If you own rental real estate, you must report your income and expenses to the IRS come tax season. This article outlines the various types of income and expenses, then goes on to discuss how your type of ownership and activity in your property affects the way you file.
The following is intended for informational purposes. We recommend consulting with a tax professional before conducting any economic activity.
Income and Expenses
When filing your taxes you must record your income and expenses for that tax year. To ease this process, we recommend maintaining detailed records of all transactions and working with a tax professional to ensure you correctly categorize each entry. There are various types of income and expenses.
What Counts as Income?
The rent money you receive from your property is taxable income. However, there are other forms of income that you must report on your taxes, including:
- Advance rent – Any rent that you receive before the covered period. For example, if your tenant pays their January and February rent in December, that classifies as advance rent. You must record the advance rent as income for December. In our example, you would record December’s rent.
- Security deposits that you keep – You do not report the security deposit as income when the tenant initially pays it. Only report it if and when you keep it due to a lease break or for repair expenses if the tenant damages the property. In the case of using the income for repairs, you would report the income and then deduct the repair as an expense.
- Deposit for the last month’s rent – This is considered advance rent and you will count it as income when you receive it.
- Money paid to cancel a lease – If a tenant cancels a lease and pays you, that money is considered rent income.
- Expenses your tenant paid – You must count any expenses your tenant pays as income. If the expense they paid counts as a deductible rental expense, you can also deduct this while completing your taxes.
- Property or services that you receive in exchange for rent – If you and your tenant agree to trade rent for a service or property they provide, you must report the fair market value of that good or service as income. For example, if the tenant re-tiles a room in exchange for a month’s rent, you would report the cost of one month’s rent.
If you own a portion of a rental property, you will report your part of the income as rental income from the property.
What Classifies as an Expense?
There are several available deductions you can claim while filing your taxes, including
- Operating expenses. According to the 2020 NAA Survey of Operating Income & Expenses in Rental Apartment Communities, the average total operating expenses per housing unit amounted to $6,241 per year. Any payments you make toward managing and maintaining the rental count as operating expenses. Examples are mowing services, advertising, accounting services, insurance, local utilities, and legal services. Check Publication 527, Residential Rental Property, to review the complete list of potential expenses.
- Real estate taxes. You can deduct your state and local real estate taxes up to $10,000 or $5,000 if you are married and filing separately.
- Travel expenses. If you need to travel to manage your property or collect rental income, you can deduct the travel expenses. When using your car, truck, etc., you can deduct the costs as the actual expense or at the standard mileage rate.
- Repairs. The materials, supplies, and cost of repairs are deductible when used to keep the property in good, operating condition.
- Capital expenditures. Different from repairs, CapEx are home improvements that add value to your property. Examples include kitchen renovations, driveway improvements, and bathroom upgrades. However, you cannot deduct the entire cost of the improvement in the year that you purchase it. You will deduct it under depreciation, see below.
- Depreciation. You can recover the cost of the rental property when you factor in depreciation. Rental property depreciation occurs over a 27.5-year period. When determining depreciation, you must differentiate between an improvement that depreciates overtime or a repair that you can deduct immediately. Refer to IRS Publication 946 for more information on how to calculate depreciation. Capital expenditures get deducted through depreciation, where the value decreases over a period of time.
- Mortgage interest. You can claim a mortgage interest deduction on your rental property. If you refinance, you may not be able to deduct the interest depending on if the new amount is larger than the previous outstanding balance.
Rental and Passive Activity
When participating in an income-producing activity, you will abide by one of two sets of rules that influence your deductible loss. Any activity where you make money classifies as active or passive. This article discusses how to report your income and expenses for a rental activity, which falls under the passive activity umbrella.
A rental activity is any activity where a customer uses the tangible property, or the owner holds the property for the renter’s use, and the gross income primarily represents the amount paid for the use of the property. For most tax-filers who passively participate in real estate activity, you will use a Schedule E, Supplemental Income and Loss, on your Form 1040 to report your rental income and expenses.
Those who participate in a rental activity must abide by passive loss limitations, where your losses from your rental activity may only be used to offset income from a passive activity. Your passive losses which exceed your passive income for a tax year will carry over to the next tax ear. The Tax Reform Act of 1986 created IRC § 469, which limits how much loss you can deduct from rental activity.
While most taxpayers who participate in a rental activity must abide by the limitations, there are exceptions. See below.
Real Estate Professionals
If you materially participate in the real estate activity as a real estate professional, then you can overcome the presumption that your activity qualifies as passive. A qualified real estate professional is anyone who meets both of the following requirements:
- You perform more than half of your personal services in a tax year in real property trades or businesses in which you materially participate.
- You perform more than 750 hours in a tax year toward real property trades or businesses in which you materially participate.
