Prepping for Tax Time - What Landlords Should Know

While rental properties can be an excellent way to generate passive income, tax time can be a critical and complex aspect of owning rental properties. Ensuring you’re aware of all the tax laws and regulations surrounding rental income can make the difference between maximizing your returns and paying more taxes than necessary. 

In this guide, we’ll cover all the key aspects of prepping for tax time for landlords in the US. Whether you’re a seasoned landlord or just starting out, this article will provide the knowledge and tools you need to take control of your taxes and ensure you’re prepared for tax time. 

What Constitutes Rental Income?

The Internal Revenue Service (IRS) defines rental income as any compensation received for the usage or occupancy of a property. This encompasses more than just regular rent payments and can include a variety of different forms of compensation such as advance rent payments, security deposits, lease cancellation payments, tenant-paid owner expenses, property or services received instead of rent, lease with an option to buy, and partial interest in a rental property. 

According to Uncle Sam, security deposits that are returned to the tenant are not considered rental income. However, any portion kept to cover damages is counted as such. Similarly, security deposits utilized as final rent payments are viewed as advance rent and if a tenant pays to cancel a lease, that amount is also considered rental income. 

In cases where a tenant pays for the owner’s expenses they are not obligated to pay, such as the water and sewage bill, the amount paid counts as rental income. If a tenant offers to perform services, such as painting the property, in exchange for rent, the amount they would have otherwise paid counts as rental income.  

As a landlord, you are responsible for reporting this income on your tax return and paying any applicable taxes according to your Internal Revenue Service (IRS) tax bracket. Taxes on rental income are paid based on an investor’s federal and state income tax brackets. 

Still a little confused about your responsibilities? Read our comprehensive guide on everything you need to know about Learn about Tax Law for Landlords.

What Constitutes a Rental Expense?

Rental expenses are the costs associated with owning and operating a rental property. It’s important to keep track of all rental expenses, as they can be deducted from rental income to lower your tax bill. Some common rental expenses include:

• Advertising: Advertising costs include costs associated with advertising the property for rent, such as listing it online or placing ads in newspapers.

• Property Repairs: This includes costs for repairs made to the property, such as fixing a leaky roof or replacing a broken window.

• Insurance: This includes costs for insurance policies covering the property, such as liability insurance or insurance for the damage caused by fire or other disasters.

• Utilities: This includes costs for utilities used in the property, such as water, gas, and electricity.

• Property Management: Property management fees include costs for managing the property, including hiring a property manager.

• Auto and Travel Expenses: If you need to travel to your rental property for maintenance or management purposes, you may be able to deduct some of your travel expenses, including gas, lodging, and meals. You can usually deduct 50% of your meal costs. If you use your personal vehicle for business purposes, you may also be able to deduct a portion of your vehicle expenses, such as depreciation, insurance, and repairs.

• Cleaning and Maintenance: In addition to repairs, you may also incur expenses for routine cleaning and maintenance, such as lawn care, pest control, and housekeeping services.

• Homeowners Association (HOA) Dues: If your rental property is part of a homeowners association, you may be required to pay monthly or annual dues. These dues may cover maintenance of common areas, such as landscaping or building exteriors.

• Legal and Professional Fees: If you incur legal or professional fees related to your rental property, such as consulting with an attorney or accountant, these expenses may be deductible.

• Mortgage Interest: If you have a mortgage on your rental property, you can deduct the interest portion of your monthly payments on your tax return.

• Trash and Recycling: If you pay for trash or recycling services for your rental property, these costs can be deducted.

• Yard Maintenance: This category includes expenses for maintaining outdoor areas, such as mowing the lawn, trimming hedges, and removing fallen leaves or debris.

How to Deduct Rental Expenses From Rental Income

To deduct rental expenses from rental income, you’ll need to complete a tax return and report your rental income expenses on Schedule E of your tax return. You can claim most rental expenses in the same year you incur them. This includes the cost of maintaining and improving the rental property.

However, the process for claiming expenses related to buying the property is different. Instead of a one-time deduction, these costs are recuperated gradually over time through depreciation. However, keeping accurate records of all rental expenses is important, as the IRS might not allow deductions that are not adequately documented.

