the IRS uses to determine if an investor has rental income:
You Might Also Like: Top 7 IRS Audit Triggers Real Estate Investors Need to Know
Neglecting to report your rental income can lead to significant penalties from the IRS. These may include:
Aside from the taxes and other costs that come with buying a rental property, there are several benefits that it offers. For example, you can qualify for certain tax deductions that help reduce your overall tax liability.
Below is an overview of some of the key tax benefits and costs involved in owning rental properties.
Many operating expenses necessary for managing and maintaining a rental property are generally tax-deductible. These can include:
Get a complete list of all your rental property tax deductible expenses here
The interest paid on a mortgage for a rental property is fully deductible, which can substantially lower your taxable income. This deduction also applies to interest on loans used for property improvements or related business expenses.
Real estate investors can depreciate their rental properties over 27.5 years, allowing them to recover costs associated with wear and tear. For example, if you purchase a property for $150,000 (excluding land value), you would be able to deduct approximately $5,454 each year in depreciations.
Utilizing a Section 1031 exchange allows investors to defer capital gains taxes when selling one rental property to purchase another of equal or greater value. This strategy enables you to reinvest your profits without facing immediate tax consequences.
Even if you hire a property manager, you can still deduct certain owner-related expenses. These may include continuing education costs related to real estate, travel expenses for business purposes, and home office deductions if applicable.
Income generated from rental properties is typically not classified as earned income, meaning it is exempt from FICA taxes (Social Security and Medicare taxes). This distinction can lead to substantial savings compared to income from traditional employment.
If your rental business qualifies as a pass-through entity (such as an LLC or S corporation), you may be eligible to deduct up to 20% of your net business income from your taxable income, subject to specific limits. This is one of the notable tax benefits of rental property ownership.
While there are numerous tax benefits associated with owning rental properties, it’s also important to consider the costs involved:
When assessing a potential investment it is essential that you take a balanced view of the finances to ensure the property produces the cash flow you need for it to make sense as an investment.
Depreciation allows property owners to deduct a portion of the property's cost from their taxable income each year, reflecting the gradual wear and tear on the property.
According to IRS guidelines, residential rental properties can be depreciated over 27.5 years, while commercial properties typically follow a 39-year depreciation schedule. This means landlords can write off a consistent annual amount based on the property's depreciable basis, which excludes the value of the land since the land itself does not depreciate.
Depreciation on rental property can start as soon as the property is ‘placed in service’. A property is generally considered ‘placed in service’ when you start looking for your first tenant - i.e. you create and publish the listing online.
The ‘placed in service’ date is also important when tracking expenses, as any repairs undertaken before the property is placed in service are deemed ‘improvements’ by the IRS and needed to be added to the property ‘cost basis’ and depreciated - meaning they cannot be deducted in full in that year.
Depreciation is a non-cash expense which means it does not impact actual cash flow; it merely provides a tax benefit that enhances financial performance.
Finally, it’s important to also understand depreciation recapture. This is the process by which the IRS will reclaim some of the depreciated value should you sell the property at a later date. The IRS will claim the depreciation recapture value whether or not you claim depreciation, so make sure you do.
When it comes to real estate investment, the interplay of property location, financing options, and property types significantly influences tax obligations and benefits for landlords. By understanding these factors, investors can make informed decisions that optimize their financial outcomes.
The location of a property is a critical determinant of its tax obligations. Different states and municipalities impose varying tax rates and assessment practices, leading to significant disparities in property taxes.
For example, urban areas typically feature higher property values, which results in elevated tax rates compared to rural locations. Additionally, local government services funded by property taxes—such as schools, police, and infrastructure—vary greatly depending on the needs and resources of the area.
Consequently, a property situated in a high-demand urban center may incur higher taxes than a similar property in a less desirable location, ultimately affecting overall investment returns.
Financing choices also play a pivotal role in shaping tax implications for property owners. For example, if a landlord finances their properties through mortgages, they often benefit from the ability to deduct mortgage interest from their taxable income.
Other financing structures such as conventional loans and government-backed loans also provide different advantages and disadvantages concerning tax treatment.
Furthermore, it's important to note that the choice of business entity for property ownership further impacts tax liabilities. For instance, owning properties through a Limited Liability Company (LLC) can provide pass-through taxation benefits, potentially lowering overall tax burdens compared to personal ownership.
Finally, the type of property also significantly influences tax obligations. Single-family homes are often assessed differently than multifamily units, such as apartment buildings. Typically, single-family homes enjoy lower property tax rates and may qualify for various homeowner exemptions that reduce their taxable value.
In contrast, multifamily properties might face higher assessments due to their income-generating potential. Additionally, multifamily properties offer substantial deductions through depreciation.
Landlords can depreciate the building's value over time while offsetting rental income with expenses related to maintenance and management. This depreciation is particularly advantageous for investors seeking to maximize cash flow and minimize taxable income while reaping the tax benefits of rental property.
Looking for an easier way to report and file your rental taxes? Landlord Studio is an invaluable tool for landlords seeking to streamline their expense tracking and maximize tax benefits.
The smart receipt scanning feature simplifies the documentation process by digitizing receipts and automatically inputting details. You can also create recurring expenses for routine overheads, such as mortgage and insurance payments, saving you time and ensuring consistent expense tracking.
Landlord Studio makes it easy for you to track your income and expenses on a property-by-property basis, which is essential when filing your Schedule E at tax time and comes with default expense categories in line with IRS requirements making it super easy to get started.
The integration with bank feeds automates income and expense tracking, while built-in mileage tracker helps landlords maximize travel deductions.
And at tax time, instantly generate any of over 20+ customizable reports with the click of a button.
Keeping up with rental taxes doesn't have to be stressful. Create your free Landlord Studio account and discover how it can transform your property management and accounting.
