A Guide to Rental Income and Expenses
Reporting income and expenses from your rental property for tax purposes may seem like a necessary evil, but it goes with the territory of real estate investing. As long as you keep good records and stay informed about tax rules, it’s a straightforward process.
Here are the basics to get you started.
Is This a Passive Activity?
Much of your approach to reporting rental income and expenses for tax purposes will depend on whether you are “materially participating” or conducting a “passive activity.”
Unless you’re a real estate professional or you provide “substantial services” to renters like housekeeping and other hotel-like services, owning rental property is considered a passive activity. There are a few other exceptions; see Publication 925, Passive Activity and At-Risk Rules, to find out whether you meet any of them.
If none of the exceptions apply, use Schedule E, Supplemental Income and Loss, on your Form 1040 to report your rental income and expenses.
What Counts as Income?
The cash you receive for rent is obviously taxable income. However, much more can be included:
- The fair market value of any property or services that you receive in exchange for the use of your property – Yes, the IRS considers bartering to be taxable.
- Advance rent – If your tenant pays enough rent in December to cover the next three months, you have to include the entire payment in December’s income.
- Expenses your tenant paid – You’ll likely also be able to deduct the expenses, but you still have to report them as income.
- Security deposits that you keep – When a security deposit is paid to you, you do not report it as income. However, if you keep part of all of a security deposit because your tenant broke the lease by moving out early, you must report that as income. Similarly, if you use the security deposit money to cover repair expenses because your tenant damaged the property, you must count it as income and then deduct the repairs as expenses.
- Deposit for the last month’s rent – This is considered advance rent, so you need to count this as income when you receive it.
- Money paid to cancel a lease – Fees you charge for your tenant to break the lease are considered income.
What Can be Included in Expenses?
Repair costs are the obvious expenses that you’ll be able to deduct. However, there are other possibilities you might not have thought of:
- Operating expenses – This includes any payments you make for keeping the house up and managing the rental. Some examples are mowing services, advertising, accounting services, insurance, mortgage interest, real estate taxes, and legal services. There are many more possibilities. According to 2015 U.S. Census Bureau data, the average total operational expenses per housing unit amounted to $4,751. Check Publication 527, Residential Rental Property, to make sure you don’t miss anything that you can deduct.
- Travel expenses – If you need to travel to manage your rental property, you can deduct at least a portion of the expenses.
- Depreciation – This is a way to slowly deduct over several years the cost of the property and any improvements you make or furniture you put in it. The tricky part can be determining what is an improvement that gets depreciated over time and what is just a repair that can be fully deducted right away. Generally, though, if you’re replacing something with an identical item or doing something that doesn’t add value to the house, it will be deducted as an expense in that year and not depreciated. Also, landscaping improvements can’t be depreciated because they are added to the cost basis of the land, and land is not depreciable.
If you Live There at Least Sometimes, There is More to Think About
Your personal use of your rental property can affect the tax treatment of your rental expenses. They might be limited if you or someone in your family lives there for at least 14 days or 10 percent of the total days you rent it out, whichever is greater.
On the other hand, if you live in a property that you rent out for fewer than 15 days, you don’t report the rental income or expenses.
If You Have a Loss, It Might be Limited… or Not
Once you’ve calculated your rental income and deducted expenses, you’ll either have a net income or a net loss. If it’s income, that’s not too complicated; you just have to pay taxes on the income. If your overall income is over a certain threshold, for example, $250,000 if you’re married and filing jointly, you might have to pay an extra 3.8 percent for the Net Investment Income Tax.
If it’s a loss and it’s a passive activity, it may be a little more complicated. Generally, you can only count your passive loss against any income you have from other passive activities. You can, however, carry the loss forward to the next year, and you can continue to carry losses to subsequent years until you no longer have a loss.
However, there are two ways that you might be able to count your loss immediately:
- You can use a special $25,000 allowance to count your rental loss if you or your spouse “actively participated” in rental activities like making management decisions. This may sound confusing, but, yes, you can still “actively participate” in rental activities even though it is considered a passive activity. How much of your loss that can be deducted depends on your income level and your filing status.
- You can deduct all of your loss for the year in the year that you sell your property, but only if you sell it to an unrelated party.
Check the Fine Print
Many more nuanced situations may affect your tax reporting. Be sure to check these IRS resources to see if any unusual circumstances apply to you:
- 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
Also, remember that tax laws change often. It’s important to talk to your accountant and stay up to date with any changes.
All information contained in this guide should be considered for informational purposes only. Before conducting any financial activity, it is best to consult a tax or financial professional.