How To Save Tax On Rental Income? Are Rent Payments Tax Deductible?

  • By: Peter Parker
  • Time to read: 7 min.
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A landlord rents out his property to the tenant to receive rent in exchange. Being a landlord is akin to doing business. The house is the asset, the tenant is the customer and the rent is your business income.

A responsible landlord must be aware of the federal tax laws on rental income and report all the rental income in the tax returns.

Here is some useful information on the tax reporting of rental income, permissible deductions from the rental income, documentation required, and how to save tax on rental income. 

What is rental income? 

According to the IRS, rental income is the amount you receive in exchange for giving out your property for use or occupation.

You must report all your rental income in your tax returns.

If you have more than one property, the gross income from all the properties must be reported in your tax return. 

Apart from the actual rent received, you must also report other amounts such as 

  • Advance rent
  • The portion of security deposits that are not returned to the tenant to pay for damages or repairs caused by them.
  • Amount received as a penalty for canceling the lease
  • Additional monthly fees such as pet fees, parking fees, etc.
  • Expenses paid by the tenant in lieu of rent
  • Property and services received instead of money for rent

As a landlord, Do I need to pay tax for rental income?

Yes, a landlord is required to pay rent for all the rental income received during a financial year, if you rent out your property for more than 14 days in a year.

The level of your participation in the real estate activity is considered to determine the tax treatment of your rental income.

The IRS mentions three types of real estate participation. They are 

Real estate professionals

Real estate professional spends more than half of their working hours (more than 750 hours in a year) on their rental business.

The rental income generated by real estate professionals is treated as active income.

If you are a real estate professional, you can offset the losses in the rental business with other income generated as wages, salaries, interest, and dividends.

Real estate professionals are not subjected to the net investment tax on the rental income. 

Material participation

To qualify as material participation, you must spend more than 500 hours in a year on the rental business.

You must take care of the majority of the work on a regular, substantial, and continuous basis. You must be in material participation in the activity for a period of 5 years in the last 10 years.

Rental income generated through material participation is treated as active income. The losses in the rental business can be offset with other income generated as wages, salaries, interest, and dividends.

Active participation

According to the IRS, active participation in real estate involves making management decisions in a significant and bonafide sense.

Management decisions include approving new tenants, determining the terms of the rental lease, and approving expenditures on the rental property.

There are special rules to offset the losses incurred in the rental business. You can deduct only a fixed amount of your passive losses depending on your Modified Adjusted Gross Income (MAGI). However, your MAGI should be less than $150,000 to take a deduction of passive losses. 

Passive activity

Most of the real estate participation is passive. Passive participation means that you are not actively involved in your rental property and consider it only as a side-line investment.

The income is treated as passive income and you cannot offset losses from the rental property with other taxable incomes.

However, the losses are carried forward and can be offset by the profits generated from the rental business or by the sale of the property. 

Deductions allowed on rental income 

There are some permissible expenses that you can deduct from the rental income.

The ordinary and necessary expenses incurred for maintaining, managing, and conserving the rental property can be deducted from the rental income.

Ordinary expenses are the common expenses that are generally accepted in the business and necessary expenses are those expenses that are deemed to be appropriate. 

The permissible deductions for rental properties include 

Mortgage interest

If you have a mortgage on the rental property, you can deduct the amount paid as interest on the mortgage from the rental income. 

Repairs and maintenance

It is the duty of the landlord to keep the rental property clean and habitable. All the expenses you incur on keeping the house inhabitable condition are tax-deductible.

For example, plumbing, painting, routine property maintenance, etc. 

Depreciation

A property undergoes wear and tear due to regular use, which causes it to lose value over the years.

You can deduct a certain amount every year from your rental income to compensate for the devaluation of property over time.

Depreciation must be calculated on the physical structure of the house and other items belonging to the landlord such as the furniture, appliances, carpets, etc. 

Insurance

Insurance is a significant cost for landlords, however, having insurance is necessary to protect the financial interests of the landlord, in case of any accidents and unexpected events.

