If your rentals earn a profit for the year, you are required to pay income tax on the amount. The amount of tax you'll have to pay on your rental income depends on your top tax bracket. For example, if your top bracket is 24% and your annual rental profit is $4,168, you'll owe $1,000 in income tax. If you expect to owe at least $1,000 in income tax on your profit, you are supposed to prepay these taxes to the IRS during the year.
You can prepay your tax two ways: (1) by paying estimated taxes to the IRS, or (2) if you work and have income tax withheld from your pay, by increasing your annual withholding. You can also combine these two methods. The IRS doesn’t care what method or methods you use, so long as you prepay all your taxes due. If you fail to do so, you could owe an underpayment penalty to the IRS.
If you work and have income tax withheld from your pay, you’ll need to pay estimated tax only if your total withholding (and any tax credits) amounts to less than 90% of the total tax you expect to pay for the year. Thus, you can avoid paying any estimated tax if your withholding is sufficient to pay for 90% of the tax you’ll owe on all your income, including your rental income. You can have your employer increase your withholding to make sure you meet this threshold. To do so, you must file a new IRS Form W-4 with your employer. You can use the IRS Withholding Calculator to determine how much should be withheld to cover your expected tax liability for the year.
Increasing your withholding is easy to do and eliminates the necessity of making payments to the IRS yourself during the year. However, it does have one big drawback: If the profit you earn from your rental activity turns out to be smaller than you estimated, you could end up overpaying your taxes for the year. This could happen, for example, if you have to pay for unexpected expensive repairs to a rental unit that eat up part of your expected profits. You’ll get your tax overpayment back in the form of a refund from the IRS. But overpaying means you gave the IRS an interest-free loan of your money.
You can largely avoid this problem, and also hold on to your money a bit longer, if you pay estimated tax instead of having the money taken out of your paychecks every pay period. If you do pay estimated tax, the payments are due four times per year: April 15, June 15, September 15, and January 15. If it looks like your rental profit will be lower than you expected at the beginning of the year, you can lower or even eliminate the payments you make later in the year.
To avoid having to pay an underpayment penalty, your total withholding and estimated tax payments must equal the lesser of either (1) 90% of your tax liability for the current year, or (2) 100% of what you paid the previous year (or 110% if you’re a high-income taxpayer).
The easiest way to calculate your quarterly estimated tax payments is to subtract your total expected income tax withholding for the current year from the total income tax you paid last year. The balance is the total amount of estimated tax you must pay this year and avoid an underpayment penalty. But, if you’re a high income taxpayer, add 10% to the total. Note, however, that if your income is higher this year than last, you’ll owe extra tax to the IRS on April 15. To avoid this you can increase your estimated tax payments or simply save the money you’ll need to pay the taxes when you file your annual return.
You pay the money directly to the IRS in four installments. You can pay by mail, electronic withdrawal from your bank account, or by credit or debit card. For details, see the IRS estimated tax webpage.