Types of Taxes if You Own Residential Property

January 13, 2025 7 min read

Types of Taxes if You Own Residential Rental Property

Owning residential rental property comes with a variety of financial responsibilities, including managing multiple types of taxes. For landlords, understanding the nuances of these taxes is crucial to staying compliant and optimizing your income. This article breaks down key tax categories for landlords including rental income taxes, Social Security and Medicare taxes, net investment income tax 2024, and the distinction between real estate taxes vs property taxes.

Rental Income Taxes

According to the IRS, any income you receive from renting out a property is taxable and must be reported on your annual tax return. Rental income taxes apply to the net income generated from your property, which is calculated by subtracting deductible expenses from the total earnings that your rental property generates. Deductible expenses include repairs, property management fees, depreciation, and others. When you report rental income, claiming these deductions can reduce your tax bill.

For example, if you rent out a property for $20,000 a year and incur $5,000 in eligible expenses, you’ll report $15,000 in taxable income. This net rental income is combined with other sources of income, such as wages or dividends, and taxed according to federal income tax brackets. As reported by the IRS, these brackets for 2024 range from 10% to 37%, depending on your income level and filing status.

In addition to federal taxes, many states impose their own income taxes on rental earnings. However, states like Florida and Texas do not levy income taxes, which can be advantageous for property owners in these states.

Medicare Taxes

What are Medicare taxes?

Medicare taxes are payroll taxes imposed on income to fund the Medicare program. If your rental property income is considered business income rather than passive income, you may owe Medicare taxes. The Medicare tax rate is 2.9%, split equally between employees and employers. If you’re self-employed, you are responsible for the full 2.9%.

In addition, individuals with higher incomes are subject to an Additional Medicare Tax of 0.9%. This additional tax applies to single taxpayers earning over $200,000 and married couples earning more than $250,000 annually. For rental property owners classified as self-employed, Medicare taxes can amount to 3.8% of total net earnings.

It’s important to determine whether your rental income qualifies as active business income or passive income. Passive income is generally exempt from Medicare taxes, whereas active income is subject to these taxes. The IRS specifies that active income requires material participation in managing your rental property, such as handling tenant relationships, making repairs, or overseeing daily operations.

Net Investment Income Tax 2024

The net investment income tax 2024 is another consideration if your rental income qualifies as passive. This tax is set at 3.8%, and applies to individuals, estates, and trusts with income exceeding $200,000 for single filers or $250,000 for married joint filers. It encompasses income from interest, dividends, and rental earnings if you do not meet the IRS’s material participation requirements.

Imagine you own a rental property, but hire a property management company to handle everything, including tenant screening, maintenance, and rent collection. You spend little to no time managing the property yourself. In this case, your rental income is classified as passive, and if your total modified adjusted gross income exceeds the threshold, the 3.8% net investment income tax would apply to your rental earnings. Passive income includes any trade or business activity in which you do not materially participate (26 U.S. Code § 469). Therefore, delegating significant responsibilities, like management and operations, often results in your rental income being categorized as passive.

On the other hand, if you actively manage the property, spending more than 500 hours annually addressing tenant concerns, performing repairs, and marketing vacancies, the IRS may consider you materially participating. Material participation involves regular, continuous, and substantial involvement in the operations of the activity (26 U.S. Code § 469). Specifically, activities meeting criteria such as spending over 500 hours on property management can qualify as material participation under Section C(2) and (7). In this case, your rental income could be exempt from the net investment income tax, even if your total income exceeds the threshold.

Material participation is defined by the IRS as being substantially involved in the operation of your rental property, such as handling tenant relations, performing repairs, or managing bookings for short-term rentals. Meeting these criteria may exempt your rental income from the net investment income tax. However, passive income from rental properties, particularly for absentee landlords, is likely subject to this tax.

Real Estate Taxes vs Property Taxes

Although the terms real estate taxes vs property taxes are often used interchangeably, they have distinct definitions:

Real Estate Taxes: Real estate or real property taxes are taxes levied by local governments on land and buildings. They are assessed annually based on the property’s fair market value and fund public services such as schools, infrastructure, and emergency services.
Personal Property Taxes: This broader category includes real estate taxes but also taxes levied on personal property, such as vehicles, boats, or business equipment. Like real estate taxes, they are based on the tax assessment value of your property.

As a rental property owner, you can deduct real estate taxes on your federal tax return, reducing your taxable income. Understanding this distinction ensures that you categorize and deduct your expenses appropriately, optimizing your tax savings.

Key Deductions for Rental Property

Understanding and utilizing deductions is essential to offsetting your tax obligations. Here are some common deductions for property owners:

Operating Expenses: These include the costs of advertising, utilities, property management, insurance premiums, and other regular expenses.
Repairs and Maintenance: You can deduct costs for repairing damages or maintaining the property provided they do not improve the asset's value.
Depreciation: Depreciation deductions allow you to recover the cost of wear-and-tear on your property over time. The IRS requires residential rental property to be depreciated over 27.5 years and commercial property over 39.

Maintaining detailed records of your expenses is critical in substantiating your claims in case of an IRS audit.

Navigating Complex Tax Scenarios

Taxes become more complex if you sell your property or engage in alternative income-generating activities:

Capital Gains Taxes: If you sell a rental property, you may owe capital gains tax on the profit from the sale. However, strategies like 1031 exchanges allow you to defer these taxes by reinvesting the proceeds into another property.
Short-Term Rentals: If you rent your property as a vacation rental, the tax treatment may differ, particularly if the property is rented for fewer than 14 days annually. In this case, your property would likely be considered a personal residence and will not be subject to certain taxes or eligible for certain deductions.

Staying Compliant and Seeking Professional Advice

Tax laws are subject to change, as evidenced by modifications under the Tax Cuts and Jobs Act and other recent legislation. Staying informed about current tax codes, such as updates to the net investment income tax 2024, is critical for compliance. Consulting with a tax professional or CPA can help you navigate these complexities and identify opportunities to save on your taxes.

Understanding Residential Rental Property Taxes

Owning residential rental property offers significant financial rewards but requires a thorough understanding of the associated tax obligations. You can optimize your tax strategy by understanding how to calculate rental income taxes, Medicare taxes, net investment income tax 2024, and how to distinguish between real estate taxes vs property taxes. Staying organized, keeping detailed records, and seeking professional advice when needed are essential steps to ensuring compliance and minimizing your tax liability.