Insurance premiums for fire, natural calamities, or personal liability insurance can be shown as business expenses and deducted from the rental income. 

Property taxes

Homeowners have to pay property taxes on a regular basis.

The amount up to $10,000 can be deducted from your rental income. However, if you are renting homes as a business, the total amount paid as taxes can be deducted as business expenses. 

Travel expenses

The money spent on travel to your rental property either to collect rent or for maintenance purposes can be deducted from the total rental income.

However, if you travel for the purpose of home improvement, it should be included in the improvement expenses. 

Other expenses

Apart from the above-mentioned expenses, there are some other common expenses that can be deducted. They include

  • Advertising costs
  • Home office expenses
  • Salaries of employees and other third party contractors
  • Losses from natural calamities or thefts
  • Cost of professional services such as property managers, attorneys, accountants, etc.

Reporting rental income in your tax return

It is crucial to provide accurate information about your rental income when filing tax returns.

It is important to keep all the records of the property such as rent receipts, records of expenses along with their receipts, and financial statements such as profit loss statements and balance sheets. 

The rental income should be reported in your tax return using Schedule E: supplemental income and loss Form 1040, or 1040-SR.

You also need to fill out Form 4562 to report depreciation expenses on your real estate property. 

Landlords can report up to 3 properties in Schedule E. However, if you own more than 3 properties, you have to file additional Schedule E to report the income and losses from all the properties. 

How is the rental income taxed?

Net rental income after the permissible deductions is included in the investor’s total income and taxed according to his/her federal tax bracket. 

Tax benefits of being a landlord

The US tax laws are very favorable to real estate investors.

The tax benefits of owning a real estate property and the tax deductions available for the biggest reasons for rising interest in real estate.

You can increase your investment capital and generate huge returns, if you are well-informed about the tax laws on real estate and wisely use them to your advantage. 

  • Deduction on mortgage interest.
  • They are eligible for deductions such as insurance premiums, cost of repairs and maintenance, property taxes, and utility bills not paid by the tenants.
  • Landlords can offset depreciation on the house and other items inside the property.
  • Travel costs such as airfare, hotel rooms, taxi fare, and meals during the travel are deductible from the rental income. 
  • Landlords can conduct unlimited 1031 exchanges to defer the payment of capital gains and depreciation recapture taxes. 
  • Expenses on continued education such as subscriptions to business or real estate magazines, membership in real estate investing clubs, or fees paid to pursue relevant courses can be deducted from the rental income. 
  • Operating expenses for maintaining and managing the rental property are deductible. 
  • Landlords can qualify for pass-through deductions that enable them to deduct up to 20% of the net business income from the taxable income. 

Do landlords pay council tax?

A majority of local governments in the US impose property tax or millage rates on real estate or personal property.

The tax is levied on land, buildings, and fixtures that cannot be removed without damaging the building. It is the responsibility of the property owner to pay the property tax. 

Do overseas landlords pay tax?

Yes, non-resident landlords who rent their homes in the US have to file their tax returns and pay the applicable tax to the IRS. 

Foreign owners are also subject to a 30% withholding tax on the gross rental income, every time it is paid.

The tenants, property managers, and the owner are all responsible to deposit the 30% withholding tax with the IRS.

Overseas landlords must follow the following procedure to remove the 30% withholding tax on rental income 

  • The overseas landlord must obtain the US individual Taxpayer ID Number (ITIN).
  • The landlord must file the IRS Form W- 8ECI. The form is applicable for 3 years. A new form must be filled out after the end of 3 years. 
  • The overseas landlord must file a US tax return disclosing his rental income after the permissible deductions.  

The tax laws are extremely friendly to real estate investors and landlords.

There are many tax benefits that landlords can benefit from and reduce their tax burden while increasing their rental properties.

Landlords must be up-to-date with the prevailing federal and state tax laws to be well versed on how to save tax on rental income.