How Federal Income Tax on Rental Properties Works

How Federal Income Tax on Rental Properties Works

Taxes can be a confusing ordeal under the best of circumstances, but they are especially confusing when it comes to accounting for rental properties.

Many first-time landlords often overlook the depreciation write-down, which can yield "taxable losses" to be deducted from their annual income on their return. What this means it that, In many cases, having a rental property with income can actually be a tax benefit.

Here are some of the basics, courtesy of Zillow, to help understand rental properties and federal income taxes. Keep in mind that we are not tax professionals - neither accountants nor tax attorneys, and you should rely on those folks for decisions that impact your financial situation. We're just trying to whet your appetite!

How to Determine if an Investment Makes Sense for You

In order to first decide if owning a real estate investment property will make sense for you, consider these factors with a CPA, attorney, or licensed tax professional, based on the conditions of your property in question:

It is important for all of these factors to make sense; once you have a handle on costs and risks, you can then (and only then) begin to contemplate the tax effects of your rental property. 

The IRS 1040 Form

The IRS 1040 form, the tax form that you fill out every year every year as a landlord, has two functions:

  1. First, it calculates the amount of federal income taxes that you owe for the year.  This is based on all avenues of "earnings" you have (salary, income, wages, profits, distributions), minus all of the deductions to those totals (losses, deductions, exemptions).  This yields your taxable income on Line 43.  Reference this number against your tax filing status (Single, Married, Filing Jointly, etc.) for your final Taxable Income amount.
  2. Second, it registers the amount you owe from #1 against the amount you have already paid during the year (typically, withholdings from salary or, for those who are self-employed, the estimated income tax amounts that you've already paid quarterly to the IRS during the year).

If you paid more in #2 than #1, you'll get a refund.
If you paid less in #2 than #1, you'll need to pay the IRS money.

Taxes on Rental Properties

Rental properties often yield taxable losses for many years of the property, even though they could have positive cash flow, due to the depreciation write-down that we discussed earlier. This falls under the "deduction" category from #1 above, and will lower your income taxes.

“Rental real estate allows the property to be depreciated over its useful life – allowing the landlord to take a deduction against its rental income and helping save real tax dollars," explains Adam M. Levine, CPA, CFP®.

 

This chart from Zillow illustrates how a loss would be calculated. The loss, $7,500, goes into your IRS 1040 form and will reduce your taxes.

In this situation, you would save money on taxes by owning a rental property. How MUCH this deduction will reduce your income taxes specifically depends on your income level and your filing status, as well as other IRS limitations.

The Variables of Income Taxes

Making real estate investment decisions based on tax considerations alone isn't a wise decision, as there are many factors which influence your cash flow and investments. As this information is situational, we recommend you walk through this process with a licensed professional - like a CPA, attorney or licensed tax professional - to help get a grasp on your individual tax picture.

Need help? Have a question about property ownership in Chicago? Don't hesitate to send Real Group an email or give us a call! Our experienced team is here and always happy to help!

Adam Levine Headshot     

 Our thanks to Adam Levine for his input on this post!

 Adam has been with ORBA since 2005 and is a member of the firm's Real Estate and Wealth Management Groups. He has spent his career  serving individuals, partnerships and privately-held corporations. In addition to accounting and auditing services, Adam provides tax planning,  business consulting, financial planning, and tax compliance consulting. 

Real Group Real Estate

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