 If you are thinking of relocating to a state with low property taxes, take a look at our article on the 7 states with the lowest property taxes.

Other Factors That Can Affect Your Tax Filing

• Depreciation on a Rental Property

Rental property depreciation is a significant tax advantage for rental property owners, allowing them to reduce their taxable income by deducting the costs of buying and improving the property over what is considered to be  its useful life. As soon as an asset is put into use or made available for rental purposes, depreciation starts. Conventionally, the majority of residential rental property in the United States depreciates at a rate of 3.636% per year for a period of 27.5 years.

For residential properties placed into service after 1986, the Modified Accelerated Cost Recovery System (MACRS) is used to calculate depreciation. This accounting method spreads the costs over 27.5 years, the period the IRS considers to be the useful life of a residential property. For commercial properties, the depreciation period is 39 years.

The IRS has specific guidelines for depreciating rental properties. A property is only eligible for depreciation if the following criteria are met:

• You must own the property

• The property must be used for business or as a rental.

• The asset must have a predetermined life, which means it must eventually wear out, deteriorate, or lose value.

• The property must have a useful life of at least one year.

 However even if a real estate property satisfies all of the above mentioned criteria, it cannot be depreciated if you put it in use and then dispose of it (or stop using it for business purposes) in the same year.

How to Calculate Depreciation on a Rental Property 

The process of determining the annual depreciation amount involves several steps:

1. Determine the basis of the property, which is the cost of acquiring the property through cash, mortgage, or other means, including certain closing costs and settlement fees.
   
   

2. Separate the cost of land from the cost of the building as only the cost of buildings can be depreciated. This can be done by using the fair market value of the property when purchased or real estate tax assessments.
   
   

3. Calculate the basis in the home, which is the amount that can be depreciated. This is done by determining the basis of the property (house and land) and the value of the buildings, then allocating the depreciable amount.

• Qualified Business Income Deduction

The Qualified Business Income deduction can be important for landlords who operate their rental activities through a pass-through entity, such as a sole proprietorship, partnership, or S corporation.

 Under the Tax Cuts and Jobs Act of 2017 (TCJA), the QBI Deduction allows eligible taxpayers to deduct up to 20% of their qualified business income from their taxable income. This deduction can significantly reduce the landlord's taxable income and resulting tax liability. 

To qualify for the QBI Deduction, the landlord must meet certain requirements, including having taxable income below a certain threshold, and the rental activity must be considered a "qualified trade or business" under the tax law.

In general, a rental activity will be considered a qualified trade or business if the landlord is actively involved in managing the property, and the rental is not considered a triple-net lease. This means the landlord must provide significant services in addition to just renting out the property, such as maintaining the property, advertising the property to get tenants, and handling tenant requests and complaints. 

It's important to note that the QBI Deduction is subject to certain limitations and restrictions, and the calculation of the deduction can be complex. Landlords who are considering claiming the QBI Deduction should consult with a tax professional to ensure they are eligible and to properly calculate the deduction.

• The 14-Day or 10% Rule

The number of days the property is rented out and how much time the owner spends there helps determine the tax benefits from rental properties. There are three primary groups:

• Properties rented for no more than 14 days annually. In this situation, rental income is not reported, but homeowners can write off their mortgage interest and property taxes as a personal residence. No deductions are allowed for rental costs.

• Properties used for fewer than 14 days after being rented for more than 15 days. The property is regarded as a rental property in this scenario, and rental income and some expenses are recorded based on the percentage of rental days.

• Properties used for over 14 days or ten percent of the total rental days. In this situation, the property is regarded as a personal residence, allowing a deduction for mortgage interest, real estate taxes, and rental expenses up to the amount of rental income.
  

Record-Keeping for Tax Purposes

Accurate record-keeping is essential for landlords when preparing for tax time. By keeping accurate records of rental income and expenses, landlords can ensure they pay the correct taxes and take advantage of all eligible deductions. Inaccurate record-keeping can lead to disputes with the IRS and result in fines or additional taxes. 

