What’s the tax bite when you own—or sell—a rental property?
Jean Folger has 15+ years of experience as a financial writer covering real estate, investing, active trading, the economy, and retirement planning. She is the co-founder of PowerZone Trading, a company that has provided programming, consulting, and strategy development services to active traders and investors since 2004.
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Whether you already own a rental property or are thinking about buying your first investment, it’s essential to understand how real estate taxes work. After all, taxes can mean the difference between earning a profit and losing money on a rental property. In general, rental property owners need to be aware of two sets of taxes: those that relate to their rental income and those that relate to the eventual sale of their property.
Rental income is taxed as ordinary income according to your Internal Revenue Service (IRS) tax bracket. Here’s a look at the 2023 tax brackets for single filers, married couples filing jointly, and heads of households:
| 2023 Tax Brackets | |||
|---|---|---|---|
| 2023 Tax Rate | Single Filers | Married Filing Jointly | Heads of Households |
| 10% | $0 to $11,000 | $0 to $22,000 | $0 to $15,700 |
| 12% | $11,000 to $44,725 | $22,000 to $89,450 | $15,700 to $59,850 |
| 22% | $44,725 to $95,375 | $89,450 to $190,750 | $59,850 to $95,350 |
| 24% | $95,375 to $182,100 | $190,750 to $364,200 | $95,350 to $182,100 |
| 32% | $182,100 to $231,250 | $364,200 to $462,500 | $182,100 to $231,250 |
| 35% | $231,250 to $578,125 | $462,500 to $693,750 | $231,250 to $578,100 |
| 37% | More than $578,125 | More than $693,750 | More than $578,100 |
For example, if you have $10,000 in rental income and you’re in the 22% tax bracket, you will owe $2,200 in taxes on that rental income.
The IRS describes rental income as “any payment you receive for the use or occupation of the property” and in addition to regular rent payments, rental income includes:
While rental income is taxed as ordinary income, you can reduce that income and lower your tax bill by deducting allowable expenses. As a rental property owner, you can generally deduct your expenses for managing and maintaining the property, including payments that you make related to the property for:
These deductions are generally taken in the same year when you spend the money. You can also deduct the cost of buying and improving your rental property, but that works differently. Instead of claiming one big deduction all at once, you recover these costs over time through depreciation.
Depreciation is one of the biggest tax perks that rental property owners get. It allows you to deduct the costs of buying and improving a rental over its useful life, lowering your taxable income in the process.
Residential rental property placed in service after 1986 is depreciated using the modified accelerated cost recovery system (MACRS). This accounting method spreads costs over 27.5 years—the length of time considered the “useful life” of a residential rental property by the IRS. Commercial properties are depreciated over 39 years.
Not surprisingly, the IRS has specific rules regarding depreciation. You can depreciate a rental property only if all of the following statements are true:
You can’t depreciate a rental property if you placed it in service and disposed of it (or no longer used it for business) in the same year.
Land is not depreciable because it never gets “used up.” Similarly, you can’t depreciate the costs of clearing, planting, and landscaping, as these costs are tied to the land, not to buildings.
Determining how much to depreciate each year isn’t as easy as dividing your purchase price by 27.5. Instead, there are a few basic steps to follow:
Section 199A of the Internal Revenue Code (IRC) provides another tax break called the QBI deduction, which allows pass-through entities to reduce their qualified business income (QBI). While there are income thresholds, eligible taxpayers can deduct up to 20% of their pass-through business income—including rental income from an investment property. However, keep in mind that QBI only qualifies if you are actively managing your property.
The tax benefits to which you’re entitled depend on how many days the property is rented out each year and how much time you spend in the home. Here are the three main categories:
When you sell a rental property, you may be liable for two types of taxes: capital gains and depreciation recapture.
If you hold a property for more than a year, any profits from the sale are taxed at the long-term capital gains rate. Here’s a look at the capital gains tax brackets for 2023:
| Capital Gains Tax Brackets for 2023 | |||
|---|---|---|---|
| Rate | Single Filers | Married Filing Jointly | Heads of Households |
| 0% | $0 to $44,625 | $0 to $89,250 | $0 to $59,750 |
| 15% | $44,625 to $492,300 | $89,250 to $553,850 | $59,750 to $523,050 |
| 20% | Over $492,300 | Over $553,850 | Over $523,050 |
Higher-income taxpayers may owe an extra 3.8% net investment income tax.
Conversely, if you sell after owning for less than a year, the profit is a short-term capital gain, taxed as ordinary income at your marginal tax rate.
When you sell your rental property, the IRS will remember the depreciation deductions you took and it will want some of that money back. This is known as depreciation recapture, and it can come as a financial shock to unprepared property owners.
Depreciation recapture applies to the portion of the gain attributable to the depreciation deductions you have already taken. If you depreciated $6,000 a year for 10 years, you would owe depreciation recapture tax on $60,000 when you sell.
If you think you can avoid the depreciation recapture tax by not depreciating your rental property, think again. The IRS calculates depreciation recapture based on what you should have depreciated whether or not you did.
The tax is based on your ordinary income tax rate and is capped at 25%. You report it on Form 4797, Sales of Business Property.
A 1031 exchange lets you swap one investment property for another, deferring capital gains and depreciation recapture taxes in the process. The properties being exchanged must be “like-kind,” though that doesn’t mean the properties need to be identical. Instead, properties are like-kind “if they’re of the same nature or character, even if they differ in grade or quality,” according to the IRS. In general, real properties are considered like-kind whether they’re improved or unimproved.
If you own rental property, you can take advantage of several deductions to offset rental income and lower taxes. Broadly, you can deduct qualified rental expenses (e.g., mortgage interest, property taxes, interest, and utilities), operating expenses, repair costs, and depreciation. You also may be able to deduct an additional 20% of your qualified business income (QBI).
You report rental property income and expenses on Form 1040, U.S. Individual Income Tax Return, or Form 1040-SR, U.S. Tax Return for Seniors, and on Schedule E (Form 1040), Supplemental Income and Loss.
Real estate rentals are a popular way for investors to tap into the real estate market. As a rental property owner, you have the potential to earn money by collecting rent and through appreciation. While you will owe taxes on the income that your rental property generates, you can reduce your income—and thus your tax burden—by claiming various deductions.
Taxes can have a significant impact on your bottom line. It’s a good idea to work with a qualified tax specialist who can help ensure that you understand the rules—and that you apply them in the most favorable way possible for your situation.