Rental Property Returns and Income Tax Calculator

Rental Income and Tax: What You Need to Know

When it comes to taxes, your rental income is taxed the same as any other ordinary income. For instance, if you’re in a marginal tax bracket of 22 percent and you earn $7,000 in rental income, you’ll pay $1,540.

How does the IRS define rental income?

To better understand your tax obligations, it’s important to first understand how the IRS defines rental income. Luckily, that’s an easy answer; the IRS defines rental income as “any payment you receive for the use or occupation of property.”

Besides normal monthly rent payments from a tenant, additional types of rental income include:

• Advanced payments: Many landlords require renters to pay both the first and last month’s rent before they can move in. In this case, you’ll need to count both of those payments as income for the year that you received them, even if the last month that the renter will live there isn’t within that year.

• Tenant Expenses: There may be some expenses that your tenants pay for that they aren’t required to. For example, your tenant might pay their electricity bill on their own, then subtract that sum from their monthly rent. If this is the case with one or more of your tenants, you’ll need to include the sum used to cover the bill as rental income.

• Security Deposits: The security deposit isn’t rental income; at least at first. If you return the full total to the tenant, the deposit will never be considered income. However, if you keep a portion of that deposit for any reason, that portion becomes income, and you’ll need to pay tax on it.

• Services rendered by tenants: Does your tenant opt to mow their own lawn in exchange for a $50 discount on their monthly rent? If so, that $50 still counts as rental income. Any services rendered by a renter in place of rent payments needs to be counted as rental income.

Real estate investing guidelines

Owning investment properties is a great chance to create more than one passive income stream. Of course, there's the obvious; you collect rent each month. However, there are other sources of income to be had as well. Over time, your investment property appreciates, and you earn equity on your home. This can allow you to get a low-interest loan that you can use to pursue other passive income streams. You can also sell your property later on.

In order to avoid having to pay capital gains taxes, you can execute a 1031 exchange. With a 1031 exchange, you use profits from the sale of your property to buy another property that’s of either equal or greater value than the home you’ve sold.

Before you purchase your first investment property, it’s important to figure out whether you’re prepared to become a landlord. Besides caring for the maintenance demands of your property, you’ll also need to invest time into managing every aspect of it, from screening tenants to listing your property to tracking down rent payments. There’s also an emotional side to the position. If you get close to a tenant, and they suffer financial hardship, you’ll need to navigate riding the line between being a friend and a landlord. It can also be tough to keep your cool when you’re getting 3 a.m. phone calls for emergencies that could likely wait until morning.

Some of the responsibilities you’ll face as a property manager include:

• Managing your tenants. This includes creating listings, finding and screening new tenants, creating legally-binding leases, and, sometimes, evicting difficult tenants.

• Managing your properties. It isn’t just your tenants you’ll need to manage; you’ll also need to manage the rental they’re living in. This includes performing routine maintenance, emergency repairs, renovations between renters, and more.

• Managing the administrative side of a rental property. From bookkeeping to setting your rent price to taxes, budgeting, and more, this all falls on the property manager.

If you don’t want to deal with the time, stress, and emotional demands of managing your property, tenants, and administrative duties, you can hire a property manager instead. However, they’ll collect between 4 and 12 percent of your rental income each month. If you have a single rental property, this may mean giving up a significant portion of the passive income that you’re looking forward to. But if you own multiple properties, hiring a property manager is definitely worth the investment.

When it comes to purchasing a new rental property, you need to first decide how much potential rent you can expect to earn. This will allow you to make a smart decision about how much you’re willing to pay for a property. Two simple ways to calculate the potential income you could receive from your rental include:

• The 1% Rule: Consider your gross monthly rental income, which is the total of your rental income before paying taxes. The property purchase price should be at least 1 percent of that total, after any necessary repairs.

• The 50% Rule: When you’re managing an investment property, you can assume that half of your rental income will go towards operating and managing the property. This does not include paying your monthly mortgage payment. The other 50% of rental income will go towards that. This will give you a rough idea of the income and profit you can expect to generate.

