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Use our free Rental Property Returns Calculator to estimate your returns and cash flow. See how your returns change with financing, and most importantly see after-tax returns and cash flow.
READ MOREThe Rental Property Returns Calculator can be used to discover invaluable information about your potential rental property in an instant. This brief video walkthrough will show you just how easy the tool is to use and provide a brief overview of the information that will become
readily available at your fingertips.
Rental income is taxed as ordinary income. This means that if the marginal tax bracket you’re in is 22% and your rental income is $5,000, you’ll end up paying $1,100. Here's the math we used to calculate that tax payment: $5,000 x .22 = $1,100.
“Any payment you receive for the use or occupation of property,” is how the IRS defines rental income.
Here are additional types of rental income:
Rental property provides you with several potential income streams. You collect rent monthly; your property appreciates over time; you earn equity in your home, which you can use to get a low-interest loan; and you can sell your property. To avoid paying capital gains taxes, you can execute a 1031 exchange, which is when you use the profits from the sale of your property to buy a property of equal or greater value.
Before you invest in a rental property, consider whether you’re up to the demands of being a property manager. In addition to the physical labor required to be a property manager, there is also the time factor to consider. This could include time spent on tasks as diverse as making trips to the store to buy supplies to waiting for tenants to arrive for interviews. Emotional labor is also involved, since it can be stressful to interact with tenants, answer emergency calls, and deal with vacancies. Some of your responsibilities will include:
You can hire a property manager to handle all of these duties, but they earn 4% to 12% of the collected rent, which can be a lot if you only own one property. If you own multiple properties, however, a property manager is well worth the investment.
There are various ways to calculate a property’s value using rental income, but there are two quick and easy ways to estimate your potential income:
If you want to invest in real estate but don’t want to own any property, you can invest in Real Estate Investment Trusts (REITs). A REIT is a company that invests in a variety of real estate options. It can be traded privately, publicly like a stock, or be public but not traded. REITS are a great way to invest in real estate without getting fully invested in real estate. Owning REIT stock enables you to ostensibly own a portion of several properties.
Depreciation is a yearly tax deduction you take based on the cost and maintenance of your property. Land is not included in depreciation because its maintenance is considered inseparable from its ownership, so when you calculate depreciation you subtract the cost of land. Depreciation is calculated over what the IRS calls the “useful life” of your residential rental property, which is the amount of time the IRS believes that the cost of renting your property outweighs the cost of maintaining your property. For rental properties, the useful life is 27.5 years, while the useful life of commercial property is 39 years.
So, if your asset is valued at $300,000 and the cost of your land is $100,000, subtract the cost of the land and divide the remainder by 27.5. That’s your yearly depreciation deduction. The math for that looks like this: $300,000 – $100,000 ÷ 27.5 = $7,272.
In addition to depreciation, you have to keep depreciation recapture in mind as well. This is a tax applied to your depreciation deduction that you pay after you sell your property. The depreciation recapture tax rate is 25% and is applied to the total amount of the depreciation deductions you’ve made. In our above example, if depreciation is deducted over the entire course of the property’s useful life, the amount you would pay in depreciation recapture would be (27.5 X $7,272) x .25% = $50,000.
The depreciation recapture tax is applied even if you don’t take advantage of the depreciation deduction. That means if you decide not to deduct that $7,272 over the course of your property’s useful life after you sell your property, you’re still going to pay $50,000 in depreciation recapture taxes. So, it's critically important to take advantage of the depreciation deduction because you’ll be taxed as if you did.
There’s yet another tax break for rental property owners known as the Qualified Business Income (QBI) deduction, which lets you deduct upwards of 20% off your taxable rental income. The QBI has a threshold of $315,00 for married taxpayers and $157,000 for everyone else. If your income falls under the threshold, then you can take advantage of the full 20% deduction. Those who make more than the threshold can still get the deduction, but it’s a new and complicated deduction so you should consult a tax professional for guidance.
To get an idea of what your rental income might look like on your tax return, let’s do some math:
Let’s say you bought a property for $300,000. Your monthly rental income stream is $2,600, and you’re in the 22% marginal tax bracket. Here are your expenses:
Your expenses total $20,620, and you can deduct $8,182 in depreciation, given the cost of your property and the value of the land. Your taxable income calculation will appear as follows.
To keep the math simple, we’ll say you get to take the full 20% QBI deduction. So, that means your taxable income is ($2,398 – [$2,398 X 20%]) X 22% = ($2,398 – $479.60) X 22% = $1,918.40 X 22% = $422.05. So, that’s $422.05 you owe for the year. All that goes on Form 1040, Schedule E when you file your taxes.
