Hi! First off, please forgive me for my level of tax ignorance. My friend asked me this question who is looking to get into REI and I honestly could not answer it. That's what BP is for :-).
If I am grossing $2,000 in rental income on a property and netting $500/month, what taxes am I paying? I know this is probably basic tax knowledge, but still trying to learn more.
I'm new to REI, and can't really answer your question (I think too many variables come into play to give even a ballpark answer, including what tax bracket you are in, what your expenses are, how much you can write off for depreciation, etc.), but on the recommendation of a fellow investor, I read John Reed's book on Aggressive Tax Avoidance for Real Estate Investors, and it has a ton of good information on this. He really gives some great strategies for ensuring that you are paying the least amount of taxes possible (while staying legal, of course). Hope that might help!
Unfortunately there is no way to answer that question since we are missing so many variables. Here is an article I wrote on how to figure out your taxes hope this helps.
Rental Income Calculate in One Simple Equation
Author’s Note: I highly recommend a CPA. Let me say it again! I HIGHLY recommend a CPA. Even with my background I hire a CPA to do my taxes. Therefore this article in particular or ANY article found on this site can’t be a substitution for a professional. That being said, I am a HUGE believer in knowledge is power.
The goal of this article is to provide the “simplified” version to explain how a rental effects your taxes . I have seen a ton of questions so I wrote this article to provide the 411! Hope it helps.
One last time: Get a CPA! I can’t recommend it enough!
Your Rental is recorded on Schedule E. As a homeowner your house is listed on Schedule A. Therefore when you turn your primary residence it will go from Schedule A to Schedule E.
The basic equation to calculate your Rental Income is as follows:
Rental Income – Mortgage Interest- Property Tax – Homeowners Insurance – Repairs – Depreciated Repairs- other expenses – depreciation= Income
The Income is what you actually pay tax on. Depending on your individual tax situation determines if you can take the negative income!
The Equation Explained
Rental Income – This is all the income you brought in such as Rent, Break Lease Free, Pet Fee, Application Fee or any other “fee” or income.
Important Note- All 3 of the next equation “parts” plus the “principle” can be found on your mortgage statement. These are usually lumped into one “payment” that you pay every month
Principle– While this is not needed or included in this equation it is still very important part to understand. This is the part of your mortgage that is paying off your balance. In the eyes of the IRS this is income, and is considered the same way as “cash” put in your pocket each month from the difference.
Mortgage Interest– This is the interest that you are paying to the bank every month for the ability to “borrow” their money. This is going to be “higher” in the earlier years of your loan and lower in the later years. The bank “stack” it so that your mortgage interest is “front heavy” with the consumer paying the most in the beginning.
Property Tax– This is the amount of “tax” that you pay for owning your home.
Homeowners Insurance– This is what you pay to insure your home every year. This also includes the separate flood coverage to cover water damage. (Flood is separate from homeowner’s insurance).
*Repairs and Improvements – Any upgrades or repairs made to the home can also be deducted. That being said, depending on how they are classified, is what signifies whether you are allowed to take the entire cost off over one year or if it must be over multiple years. A great table in the IRS publication 527 can be found herefollow for reference.
*Other Expenses- This is going to be your travel costs to the house, HOA and any other expenses.
Depreciation- This is my favorite expense. You get to “depreciate” the structure. That means that you get to depreciate the house (not land! very important) and divide the value by 27.5 years. That amount you are able to take off your taxes.
Your end number from the equation is the amount that you earned! As you can see it is a very little number and often times a negative.
Very often one can have a “book” loss (the loss due to depreciation ) but still experience a “cash flow” positive home. That is my favorite! It means I am making money and LEGALLY not paying tax on it.
Again this is the very simplified version. I HIGHLY recommend you use a CPA (have I said it enough yet?) simply because they are the experts in the field. I personally have made up the “cost” of my CPA 100 times over!
The answer depends on the amount of taxable income received from the rental. In your example, there is $500 monthly cash flow, but the amount of taxable income could be more, or, less than $500, even $0 or negative. Any taxable rental income is taxed at the same rate as other ordinary income. If your friend is in the 25% marginal tax bracket, then his net taxable rental income will also be taxed at 25%.
The short answer, and the only one you can give your friend, is that you are not a tax professional and your friend should seek advice from a licensed professional.
This is one thing I don't understand because what I have read is buy rental property because it is taxed at passive income instead of ordinary income, but from what I've seen @Dave Toelkes is right how much you claim as income is just added to your other income?
@Allen Denham taxable income will be subject to ordinary rates. There is no such thing as "passive" rates unless you are talking about long-term capital gain rates.
That said, the key question is: how much taxable income will I show for the year? Real estate investing allows for endless strategies to minimize taxable income. I'd suggest connecting with a real estate savvy CPA for help. Could be well worth the expense.
@Elizabeth Colegrove, thanks for the post!
Thanks for mapping it out like that. Side note, I grew up in Green on portage lakes. Small world.
As for real estate savvy CPA, I wonder how much of a difference a non real estate savvy CPA is vs one who is. My aunt is my CPA, but I'm not sure how much other real estate work she does.
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