Determining the tax rate for rental income is far more complex than that of personal income. Many factors specific to the landlord and how the rental property is set up play roles in determining the property’s income tax rate. In this article, we’ll go through the components that help determine the tax rate for rental property.
Rental property income can come from several sources, including rents, laundry machines, parking, and storage.
Before we get into determining the tax rate for rental properties, we need to figure out the taxable income. A rental property is a business. And like most businesses, it has business deductions. These deductions reduce net income.
Rental property expenses can be broken into different categories, which include operating expenses, loan interest, and depreciation. Operating expenses are costs incurred from managing the business. These are day-to-day expenses and include:
Once operating expenses have been deducted from rental income, you end up with net operating income or NOI.
Next are deductions for interest payments and depreciation:
Subtracting the above from NOI gives us net income.
The following is an example of the above calculations for one year of operations:
Rental property income: $50,000
Operating expenses: -$25,000
NOI: $25,000
Mortgage Interest: -$2,500
Depreciation: -$12,000
Net Income: $10,500
The taxable income for this property is $10,500.
This list of expenses is not exhaustive and doesn’t include capital expenditures. Note that depreciation is not a cash flow expense. No cash leaves the bank to pay for the annual depreciation expense.
Now that we know how rental property net income is calculated, we can discuss its tax rate, which will determine taxes owed.
Rental property income doesn’t have any special tax treatment. It is taxed as regular income. The landlord’s marginal tax rate determines the rental property’s tax rate. So, the actual rental income tax rate will vary from landlord to landlord.
Some rental properties don’t show any income during the year. This is mostly due to depreciation. When the depreciation expense (plus any loan interest and amortization) is larger than or equal to NOI, the business doesn’t show any profit. When there is no profit, there isn’t anything to tax, and taxes are not owed. The landlord might even be able to offset other income using the loss from their rental property.
Rental income can be classified as earned or passive income. Earned income means payroll taxes must be paid. These include withholding and paying federal, state, and local income tax and FICA. Earned income is incurred when the taxpayer actively participates in income generation.
Most rental property income is considered passive income. Passive income means payroll taxes are not involved. However, federal and state taxes must still be paid.
Some rental properties may qualify for qualified business income or QBI. This generally does not apply to passive rental property income.
Determining the actual tax rate of a rental property is an involved process. There are many specific factors that determine the actual tax rate. It’s best to work with your tax specialist when calculating the tax rate for a rental property.