To keep the math simple, we’ll say you get to take the full 20% QBI deduction. So, that means your taxable income is ($2,398 – [$2,398 X 20%]) X 22% = ($2,398 – $479.60) X 22% = $1,918.40 X 22% = $422.05. So, that’s $422.05 you owe for the year. All that goes on Form 1040, Schedule E when you file your taxes.
Financing: This is the amount of money lent to you by the bank expressed as a percentage of your property’s original value. The remaining amount is your down payment.
Amortization: (# of Years): This is when you divide a loan into a string of regular, consistent payment. The make-up for the payment, however, changes over time since a portion goes toward interest, and a different portion goes toward the principal. If you make an amortization table, you can see how much more principal and interest you have left to pay over time, which can be useful for making decisions ranging from budgeting to refinancing.
Interest Rate: Your interest rate is the fee the bank charges you for lending you money. It’s a percentage of your principal that you pay every month. The principal is the amount of the bank gives you.
Financed Return (ROI): Your ROI is the ratio of loss or gain relative to the size of your investment. It is usually expressed as a percentage.
Principal Paydown: The principal paydown is when you make payments only toward your principal. As you pay down more of your principal, you end up paying less interest since the less time it takes you to pay off your principal, the less interest you pay since interest is a percentage of your principal.
Net Cash Flow: This is the amount of income an operating business makes over a period of time.
Cash On Cash Return: This is the measure of your gross rental income stream relative to your mortgage payments for a particular year.
Your effective tax rate: This is the amount of taxes you pay on your taxable income. It is the average of all the tax brackets that your income is subjected to, combined with the deductions and credits that make your potentially taxable income less. Your effective tax rate applies only to your federal income taxes, so it excludes state and local taxes, for example. The alternative to your effective tax rate is your marginal tax rate, which is the highest bracket at which your income is taxed. The way you calculate your effective tax rate is by dividing your total income by your total taxable income. The result is expressed as a percentage.
Land Value as % of purchase price: This is a figure that’s important to know for several reasons. Land, for example, is excluded from depreciation, so you have to subtract the value of your land when you’re calculating your yearly depreciation deduction. There are many different ways to calculate the percentage of your purchase price that’s land, but a quick and dirty guestimate is that your land value is 20% of your purchase price
Net Operating Income (NOI): Your net operating income is all the money you make off your property after you’ve subtracted all the reasonable necessary operating expenses. Your NOI is a pre-tax figure. Some examples of operating expenses include insurance, legal fees, repair costs, etc. Your revenue may include more than just rent. Parking, vending machines, and laundry are other examples of ways in which your property can make you money.
Cap Rate: Your cap rate is your NOI divided by the current market value of your property. It provides you your return on investment as a percentage over the course of a single year (mortgages are excluded from the calculation). While this figure is useful, it shouldn’t be used independently of other metrics of evaluation because it’s not robust enough to provide a full picture of your property’s worth. The year you used to make your calculation, for example, could have been a particularly good year for you and, as a result, would provide an incomplete picture of your asset’s value. So, it can be useful to graph the cap rate over time.
Not all rental income is taxed. Property expenses are deductible against rental income. Some deductions you can make include:
Here’s an example of how your deductions might look if you collected $30,000 in rent:
Renting a room is just like renting an entire property. All the same rules apply, you just have to divide particular expenses between the part of your house you live in and the part you rent out, effectively treating your home as two separate properties. You can even deduct depreciation on the portion of your home you rent out.
To begin with, you have to rent your property for more than 14 days per year. Otherwise, you don’t need to report it. You do, however, have to report income and expenses if you rent your property for more than 14 days per year, or if you live in the house more than the greater of 14 days or more than 10% of the number of days you rent the property (20 days, for example, if you lease it for 200 days).
There’s no simple answer to this question because there are so many factors to consider. Your wealth, tax bracket, home cost, etc. will all impact what percentage of the closing cost that may or may not be tax-exempt. Additionally, you need to see which approach, taking a standard deduction or deducting your closing costs, will save you the most money.
The IRS lists the following costs as deductible:
The following are not deductible:
Consulting with a financial advisor will help you figure out how best to handle your mortgage closing.
The most crucial tax day is April 15, which is the due date for individual tax returns. Due to the Coronavirus pandemic in 2020, the filing date for individual taxes was extended to July 15. If you filed an extension, your taxes won't be due until October 15.
