Is there anything special about owning a rental property in California when it comes to taxation? After all, California is a high tax state and seems to have gotchas around every corner for business owners. There are, in fact, certain scenarios where California’s rental income taxation can be quite different from that of other states.
Taxation of Rental Income
Let’s start with some basics of how rental income is taxed. This explanation applies to most states since it is based on IRS rules (i.e., federal rather than state).
Listed below is a rental property income statement template.
Income:
Rent
Allowable deductions:
Maintenance
Mortgage interest
Property management
Insurance
HOA dues
Property taxes
Utilities
Professional services
Depreciation
= Net profit (or loss)
Net profit is the amount that will be taxed. As you can see, there are a lot of deductions/expenses allowed for rental property owners.
Some other considerations can affect income, such as:
- Advanced payments of rent
- Security deposits that are kept after a tenant moves out
- Expenses paid by a tenant if they are not obligated to pay them
- Barter arrangement — services from a tenant in exchange for rent payments
Depreciation is a non-cash expense that doesn’t affect cash flow. It shows up when annual income taxes are filed. For many rental property owners, it is a significant deduction. It can even create a loss for the business, even when the business may have actually added money to its bank account.
When filing taxes, rental income is reported on Form 1040 Schedule E.
California Rental Income
Does California tax rental income differently? For a regular rental property, there is no difference in how California taxes business owners. Income is still taxed at the owner’s ordinary income tax rate.
However, short-term rental property owners must meet specific restrictions to use rental property deductions.
California Short-Term Rental Income Taxation
In California, a short-term rental (STR) is defined by “California Senate Bill No. 60, Chapter, 307” as a residential dwelling, or any portion of a residential dwelling, that is rented to a person or persons for 30 consecutive days or less.
Why is this significant? STRs must collect a Transient Occupancy Tax (TOT) under certain conditions. This tax is charged to the guest, but the property owner must collect it and pay the tax to the local (county) authorities. The tax can vary by county.
STR taxation/rules can vary by city. Here’s a link to San Francisco’s STR document. You can find similar documents for other large cities in California.
Those renting their property for 14 days or less may be able to claim rental income as income tax-free. Keep in mind that you won’t be able to utilize rental property deductions under this scenario.
California Property Taxes
As mentioned above, property taxes are one of the deductions allowed by rental property owners. In California, property taxes are structured under Prop 13. The following is a summary of Prop 13:
- 1% of value of property yearly. This is applied against the original purchase price.
- Up to 2% increase per year. You’ll notice this is not inflation-adjusted, so your taxes will increase less than inflation, assuming inflation is over 2%.
Taxation is a complex topic because it is unique to the individual. Given the various rules and tax scenarios for California rental property owners, it’s best to work with a tax professional to figure out which ones apply to your situation.
Examples shown are hypothetical and for illustrative purposes only.
