With crypto and stocks dominating the news, there’s really only one investment that’s withstood the test of time. Even today, most millionaires agree that real estate is the best investment around.
When you think about it, it’s not too surprising. What other investment allows you the same level of control for only 15% to 20% down?
However, there are some gray areas with real estate that can cause confusion for new investors, especially at tax time. Hopefully, we can clear that up for you! Let’s talk about how to handle real estate income as a new investor.
What Type of Income Is Real Estate Income?
An investor’s net income from a rental property will likely be treated the same as dividends from stocks for tax purposes. In most cases, rental income is considered passive income, but not always.
Common exceptions would be if a real estate investor earns the majority of their income from rental properties, relies on real estate as a full-time living, or has employees. In this case, your real estate portfolio would be treated like a business. In the first case, small-scale investors would (currently) pay a 24% marginal tax rate on their rental investment income.
Let’s briefly discuss the difference between earned income and rental income. Earned income is income the taxpayer received from active participation. Common examples include W-2 jobs, self-employed side gigs, or sales commissions.
Therefore, if you are a landlord who actively manages your property, you would be categorized as a “small business owner” and be taxed on earned income. However, if you are an investor with a property manager, you will be considered an investor paying rental taxes.
How to Calculate Rental Income
Whether you’re a small-scale investor with a duplex or the owner of a large apartment complex with 15 staff, the calculations are basically the same; revenue minus expenses.
To determine your net income, you will need to develop a diligent tracking system to find where your money is coming in and where you spend it. For example, if you receive $20,000 total in rent for the year, you would then deduct the following real estate expenses with example prices:
- Mortgage interest (-$1000)
- Insurance (-$1000)
- Marketing (-$200)
- Maintenance and repairs (-$1,000)
- Management fees (-$1,600)
- Property taxes (-$2,000)
- Depreciation (-$4,000)
In this case, your expenses would add up to $10,800, which means your net income would be $9,200 from your rental property. This is the total amount you would pay taxes on. If it’s a 24% rate (federally), then you would owe $2,208 for the year. To play around with these numbers, use a rental property calculator to estimate what you will owe.
If you have a year where you struggle to find tenants or need to make a major repair like a roof replacement, it’s possible to find yourself in the negative. In this case, you can carry that loss forward to help offset future taxes! For example, if you have a $1,000 loss one year and a $2,208 gain the next, you may only owe taxes on $1,208.
How to Track Income & Expenses
Without a system for tracking your revenue and expenses throughout the year, you could wind up overpaying. Even worse, you could end up making a costly mistake on your taxes, which could potentially put you in legal trouble.
Tracking income is fairly straightforward. Your rent collection platform or checks will make it easy to do so. If you have additional income like coin-op laundry, late fees, processing fees, or anything else, then make sure you track these.
Everybody has their preferences for tracking expenses throughout the year, and it’s critical to choose yours. Automation is the easiest way to do this, but you can do whatever you want. There are plenty of apps that can help you easily sort through business and personal expenses.
Alternatively, you can use one specific account for real estate expenses. This way, you can keep all of your expenses on one statement, allowing your bank to do the tracking for you. However, this isn’t ideal for everyone.
Your other option would be to hire a professional property manager. They can take all of the work off your back, balance your budget, and ensure that you receive the maximum deductions at tax time. The best part is that they’ll only take a small portion of your rental income, typically below 10%.
What Doesn’t Count As Income or Deductions?
It’s just as important to know what doesn’t count at tax time. As we said, there are some gray areas that are unique to real estate. One obvious example is security deposits.
Security deposits are not inherently income. To remain compliant with the law, you will have to keep these in a separate savings account and return them to your tenants after they vacate your property.
If you use part or all of their security deposit for repairs, you can deduct these costs from your taxes and include the amount you kept as income. This should create a neutral effect on your taxes unless you pay out of pocket for more expenses. In which case, you will deduct these additional expenses.
Also, advance rent will count as income. If you charge for the first and last month’s rent upon moving in, you will owe taxes the following year for both.
Lastly, any amount of money you put into the building itself will be tax deductible. However, if you live in the building and upgrade your own shower or kitchen, this is considered a personal expense, which is not tax deductible.
Start Tracking Today
Now that you know how to track and file real estate income for your taxes, you can manage your budget without any issues this year. Being a first-time landlord is stressful, but with the right help, you can sit back and watch the checks come in without any worries!
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