If you’re dreaming of getting started in real estate investing, but don’t want the hassle and expense of owning your own property, you do have another option. Real Estate Investment Trusts, or REITs, are companies that invest in a variety of types of real estate. You invest in the company, and they purchase the properties. You can trade in REITs publicly, much the same as a stock, or privately. These are a great option for investing in real estate without becoming a property owner.

Rental Income and Tax Returns

What you need to know about depreciation

The yearly investment that you make in maintaining your property, as well as the cost of your property, goes into determining a yearly tax deduction, also known as depreciation. The land that your property is built on is not included as a part of its depreciation. That’s because, unlike a home or apartment, the maintenance of the land is considered to be inseparable from its ownership.

The IRS instructs property owners to calculate depreciation over the “useful life” of your rental property. This is the amount of time that the IRS believes that the cost of renting your property will outweigh what it costs to maintain your property.

For commercial properties, the “useful life” is 39 years. For residential rental properties, the “useful life” is 27.5 years.

Let’s take a look at an example. Say that your asset is valued at $500,000, and your land is valued at $200,000. You would subtract the cost of the land, and then divide what’s left by 27.5. This would give you your yearly depreciation deduction. For this example, the yearly depreciation value would be: ($500,000-$200,000)/27.5=$10,909.

Along with your property’s deprecation, you will also need to consider your depreciation recapture. This term refers to a tax that is applied to your deprecation deduction that you will pay after you sell your investment property. The tax rate for depreciation recapture is 25%. This percentage is applied to the total of your depreciation deductions. 

Even if you don’t take full advantage of depreciation deductions, you can still apply the depreciation recapture tax. So if you don’t take advantage of your deductions, you’ll still pay those high depreciation recapture taxes. That’s why it’s important that property owners take advantage of all available deductions.

What is Qualified Business Income (QBI)?

Another tax break that rental property owners can take advantage of is the Qualified Business Income, or QBI, deduction. This deduction allows property owners to deduct upwards of 20 percent from your taxable rental income. QBI has a maximum threshold of $315,000 for taxpayers who are married and filing jointly, and $157,000 for individuals. For those with income that falls under the threshold, you can claim the full 20% deduction.

If you make more than the threshold, you will still get a deduction. However, it’s a complicated deduction process, and will likely require the help of a tax professional in order to navigate.

Let’s take a look at a sample rental income tax return

To help property owners better understand what a tax return that includes rental income might looks like, take a look at the following example:

Consider a rental property purchased for $300,000. You charge $2,600 per month in rent, and fall within the 22% marginal tax bracket. You’ll also face the following expenses:

• $10,000 in mortgage interest

• $2,000 in insurance

• $1,000 in tenant-paid utilities

• $3,120 for property management

• $4,000 for real estate taxes.

• $500 for other deductible expenses.

In total, you have $20,620 in expenses. Of that, you can deduct $8,182 in depreciation. Your taxable income calculation will appear as follows.

Rental Income Calculator Terms You Need to Know

Amortization: 

Loans are divided into consistent payments that you make each month. Over time, the make-up for the payment changes because a portion of the payments goes towards interest on the loan, and another portion goes towards the principal on the loan. You can create an amortization table to see how much more principal and interest you’ll need to pay over time. This can help you better budget, and consider your refinancing options.

Cash On Cash Return:

The Cash on Cash Return is a measure of your gross rental income relative to mortgage payments made within a single year.

Effective Tax Rate:

The Effective Tax Rate is the amount of tax you’ll pay on any taxable income that you receive. This is calculated as an average of each of the tax brackets that your income is subjected to, after the deductions and credits that you are eligible for.  

A property owner’s Effective Tax Rate applied only to their federal income taxes. It excludes state and local taxes. Your marginal tax rate, or the highest bracket your income is taxed at, can also be used in place of your Effective Tax Rate. To calculate your exact Effective Tax Rate, divide your total income by your taxable income.

Financing

Financing refers to the money lent to property owners by the bank. The money is expressed as a percentage of a property’s value. The remaining amount paid for a property is the down payment.

Financed Return (ROI):

Your Financed Return, or ROI, is the ratio of the loss or gain compared to the size of your investment, usually expressed as a percentage.

Interest Rate:

When a bank lends you money, they charge a fee. This fee is applied as a percentage of the total of your loan, applied to that loan each month. This is called your interest rate. The principal is the total amount of the loan that the bank gives you, before the interest rate is applied.

