How Do Taxes Work on a Rental Investment Property?

February 22nd, 2024

Renting out property can be a smart investment move allowing owners to generate income. However, along with the benefits of rental income comes tax implications that need to be understood. As investment property owners ourselves at Empire 8 Property, we often get asked – how exactly do taxes work on rental houses, units, townhouses, duplexes or land?

There are specific rental property tax rules around income, expenses, capital gains, record keeping and more. While confusing, getting a handle on taxes is crucial to maximize returns. In this comprehensive guide, we’ll break down key things landlords need to know when it comes to filing taxes on rental investments.

Overview of Rental Property Taxes

In most countries, money earned from renting real estate is considered taxable income by the federal government and state or territory. Some key areas that are impacted and need to be reported properly include:

  • Rental income amount and taxes owed annually
  • Claiming allowable expense deductions
  • Property and land tax obligations
  • Tax implications when selling the rental asset

Understanding these components will better equip investors to make smart decisions that lower their tax liability. Getting solid professional advice is also key. As responsible property investors, We advise you to consult closely with our financial planner and accountant to explore taxes.

Calculating and Reporting Rental Income for Tax

The first thing to determine is how much income tax is owed on rental proceeds each year. Rental income includes all money received from occupants like rent payments, security deposits (if non-refundable) and other non-refundable fees.

This income must be accurately reported by filing a Schedule E along with your personal tax return. The rental revenue gets added to total annual income which is then taxed depending on federal income tax brackets and personal situations. As an illustration, say your rental property brought in $20,000 last year and your other income equaled $80,000 – your total taxable income would be $100,000.

Claiming Deductions on Rental Properties

The good news is landlords can reduce taxable rental income by utilizing available deductions for investment property expenses. Common write-offs include:

  • Advertising for occupants
  • Management fees
  • Travel to the property
  • Repairs and routine maintenance
  • Utility bills if owner-paid
  • Homeowners insurance
  • Mortgage interest
  • Property taxes
  • Depreciation of buildings and assets

Tracking all these allowable expenses yearly and submitting documents showing costs is key to legally maximizing deductions. We strongly advocate keeping important records both for taxes and determining cash flow. If rental costs exceed income, it’s also possible to use the loss to offset tax liability from other income sources, with certain IRS limitations.

Additionally, owners can depreciate buildings and assets within the property over a number of years to reduce tax burden. For example, things like kitchen appliances, flooring or furniture can be deducted gradually according to set schedules. An accountant can best advise on using depreciation correctly when filing.

Understanding Property and Land Taxes

Beyond federal income tax on rental proceeds, landlords need to be aware of other property taxes that may apply:

  • Property (Council) Rates

This annual local government tax pays for community services based on the property’s value and location.

  • Land Tax

An annual state tax on the ownership of land excluding residential land used as a primary residence. Rate is based on the land’s taxable value.

Determining responsibility for these taxes will depend on local practices and arrangements made in the lease. But they impact expenses that can be claimed or profit kept after rents are collected so are essential to account for.

Tracking Incomes and Expenses for Record Keeping

As mentioned, thorough record keeping is strongly advised for rental investors. The IRS requires all income and expenses to be supported by proper documentation for 3 years in case of an audit or inquiry. Failing to produce validation if questioned can lead to denied deductions or even penalties.

We recommend setting up a clear organization system to keep various documents like signed leases, invoices for improvements, maintenance logs, mortgage statements and insurance paperwork. Digital files stored securely in the cloud provide redundancy if originals are damaged. Keeping accurate current records also assists with cash flow analysis and making the right business decisions.

How Selling a Rental Property is Taxed

At some point, landlords may opt to sell their rental investment and it’s key to factor in tax implications at disposition. Though various techniques can help defer taxes, any gain from appreciated property value will ultimately be taxed.

When a rental is sold, capital gains tax applies based on the difference between net selling price and the adjusted cost basis, which is the property’s purchase price minus total depreciation deducted over the years. Investors held properties longer than one year benefit from lower long-term capital gains rates while short-term hold periods use regular income rates.

We always connect with our financial planner and accountant when considering selling rentals to project tax scenarios under different strategies like 1031 exchanges that can minimize current tax liability. Doing this assessment ahead of listing helps optimize decisions.

Passive Loss Rules for Rental Investing

Special “passive loss” rules also come into play with rental property taxes that limit deducting net losses in some cases. The IRS categorizes most real estate investing as passive activities, with losses only usable to offset taxes on other passive revenue like additional property rental proceeds. Exceptions exist for taxpayers meeting material participation standards.

The reason for this regulation is that the IRS wants to prevent those with significant wages or portfolio income from pursuing real estate just as an easy tax write-off. There are good arguments this disincentivizes affordable housing investment so updates around loss deductibility have been proposed.

But under current statutes, passive losses usually can’t reduce taxes on non-passive income from sources like salaries, dividends or interest. Though they can be carried forward to apply in future years when a property is sold or starts generating net income.

Using a Tax Professional for Rentals

Given the complex and evolving nature of taxes on investment properties, we highly recommend connecting with a tax professional. At minimum, an experienced accountant should prepare annual returns for those with rental income. Depending on the size of the portfolio, a financial advisor and legal counsel may also be prudent.

These experts stay continually updated on the newest regulations and case law that can impact filing obligations and strategies. They also provide personalized guidance for maximizing write-offs while remaining compliant based on individual investor circumstances.

We partner year-round with our dedicated financial team to navigate everything from record keeping to assessing audits to planning major transactions.. They’ve been invaluable resources for building our rental business.

Special Rules for Renting Part of a Primary Home

Some unique tax situations arise when renting part of personal residence like a basement suite. While supplemental income can be attractive, IRS rules around deducting expenses are stricter than investment properties. We recommend consulting a tax professional to ensure proper reporting in these cases.

But in general, careful tracking of days residence was rented along with allocating bills like utilities can allow a prorated portion of costs. It’s essential however to calculate percentages meticulously based on actual rental days compared to personal use. Improper deduction claims can trigger audits and penalties.

Key First-Time Landlord Tax Tips

If you are starting out as a new landlord, make sure to get up to speed on tax compliance from day one. It’s much easier than trying to recreate records down the road. Beyond keeping all income documents and expense invoices as outlined above, we have two other recommendations:

Determine Business Structure
Decide whether to own rentals under your personal SIN, jointly with a spouse or within a formal corporate structure. Each approach has different tax implications.

Learn Accounting Methods

Two options exist – the cash or accrual method. Cash basis is easier for small landlords, reporting income when received and expenses when paid. But accrual may provide more deductions.

Doing some foundational reading around investing structures and accounting methods will pay off in the long run. And work closely with an accountant from the start to stay compliant as your rental portfolio grows.

Key Takeaways – Taxes Are Part of Owning Rental Properties

While not the most exciting topic, managing taxes is a fundamental part of operating successful rental property investments. Staying organized with record keeping year-round and partnering with financial professionals is key to maximizing returns while avoiding any costly missteps.

Done right, thoughtful tax planning allows landlords to build significant wealth through real estate while retaining more rental proceeds for future opportunities. As always, the friendly and knowledgeable team at Empire 8 Property can answer any questions about rental investments to help investors thrive. Reach out us today!