Investment property income tax issues can be rather complex, especially to an investor who is just getting started. The taxation of rental income isn’t entirely straightforward, there are some big and complex deductions that investment property owners are entitled to, as well as some other potential income tax implications that are important to know before you buy your first rental property.
Rental income is taxable
The first income tax topic you should know when you buy an investment property is that rental income is taxable. And your taxable rental income is taxed at your marginal tax rate, or tax bracket.
One piece of good news is that rental income is considered a passive form of income, which is significant because this means that it is not subject to Social Security or Medicare taxes. If your marginal tax rate is 22% and you earn $1,000 in active income (say, a bonus from your job), it will be subject to federal income tax at a 22% rate, plus 6.2% Social Security tax and 1.45% Medicare tax. Meanwhile, $1,000 in taxable rental income is only subject to the 22% federal income tax.
Rental income is also generally subject to any applicable state and local income taxes, and you may have to pay certain taxes that are specific to rental properties -- this is most common in popular vacation destinations where local governments rely heavily on tourism revenue.
Operating expenses can lower your taxable rental income
Rental income is taxable, but that doesn’t mean that you’ll pay tax on all of the rental income you collect. There are two big ways you can reduce your taxable rental income -- operating expenses and depreciation. We’ll look at operating expenses first.
Before taxes are calculated on rental income, you can subtract any of your operating expenses associated with owning, maintaining, and operating the property. Just to name a few of the most common examples, you can subtract costs such as:
- The cost of advertising the property and screening tenants
- Interest on a mortgage you have on the property
- Property taxes and hazard insurance
- Yard maintenance
- Pest control
- Landlord-paid utilities, such as garbage collection, sewer, and water services
- Routine maintenance costs, such as changing air filters
- Fees you pay to a property manager
The point is that these operating expenses can dramatically reduce your taxable rental income. If your investment property produces $12,000 in rental income this year and you have $5,000 in various operating expenses, it reduces your taxable rental income to $7,000.
Can you write off the cost of your investment property?
It’s well-known that Americans can generally deduct the cost of business assets they buy. For example, if I purchase a laptop to use for business reasons, I can deduct it on my tax return. The same can be said if I buy assets like furniture, domain names, or other assets that are to be used for my business.
Since an investment property is technically a business, it’s natural to wonder whether you can deduct the cost of acquiring an investment property. In other words, if I spend $150,000 buying a home to rent out, do I get a $150,000 deduction to report on my next tax return?
The short answer is "sort of." When you purchase a business asset that has a useful life of more than a year or two, it is generally deductible over a certain number of years, a concept known as depreciation. For example, if you buy a piece of machinery for your business and it has a useful lifespan of 10 years, you could deduct one-tenth the cost of the machinery this year, another one-tenth next year, and so on, until the entire cost has been deducted.
Investment properties can be depreciated in this way as well. It may sound a little tricky to determine the useful lifespan of real estate -- after all, some cheaply built dwellings might only last a decade or two, while there are some well-constructed historic homes that are still perfectly habitable after several hundred years.
Because of this, the IRS sets a standard depreciation period of 27.5 years for investment properties of a residential nature and 39 years for investment properties of a commercial nature. In other words, if you buy a residential investment property for $150,000 (including acquisition costs), you would divide this amount by 27.5 to get an annual depreciation deduction of $5,455. This would further reduce your taxable rental income every year you own the property, until the entire $150,000 purchase price had been deducted.
An example of taxable rental income
Here’s a quick example to show how the depreciation and operating expense deductions can help reduce your taxable rental income. Let’s say that you spend $120,000 to acquire a single-family investment property, and that it generates $12,000 in rental income in your first full year of ownership.
We’ll also say that you have the following expenses of ownership:
- $3,000 in mortgage interest
- $1,000 in property taxes
- $1,000 in hazard insurance
- $500 of routine maintenance expenses
- $500 for landlord-paid utilities
This totals $6,000 in operating expenses, which reduces your taxable rental income to $6,000.
Next, we calculate the annual depreciation deduction by dividing your $120,000 acquisition price by 27.5 to get $4,364. This is also subtracted from the taxable rental income, which brings it down to just $1,636. So even though you took in $12,000 in rental income, only a small fraction of this is considered to be taxable. In fact, it’s not uncommon for profitable rental properties to report a loss for tax purposes because of this combination of deductions.
The Qualified Business Income (QBI) tax deduction can save you even more
Believe it or not, there’s more. The Tax Cuts and Jobs Act created a deduction known as the Qualified Business Income, or QBI deduction. There are some criteria that need to be met, but the idea is that you can deduct up to 20% of your income that comes from pass-through sources, such as an LLC, partnership, or S-Corp. Real estate rental income typically qualifies, but be sure to consult with a tax professional in order to make sure your situation meets the IRS requirements.
One big caveat of the depreciation deduction
So far we’ve spent our time discussing the tax benefits of real estate investing. If you thought the depreciation deduction sounded too good to be true, I’m about to talk about the uglier side, known as depreciation recapture.
The whole idea behind depreciation is that business assets tend to lose value over their useful lifespan. In other words, if you buy computing equipment to use for your business, it will likely be worth far less in a few years.
With real estate, however, this doesn’t usually happen. As long as it’s properly maintained and cared for, real estate doesn’t get "used up." Quite the opposite, actually -- real estate values tend to go up over time, not down.
For this reason, if you end up selling an investment property, the IRS wants its depreciation benefit back. This is known as depreciation recapture. Let’s say that you sell a property for $150,000 that you originally purchased for $120,000 and in which you had taken a total of $15,000 in depreciation deductions. The $30,000 profit would be taxable as a capital gain, which is taxable at favorable rates, and the $15,000 depreciation deduction would be considered taxable income, taxable at your marginal tax rate.
A 1031 exchange can help you defer capital gains and depreciation recapture taxes. Head over to our 1031 exchange homepage for more information, but the general idea is that a 1031 exchange allows you to sell an investment property, use the proceeds to buy another investment property, and defer your tax liability (capital gains and depreciation recapture) on the property you sold until you eventually sell the newly acquired property.
What about repair costs?
One potential grey area is the tax deductibility of repairs and property improvements. Here are two general rules to follow:
If the repair you make doesn’t add substantial value to the property and is necessary to maintain the property’s functionality and isn’t a high-cost repair such as a roof replacement, you can deduct it all at once.
On the other hand, if the repair/improvement adds substantial value (such as a kitchen renovation or adding a swimming pool), is a major expense (like a roof replacement or new flooring), and/or has a useful lifespan of more than a couple years, you would add the expense to the property’s cost basis and take it as part of the annual depreciation deduction.
Don’t be afraid to ask for professional advice
One key takeaway from this discussion is that investment property income taxes can be complex, and there are several topics where you might run into some gray area. For this reason, it’s important to seek the advice of a qualified tax professional if there are any deductions or other tax issues that you’re unsure about. The IRS tends to look more closely at rental income than earned income from a job, so it can be well worth spending a bit of money on professional advice to get it right.