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 the good news – there are proven ways to minimize your rental property tax burden completely legally.
You don’t have to accept overpaying a single penny!
With the right tax planning, you can leverage deductions to lower your taxable rental income and maximize your bottom line. In this post, you will learn how rental income is taxed and more importantly, how you can reduce your taxes.
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How Is Rental Income Taxed?
Rental income is taxed as passive income on your personal tax return. Your tax will depend on your total income and resulting tax rate on a federal and state level.
But what comprises rental income, exactly? Many real estate investors miscalculate their income and overpay on their taxes. So let’s closely examine what makes up rental income.
What is Rental Income?
Rental income equals your rental revenue receipts minus related rental expenses. To fully understand your rental income, you must understand your rental revenue and expenses.
Rental revenue is comprised of several sources, including:
- 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 would need to subtract your rental expenses.
What are Rental Expenses?
Rental expenses would consist of any ordinary and necessary expense incurred to operate your rental business. This includes:
- Legal fees
- Management fees
- Mortgage interest (excluding principal)
- Depreciation (more on this later)
A common mistake many real estate investors make is that they include their mortgage principal as an expense on their tax return. However, your mortgage principal payments are not a tax deductible expense. Only the interest expense is deductible.
To get an idea of your rental income, simply add up all of your rental revenue, subtract all rental expenses, and the result will be your rental income.
How To Avoid Taxes On Rental Income
Savvy real estate investors are able to accelerate their rental expenses to show a loss on their tax return. This allows them to:
- Avoid paying taxes on their rental income because they are showing a loss
- Use the real estate loss to offset other income on their tax return
And this strategy is 100% legal and by the book. The tax code explicitly facilitates it.
Many think if you make money on real estate, you automatically owe tax on those gains. But savvy investors use smart planning to create deductible losses out of profit-making properties.
With the right property and strategy, you can enjoy strong real estate returns AND lower your overall tax bill substantially. Understanding how rental income is taxed is key.
The tax code incentivizes real estate investment by allowing generous deductions like depreciation. This lets investors show losses while profiting – reducing taxes.
The primary mechanism to accomplish this is through real estate depreciation.
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
To fully utilize real estate tax benefits, you must first grasp the power of depreciation deductions.
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 deductions 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 rental income is $20,000 rent – $15,000 costs = $5,000.
Now, let’s add-in depreciation.
By default, lets 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.
(Even though in reality you profited $5,000 cash and increased equity through appreciation).
That’s the magic! The power of depreciation allows you to report less taxable income than the rental cash flow and appreciation you actually receive.
But it gets even better…
You can accelerate depreciation to maximize these losses even more quickly. Resulting in even greater tax savings.
Here is how it works
How To Accelerate Depreciation for Greater Tax Benefits
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 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:
Plus elements like:
- 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
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.
The ultra wealthy have used real estate tax strategies for years 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.