When you participate as a real estate professional, you make the decision to either consider each individual interest you have in rental real estate activity as separate activities or group them together as one. A qualified real estate professional can prove that they materially participate in their real estate activity, and therefore categorize their activity as nonpassive. Therefore, the professional can then use their losses to offset the income that encompasses all of their nonpassive real estate activity.
Currently, those who qualify as real estate professionals avoid a 3.8% surtax on rental passive income.
If you materially participate in a rental activity during the tax year, then that rental activity classifies as nonpassive and you do not have to abide by the passive income limitations. To materially participate in your activity, you must have done one of the following:
- Participated for at least 500 hours in the tax year.
- Been the person who participated in substantially all the activity.
- Participated for more than 100 hours in the year and participated at least as much as any other individual, regardless of if they hold any interest in the property.
More nuanced conditions do apply. You can read about these additional conditions from IRS Publication 925, Passive Activity and At-Risk Rules.
In the above cases, participation qualifies as any work you do related to the rental activity. Additionally, your spouse’s participation counts toward your participation, even if they do not have interest in the property and you file separately.
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Rental Income and Loss
After calculating the rental income and deducting your expenses, you’ll either have a net gain or a net loss. You will take the following appropriate steps for either outcome. In most cases, your rental activity classifies as a passive activity, and you will abide by passive loss limitations.
If you have a net gain, you just have to pay taxes on the profit. You will complete the information on your Schedule E. If you own more than three rental properties, complete and attach as many Schedule E’s as necessary.
If it’s a loss and considered a passive activity, you will complete extra steps. Two sets of rules limit the amount of loss you can report on your income tax return, including at-risk rules and passive activity limits. Since rental real estate is a passive activity, you will likely fall subject to the passive activity limitations. You typically cannot offset your income with losses from passive activities. Excess loss carries over to the next tax year.
However, if you or a spouse actively participate in passive rental real estate activity, you may be able to deduct up to $25,000 from your nonpassive income. The amount you deduct depends on your total modified adjusted gross income (MAGI).
If you are subject to casualty or theft, additional conditions apply, and you may be able to deduct the loss on your income tax return.
Is Your Property a Condo or Co-Op?
When you rent out your condominium or cooperative, you will file your taxes accordingly. If you own and rent out a condo, you can claim all forms of income and expenses discussed above. However, you cannot deduct any special assessment that you pay to management for improvements.
If your unit is a co-op, that means you don’t have sole ownership of that unit and serve as a stakeholder in the cooperation. You can rent out your unit and then deduct all maintenance fees, direct payments for repairs, and other rental expenses including the interest you pay on the loan to buy stock. When it comes to depreciation, you will depreciate the cost of your stock in the corporation rather than the unit itself. Refer to the IRS guidelines on cooperative depreciation for more information.
If you own a condominium, renters may stay there for varying lengths of time. Some condominium owners may treat their rental property as a vacation rental, where guests stay for an average duration that is less than seven days. In this case, vacation rental owners treat their property as a business, and their real estate activity does not classify as passive. Therefore, they do not abide by income loss limitations. See more about rental vacation property in the below section.
Owners of condos and co-ops with tenant durations longer than seven days will abide by passive income limitations. However, some areas have programs to decrease the amount of your income tax.
Do You Use the Property as a Home?
How you file your taxes will change if you occupy the property as a home. You use the property as a home if you:
- Use it for personal purposes greater than 14 days a year.
- Use it for personal purposes greater than 10% of the total days you rent it to tenants at a fair rental price.
If you use the property as a home and your rental expenses exceed your rental income, you will experience a dedication limit. However, you can carry your excess expenses over to the following year. If you use the property for personal use less often than the above criteria, you will report all the rental income. Then, you appropriately divide your expenses to ensure you only deduct for the period of rental activity.
Do you own a vacation home that you rent out for most of the year? Refer to the IRS’ Topic No. 415 Renting Residential and Vacation Property
Additionally, if you rent the unit you use as a home for less than 15 days a year, that is not considered rental activity and you do not report taxes.
If you own a duplex or multi-family where you live in one unit and rent out the rest, you can report and deduct the proportional share of income and expenses. Essentially, you approach the situation as if you own two different pieces of property, one for personal and one for your rental. You can choose to calculate how you see fit. It may make more sense for you to calculate based on the square footage that the tenant rents in the home, or if you own a duplex it might make sense to divide by two.
Check the Fine Print
Many more nuanced situations may affect your income tax reporting. Check the following IRS resources to see if you fall into any extraneous circumstances:
- Publication 527, Residential Rental Property
- Publication 925, Passive Activity and At-Risk Rules
- Publication 946, How to Depreciate Property
- Topic No. 415, Renting Residential and Vacation Property
Additionally, tax laws change often. Consult with your accountant to stay updated with any changes and ensure you file correctly.
All information contained in this guide is for informational purposes only. It is best to consult a tax or financial professional before conducting any economic activity.