 Landlords should keep records of all rental income and expenses, including: 

• Rental agreements

• Receipts for expenses

• Bank statements and canceled checks related to the rental property

• Records of rent payments received

• Records of repairs and improvements made to the property

• Records of property insurance and property management fees

 To ensure that records are easy to access and organized, landlords can follow these simple tips:

 Keep records in a safe and secure place: 

• Store records in a logical order, such as chronologically or by category

• Use a digital file system, such as a cloud-based storage solution, to store and organize records

• Regularly review records and discard old or unnecessary documents

• Talk to an accountant or tax advisor if you are unsure about what records to keep or how to organize them effectively

Filing Your Tax Return as a Landlord

Filing a tax return is necessary for landlords to report their rental income and expenses to the IRS. The process involves calculating total rental income, deducting eligible expenses, and reporting the net income on a tax return. The main forms and schedules used by landlords to report rental income and expenses include the following:

• Schedule E: Supplemental Income and Loss - used to report rental income and expenses

• Form 1040: Individual Income Tax Return - the main tax return form that landlords use to report their rental income and expenses

• Form 1099-MISC: Miscellaneous Income - used to report rental income if the landlord received rental income from more than one source

The deadline for landlords to file their federal tax return is April 15th. If a landlord fails to file a tax return by the deadline, they may be subject to penalties and interest charges. To avoid these penalties, landlords need to file their tax return on time and ensure that it is accurate and complete.

Tips for filing your tax return:

• Accurately calculate rental income by keeping a record of all rental payments received.

• Properly document rental expenses by keeping receipts and other documentation for expenses incurred.

• Hire a tax professional for complex tax situations.

• Take advantage of available tax credits and deductions, such as the energy efficiency tax credit, depreciation, and mortgage interest deductions.

• Stay organized and up-to-date on the latest tax laws and regulations by regularly reviewing them, keeping accurate records, and filing the tax return on time.

 In addition to rental income and expenses, landlords must be aware of other tax considerations that may affect their bottom line. These can include: 

1. Self-Employment Taxes: Social Security and Medicare taxes make up the self-employment tax, which is mostly levied on people who work for themselves. It is comparable to the Social Security and Medicare taxes that are deducted from most wage employee paychecks. You can find more about how much this is here.
   
   

2. Passive Income Rules: Passive income rules may limit the ability of landlords to deduct losses from their rental properties if they do not actively participate in the rental activity.
   
   

3. State and Local Taxes: In addition to federal taxes, landlords may also be subject to state and local taxes on their rental properties, such as property taxes and sales taxes.
   
   

4. Audit and Disputes: Landlords may also face audits or disputes with tax authorities, particularly if they are audited or make errors on their tax returns. In these cases, it’s important to have accurate records and seek the help of a tax professional if necessary.
   
   

Being audited by the tax authorities can be a daunting experience, but it is important to approach it with a level head and be prepared. Here are a few things to keep in mind:

1. Gather all necessary documentation:Keep all records and receipts related to your rental property organized and readily available in case of an audit.

2. Know your rights: Familiarize yourself with the laws and regulations related to rental property taxes and understand your rights during an audit.

3. Talk to a professional: Consider seeking the assistance of a tax professional to help you navigate the audit process.

4. Be cooperative: Respond promptly to any requests from the tax authorities and be honest and cooperative throughout the audit process.

5. Appeal the decision: If you disagree with the findings of an audit, you have the right to appeal the decision. Follow the proper procedures and provide a compelling argument to support your position.

Need more clarity? Read more on End of Year Taxes – What Property Owners Need to Know.

Preparing for tax time as a landlord is a critical aspect of managing rental properties. Accurate record-keeping and a thorough understanding of rental income taxation, expenses, and tax deductions are essential for landlords to make the most of their investments. Staying on top of your tax prep can range from understanding the tax laws and regulations to determining deductible expenses and claiming deductions, and staying organized.  

Ensure that you’re up-to-date with the latest information. Proper preparation and accurate record-keeping can help landlords minimize their tax liability and avoid costly disputes with tax authorities. To make the most of your investment, it’s crucial to take the time to prepare for tax time and stay informed about the latest tax developments throughout the year, that way it’ll be smooth sailing when tax time rolls around again.

Want to know more about doing your taxes as a landlord? Check out your FREE guide: Tax Guide for Landlords. See how you can maximize your returns.