How To Determine The Tax Rate On Rental Income

Ah, taxes… nobody likes them and yet everyone pays them. I think Ben Franklin said it best after signing the Constitution.

Nothing can be said to be certain, except death and taxes.

Ben Franklin

The funny thing about real estate is that the tax handling can work in your favor. This is due to the magic of depreciation which we will discuss later.

But first, let’s take a look at how rental income is taxed, and how to determine the tax rate.

Income from rental properties is taxed as ordinary income, and the tax rate is determined by the marginal tax rate of the owner. For example, if the rental property produced $10,000 of income and the owner is in the 24% tax bracket based on their other income, the federal tax on the rental property would be $2,400. In this case, the tax rate of the rental income is 24% — the same as the marginal tax rate.

That example seems simple enough, but the calculation for the tax rate is a little more complex. Let’s dig a little deeper.

What Are Tax Rates and Marginal Tax Rates?

In the simplest terms, a tax rate is the ratio of tax liability to the net income from the operation of a business (or income from wages).

Let’s say, for example, you make $100,000 and the IRS determines you own $20,000 in tax on this income. Your personal tax rate is $20,000 divided by $100,000, or 20%.

The marginal tax rate, on the other hand, determines how much tax you owe on the next dollar of income you earn. The IRS uses a progressive system of marginal tax rates, so the more income you make, the higher the tax rate you pay on the next dollar you make.

Using this same example of making $100,000, and assuming you are a single filer, the IRS specifies your marginal tax rate is 24%. This means that you owe 24 cents for every extra dollar you make.

Assuming you have a job or other source of income, you should be primarily concerned with your marginal tax rate when calculating your tax liability from your rental property. This is because the income from your rental property is in addition to your other income.

How Is Rental Income Taxed?

The general philosophy behind the taxation of rental income is that the rental property is a business and the owner of the business incurs taxes on the profits generated from the operation of the business.

That seems pretty straightforward, and for the most part, it is. You just add up the income, subtract the expenses, and you’re left with the taxable income.

Where it gets more complicated is determining whether an expense can be deducted immediately or if it must be depreciated over time. An accountant who specializes in real estate can save you a lot of headaches with the IRS by properly categorizing these expenses.

Once your accountant has crunched the numbers and prepared the financial statements for the rental property, you are left with your taxable income (recall that this is simply the rental income minus expenses). This is the net income that you must pay taxes on.

How much tax? That depends on all of your other income and your marital status. Depending on these factors, you have a marginal tax rate of 10%, 12%, 22%, 24%, 32%, 35%, or 37%. Nerdwallet has a good breakdown of each of these brackets.

After you have determined your marginal tax rate, you multiply it with your taxable income from the rental property. For instance, $5,000 of taxable income at a marginal tax rate of 32% has a federal tax liability of $1,600.

Calculating the tax rate in this example is trivial because all of the rental income is taxed at the same marginal rate. In some cases, however, the net income from the rental property may push your adjusted gross income into the next marginal tax bracket.

If that’s the case, then your tax liability (and rate) will be calculated on a portion of your income in one bracket, and the remainder in another. For example, if you made the same $5,000, but your other income totalled $1,000 below the 35% threshold, then your tax liability would be $1,720 ($1,000 * 0.32 + $4,000 * 0.35).

Rental Income and Expenses

You need to account for all sources of income and expenses when determining your tax liability from your rental property. Most of this is pretty straightforward, but there are some more complicated situations (particularly dealing with capital expenditures). An accountant can help you navigate your specific situation.

Here is a list of common rental income sources and expenses. Check out our full list of rental property expenses.

Income

• Rents Collected
• Rental Fees (storage fees, parking fees, pet fees, late fees, etc)
• Utility Buybacks

Expenses

• Property Management Fees
• Insurance
• Utilities you pay (electricity, gas, internet, garbage, etc)
• Landscaping and Grounds Maintenance
• Repairs
• Property Taxes

To calculate the tax rate on your rental property, you will need to first calculate the Net Operating Income. This includes all of the operating income and expenses but does not include capital expenditures, mortgage payments, or depreciation.

How To Calculate Rental Income Tax Rate

Calculating the tax rate on your rental income is relatively straightforward. The most complex parts of this process are determining your tax liability from other sources and calculating the net operating income from your rental property. You may want to enlist the help of an accountant with both of these tasks. Let’s dive into the process.

Note that if all of your taxable rental income in step #4 falls into a single tax bracket, then the tax rate on your rental income is simply the marginal tax rate of that bracket. For instance, if all of your income falls in the 24% tax bracket, then the tax rate on your rental income is 24%.

The Magic of Depreciation

In step #2 above, you subtracted depreciation from your net operating income. For many rental property owners, this is a large deduction and, along with the mortgage interest deduction, can offset the entirety of your net operating income.

What does this mean?

It means that the profits from your rental property may not be subject to any taxes at all. What is even better is these deductions can reduce your taxable rental income below zero.

When this happens, you get to deduct your taxable rental income from your adjusted gross income. This is a huge benefit to rental property owners because it reduces your tax liability at your marginal tax rate. This is one of the primary reasons people invest in rental properties — they can be used to lower your tax liability from other income sources.

Conclusion

In most cases, the tax rate on rental income is simply the marginal tax rate of the property owner. This is true except when the other income of the property owner is close enough to bump them into a higher tax bracket. Even in that case, however, the process is simple to follow.