How is Rental Income Taxed? And Tips To Reduce It

As a rental property owner, your hard-earned income is subject to taxes just like any other business. You pay taxes on rental profits each year, plus capital gains taxes when you eventually sell.

But here’s some good news – there are proven ways to minimize your tax burden. Rental real estate is widely known as one of the best tax shelters in the world. In fact, real estate is often used by the ultra wealthy to pay very little taxes.

In this post, you will learn how rental income is taxed and more importantly, how you can reduce your taxes.

How Is Rental Income Taxed?

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Rental income is taxed as passive income on your personal tax return. The amount of tax you pay on your rental income will depend on your individual tax rate.

To compute your tax, simply add your rental income to other income sources on your personal tax return. Then, taxes will be assessed on the total amount of income reported on your personal tax return, which includes your rental income.

As of 2024, the federal tax rates on individual income are broken down to the following rates:

Tax Rate	For Single Filers	For Married Individuals Filing Joint Returns	For Heads of Households
10%	$0 to $11,600	$0 to $23,200	$0 to $16,550
12%	$11,600 to $47,150	$23,200 to $94,300	$16,550 to $63,100
22%	$47,150 to $100,525	$94,300 to $201,050	$63,100 to $100,500
24%	$100,525 to $191,950	$201,050 to $383,900	$100,500 to $191,950
32%	$191,950 to $243,725	$383,900 to $487,450	$191,950 to $243,700
35%	$243,725 to $609,350	$487,450 to $731,200	$243,700 to $609,350
37%	$609,350 or more	$731,200 or more	$609,350 or more

Example: An individual who is already in the 24% tax bracket, before adding rental income, should expect to pay at least 24% in federal taxes on their rental income.

What is Rental Income?

Rental income includes all payments received for the use of property you own. This includes any:

• Monthly Rent Payments
• Advance Rent Payments
• Rental Paid In Property or Services
• Lease Cancellation Fees
• Expenses Paid By Tenants
• Security Deposits That Are Not Returned

To calculate your rental income, you would first tally up the total amount of the above payments and related payments.

Then, you should tally-up any qualified rental expenses you’ve incurred. These are expenses that can be claimed as tax deductions to reduce your reported rental income (and your taxes).

What are Rental Expenses?

Rental expenses would consist of any ordinary and necessary expense incurred to operate your rental business. This includes:

• Advertising
• Insurance
• Legal fees
• Management fees
• Mortgage interest (excluding principal)
• Repairs
• Supplies
• Taxes
• Utilities
• Depreciation (more on this later)

A common mistake many real estate investors make is that they fail to claim all available tax deductions to reduce their rental income. By failing to maximize tax deductions, you risk overpaying taxes.

To prevent this, it is recommended to implement a bookkeeping system to keep track of all rental income and expenses.

How To Avoid Taxes On Rental Income

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Savvy real estate investors are able to accelerate rental tax deductions to reduce their taxes. In fact, it is very common for taxpayers to report losses on their tax return as a result of taking more tax deductions. This allows them to:

1. Avoid paying taxes on their rental income because they are showing a loss
2. Use the real estate loss to offset other income on their tax return

Both practices are 100% legal according to the tax code. In fact, it is believed that Donald Trump avoided taxes for several years by reporting rental and business losses on his tax return.

The tax code incentivizes real estate investment by allowing generous deductions like depreciation. Real estate depreciation is the primary mechanism used by real estate investors to reduce taxes.

And you will learn that there are several ways to take depreciation – some allowing for greater tax savings than others. Let’s dig deeper into this concept.

How Depreciation Can Reduce Real Estate Taxes

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Depreciation is the cornerstone allowing investors to show tax losses while profiting overall.

What is it exactly?

The IRS defines depreciation as deducting a property’s cost over time as it deteriorates. This occurs annually.

But here’s a better definition:

Depreciation is a non-cash expense that can be deducted from your rental income.

This is the “magic” that unlocks major tax savings. Depreciation provides a tax deduction without any actual cash outflows needed from you as the investor.

You can deduct thousands in depreciation costs every year that exist purely on paper. This can significantly reduce your taxable rental income.

A Simple Example of How Depreciation Works

Let’s say you purchase a rental property for $300,000 that earns $20,000 annual income, with $15,000 in operational expenses.

Without depreciation, your net rental income is $20,000 rent – $15,000 costs = $5,000.

Now, let’s account for depreciation.

By default, let’s say the IRS says this property has a 27.5 year useful life. This means that you can deduct $10,900 as a depreciation expense ($300K purchase price / 27.5 years = $10,900).

Now all of sudden, you have a taxable loss.

This $10,900 depreciation deduction reduces your net profit from $5,000 down to a $5,900 loss on paper.

From a cash perspective, you earned $5,000 cash. But from a tax perspective, you report a $5,900 rental loss. All thanks to depreciation.

Depreciation allows you to report less taxable income than the rental cash flow and appreciation you actually receive.

But this is just the beginning. It gets even better…

The tax law allows real estate investors to take extremely large amounts of depreciation if they choose to. Taxpayers have the option to increase the rate of depreciation they take in a given tax year, resulting in even greater tax savings.

This is how it works.

How To Accelerate Depreciation for Greater Tax Benefits

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By default, the IRS lets you deduct a property’s value over its “useful life” – 27.5 years for residential rentals or 39 years for commercial.

This is “standard” depreciation.

However, the tax law also allows you to accelerate the rate of depreciation you take. Essentially, you can take a greater amount of depreciation expense in earlier years.

And the most common way real estate investors accelerate their rate of depreciation is through the use of cost segregation.

How Cost Segregation Turbocharges Depreciation Deductions

To accelerate depreciation, a cost segregation study will identify components of your property with shorter useful lives than the overall structure.

By identifying components with shorter-useful lives, you are able to take more depreciation expense over a shorter period of time.

For example, let’s say…

Your property has new floors worth $27,500. Floors must be depreciated over 5 years.

Without cost segregation, you’d deduct $1,000 yearly over 27.5 years.

With cost segregation, you’d deduct $5,500 yearly over 5 years on the floors alone.

Cost Segregation Identifies All Components With Faster Depreciation Schedules

A proper cost segregation study will analyze the entire property to identify every component with a shorter useful life than the structure overall.

This includes systems like:

• Electrical
• Plumbing
• HVAC

Plus elements like:

• Appliances
• Cabinets
• Countertops
• Ceiling fans

And much more. Anything with a lifespan under 27.5 years for residential or 39 for commercial is accelerated.

Additional Real Estate Tax Strategies

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Cost segregation is an excellent example of how to accelerate your property’s rate of depreciation to decrease your rental income.

However, this is just one way to avoid tax on your rental income.

Once your cost segregation study has identified components with shorter useful lives, you may be able to increase your deductions even more with Section 179 depreciation and Bonus Depreciation.

Both of these depreciation provisions provide additional tax benefits to increase your rental tax savings. Be sure to subscribe to our blog to learn more about these tax strategies.

Conclusion

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The ultra wealthy have used real estate tax strategies for decades to build wealth while minimizing taxes. Now you can too.

By mastering just a few key concepts like depreciation, your properties can be used as tax shelters that help you keep more of your hard earned money.

Small tweaks allow showing losses on paper while you profit handsomely in reality. Drastically reducing income tax obligations.

If you own rental real estate and you want to reduce your taxes immediately, apply to become a client today.

You may want to consult a tax advisor to evaluate how these concepts could potentially apply to your specific situation. Custom plans save clients thousands annually.

The tax code favors real estate investors. But only if you utilize the intricacies fully. Now you have the education to tap into these savings yourself.