How Can I Avoid Paying Tax on Rental Income?

Investing in rental property can be an excellent way to generate consistent income on the side, but dealing with tax on rental income can be hard to understand.

If you receive a significant amount of rental income each year, you may be asking; how can I avoid paying so much in taxes on my rental income?

Fortunately, tax strategies for rental properties can help you avoid paying exorbitant taxes. Keep reading to learn everything you need to know about tax on rental income.

Is my rental income taxable?

Rental income is any income you receive for the use of your rental property, but that doesn’t mean rental income is always taxable. In some cases, you may not have to pay taxes on your rental income depending on how many days you rent your home.

Let’s say you have a vacation home that you rent out for 10 days throughout the year. Because you rented your home for 14 days or less in the calendar year, your rental income isn’t considered taxable. This also means you can’t deduct rental expenses.

This is commonly referred to as “The Augusta Rule” which allows business owners to rent out their homes (or vacation homes) for at least 14 days per year and not report rental income as long as the amount charged is reasonable according to current market rates.

If you rent your home out for more than 14 days, your rental income is considered taxable and you may owe taxes at the end of the year. However, the amount you owe depends on whether the IRS classifies your home as a personal residence or rental  property.

How your property is classified will determine what tax deductions you’re eligible for.  If the residence is rented for 15 days or more and is used for personal purposes for not more than fourteen days or 10% of the days rented, whichever is greater, the residence is treated as a rental property. 

Expenses are allocated between rental and personal use days and may exceed rental income. Passive loss limitations may apply to any rental loss.

If the residence is rented for 15 days or more and is used for personal purposes for more than fourteen days or 10% of the days rented, whichever is greater, rental expenses are allowed to be deducted to the extent of rental income and allocated in steps.  

How to avoid paying rental income tax

Whether you have Airbnb income or full-time rental income, there are strategies you can use to lower your tax bill. 

Write-off rental property expenses

Whether your property is considered a personal residence or a rental property, writing off rental expenses is one of the best tax tips for landlords. While owning a home offers certain itemized deductions you can claim, there are several unique deductions you can claim when your property is a rental property.

You can start by deducting certain maintenance and repair costs, including landscaping, air conditioning, minor plumbing repairs, insulation, and interior upgrades. If you pay for certain utilities, you can also deduct those utility costs.

Landlords can also deduct some rental expenses you might not consider, including legal and professional fees and insurance premiums. You can even deduct the cost of travel to show your property when you’re trying to find a tenant, collect rent, or maintain your property throughout the year.

Deduct mortgage interest

When you take out a mortgage to purchase rental property, each mortgage payment goes toward the principal loan amount and interest. You can deduct the interest portion of your mortgage payment on your tax return.

At the end of the year, your mortgage company will send you a 1098 Form, Mortgage Interest Statement. This form is used to report the total amount you have paid during the year in mortgage interest. This amount is deductible as part of your rental expenses.  

If you impound your taxes (pay your property taxes as part of your mortgage payments), your 1098 Form will also list the amount you have paid during the year in property taxes. This amount is also deductible.

Write off eligible repairs

The IRS allows landlords to write off eligible repairs made to rental properties. Repairs are either considered improvements to the property or maintenance. How the expense is classified will determine what type of deduction you are entitled to.

If you invest in repairs to return something to its original condition, that’s considered maintenance. You can deduct the full amount of these repair costs in the year in which they were incurred.

Examples of maintenance costs include:

• Patching a hole in the wall
• Fixing a leaking faucet
• Replacing a broken window

Improvements are upgrades that increase the value of your home. You can still write off improvements, but they must be depreciated using the Modified Accelerated Cost Recovery System (MACRS). Examples of improvements include:

• Upgrading kitchen appliances
• Adding a deck or patio
• Remodeling a bathroom

If you’re a first-time landlord and have never dealt with rental property depreciation,  you may have questions about home improvements vs. repairs. In this situation, you may want to talk to a tax professional before investing in repairs.

Lower your taxable income with depreciation

As a landlord, you’re also eligible to take depreciation to deduct rental property and improvement costs. This depreciation only applies to the value of the building, not the land.

You can only depreciate a rental property if it meets IRS requirements:

• You own the property
• You use the property for business or other income-producing activity
• The property has a determinable useful life
• The property is expected to last for more than one year

You can start claiming depreciation the moment your property becomes available for rent. Even if you don’t find a tenant for the first month or two, you can claim depreciation from the time you list your property for rent.

Rental properties are depreciated using the Modified Accelerated Cost Recovery System (MACRS). This spreads costs and deductions out across 27.5 or 30 years, and most properties use the General Depreciation System (GDS).

Defer capital gains taxes

Deferring capital gains taxes is one way to reduce your tax liability when you sell a rental property. Normally, you’d owe capital gains taxes on any profit you earned from the sale of your rental property.

Instead, you can defer capital gains taxes by investing funds from a real estate sale into a Qualified Opportunity Fund (QOF) within 180 days. This means you can defer taxes on the original gain until a later date.

Deferring capital gains taxes can be a smart way to reduce your tax liability and remain flexible if you decide to reinvest. Since you’re not paying capital gains taxes yet, you have the funds to reinvest in new properties and other investment opportunities.

1031 exchanges and Delaware Statutory Trusts are also popular strategies for deferring capital gains taxes on rental properties.

Work with a tax professional

If you want to maximize the benefits of real estate investing and save on your taxes, working with a tax professional can be beneficial. A tax professional can help you find any tax deductions and credits you may qualify for to reduce your tax bill.

You can even consult a tax expert during the year to make sure you’re doing everything you can to maximize your savings. Tax experts can help you use tax strategies for rental properties to reduce your taxable income and save on your taxes.