Income generated from rental properties is still considered income, but is it taxed at the same rate as your paycheck? Rental income is generally considered a passive revenue stream and is subject to special considerations and rules by the Internal Revenue Service (IRS). While it is designated as “passive”, anyone who owns rental properties knows the commitment of time and effort it takes to keep everything running smoothly.
There are many things to consider when it comes to how your rental income is taxed, such as deductions, special allowances, repairs, and improvements. After you factor in any applicable deductions and special allowances, your passive rental income is taxed at a different, usually lower, rate than your active, or nonpassive, income. It is important to consult your tax professionals with questions about your specific circumstances, as we are not CPAs and are not giving tax advice.
If you received rental income during the year, there are certain tax deductions you can claim based on rental expenses. You may be able to deduct the cost of repairs, property tax, operating expenses, loan interest, management expenses, utilities, insurance, depreciation, and general maintenance. All those deductions can add up, but be sure you know what qualifies as a repair. The IRS is pretty particular about what it considers a repair versus an improvement.
Repairs can only be deducted in the tax year they were completed and in the event that they are ordinary, necessary, and reasonable in amount. Examples of acceptable repairs you can deduct include fixing floors, leaks, walls, and windows, as well as keeping appliances in working order. Basically, most costs associated with the upkeep of the rental property can be deducted and off-set the amount of taxes you’ll owe on the rental income.
In addition to repairs, any utility payments you cover for your tenants; fire, flood, and mortgage insurance; and loan interest on your mortgage are all sources of tax deductions on rental income. Everyone’s tax situation is unique, so be sure to research which tax deductions are applicable to you and your rental properties. If you skip this step, you could be paying more to the IRS than needed.
While repairs can be deducted in the tax year they are completed, capital improvements to the property are expensed, and the costs are deductible. But, the difference is capital improvements are amortized over many years. There are different amortization timelines for different types of improvements. Your CPAs can assist you in selecting the correct amortization period. A property management company, like MV Properties, assists your CPAs by providing all the documentation that you need to properly fill out your taxes.
According to the IRS, an expense is considered an improvement if “it results in a betterment to your property, restores your property, or adapts your property to a new or different use.” (1) Some concrete examples of improvements are additions such as bedrooms, a porch, garage, or patio; replacing the roof; adding a security system; heating and air conditioning additions; replacing appliances; and replacing septic systems or water heaters.
Depreciations are income tax deductions that permit property owners to recover the cost of assets over time. The IRS makes an annual allowance for a property’s deterioration, including normal wear and tear. (2) Depreciation is something that you can get a deduction for in the current year even though you might not have spent money to buy rental property in that year. Depreciation is a huge tax benefit, and it is a non-cash expense that decreases your taxable income. It’s one of the big benefits to owning investment property.
Something else to consider with your properties, is the opportunity to do a 1031 exchange. A 1031 exchange is a swap of one business or investment asset for another. Although most swaps are taxable as sales, if you come within 1031, you’ll either have no tax or limited tax due at the time of the exchange. (3) Special rules apply to depreciable properties in 1031 exchanges. I and my partners at MV Properties work with 1031 experts who assist our clients when there are complications on 1031 exchanges and carrying forward the depreciated basis. Tax law is complicated, and while we are not CPAs, we are happy to work with your tax professional to get all your rental income paperwork in order.
Passive Income Rules
Deductions are not the only way to lower the tax owed on rental income. Passive income is subject to special rules when it comes to taxes. In certain cases you can use passive activity loss to offset your active income, such as your salary.
But, a question we are often asked is, is your rental income still considered passive if you actively participated in managing and repairing the property? According to the IRS, “A rental activity is a passive activity even if you materially participated in that activity.” The only exception being if you are in the real estate business. Rental income is considered active income for real estate professionals. As long as you don’t fall into that category, you can claim the special allowance in regard to your rental income taxes.
How We Can Help
Self-managing your rental property is a huge undertaking and sometimes can seem like another full-time job. We can help alleviate some of the pressure of owning a rental by taking over the day-to-day management and repairs of your property. MV Properties can help you make your passive income truly passive. Call us today to set up a consultation and discover what you can gain by allowing us manage your rental property.
Keegan McNamara is the founder of MV Properties, a leading San Diego property management company offering the highest level of service in property management, maintenance, and leasing. His goal is to cultivate long-lasting relationships with his clients (property owners) and their tenants to provide an enjoyable leasing experience. Keegan holds a Masters in Business Administration from the Rady School of Management at UC San Diego and is a Principal at McNamara Ventures, a real estate development and investment company focused on residential and mixed-use properties.