Land Value as percentage of purchase price:

The land value as a percentage of a purchase price is important to determine for several reasons. To start, because land is excluded from depreciation, you need to subtract the value of that land when determining your yearly depreciation deduction.

In order to calculate the land value as a percentage of the purchase price, you can assume your land is a 20% value of your purchase price. While this isn’t exact, it’s a useful estimate.

Net Cash Flow:

The net cash flow is the income that a business brings in over a set period of time. Cash flow coming in from an investment property is calculated by the money that goes into maintaining a rental property, and the rental income that comes out. Property owners need to track this information in order to determine whether the rental is earning them money or causing them to lose it. It’s also useful to determine whether the property has recovered the initial investment made.

In order to calculate the Net Cash Flow, you’ll subtract the Net Operating Income from the change in the Net Operating Balance: Cash receipts-cash payments=Net Cash Flow.

Net Operating Income (NOI):

The Net Operating Income, or NOI, is the total amount of money made from a property after subtracting any operating expenses. This is calculated pre-tax. Operating expenses might include repair costs, insurance, legal fees, and similar costs. The income from your property might not come from rent alone; if you have coin laundry or vending machines on-site, or you charge for parking, this income will need to be included as well.

Principal Paydown:

Principal paydown is when property owners opt to make payments that only go towards the principal on their loan, rather than the interest. The more of your principal you pay down, the less interest you’ll wind up paying over time.

Cap Rate:

A cap rate, or capitalization rate is the NOI, divided by the market value of an investment property. This rate expresses the return on investment as a percentage received over the course of a year, excluding the cost of the mortgage payments. While useful, this rate isn’t used often because it doesn’t give a full picture of what your property is worth.

Rental Income Tax Questions You Want to Ask

What expenses can I claim for my rental property?

When you invest money back into your rental property, some of those expenses are deductible against your rental income. Common deductions property owners can make include:

• Interest on your mortgage

• Insurance for your property

• Money invested in marketing your rentals

• Any cleaning or maintenance fees

• Expenses for hiring property management professionals

• HOA fees

• Legal or bookkeeping expenses

Let’s take a look at what some common deductions would look like on a property that brings in $25,000 in rent each year.

• Total Rental Income: $25,000

• Mortgage interest: $7,000

• Insurance: $1,500

• Property Management: $1,700

• Taxes: $2,500

• Other Expenses: $750

• Rental Income After Expenses: $11,550

How is rental income different if I rent out a room in my own home?

Renting out a single room in your own home is exactly the same as renting out an entire single-family home. The same rules apply, as do the same costs and tax laws. But you will need to divide many expenses, like maintenance or insurance, between the part of your home that you rent out and the part that you live in. Essentially, you’ll treat your home as two apartments in a single building. You can still deduct depreciation of the portion of your home that you’re renting out.

What about Airbnb income?

If you rent out your property for at least 15 days each year, the same rules apply to your Airbnb property as do to other rental properties. If you rent out your Airbnb for 14 days or less, you will not need to report that income as rental income. 

How do I claim my mortgage?

Claiming your mortgage as a tax deduction is a complicated process. There are many different factors that affect this claim, including how much money you earn and how much you have, the tax bracket you are in, the cost of your home, and more. You’ll also need to consider whether you’ll take a standard deduction or deduct your closing costs, depending on which will help you save more money.

Some costs that the IRS lists as deductible include:

• Mortgage interest that you pay at the time of closing

• Any real estate taxes paid for by the mortgage lender

• Sales tax as it is issued at the time of closing

• Interest paid on a home’s purchase

Some expenses that the IRS does not consider deductible include:

• Utility charges paid before a renter moves in

• Any rent paid if you move into a property before closing

• Insurance for fires or floods

• Mortgage refinancing

• Appraisal or home inspection costs

• Real estate commissions

• Title fees

When it comes to handling your mortgage closing, it’s best to consult a financial advisor for help.

Key tax dates you need to know

The most important tax date that every property investor should know is April 15. On this date, individual tax returns are due. However, this deadline has been extended for the past two years due to COVID-19.