Here is a collection of frequently asked questions that I have put together to help you in renting or managing a property. If you have any other questions, not listed here, feel free to call or send an e-mail.
When you rent out a house or condo, taxes can be a headache.
Consider this scenario:
After buying a condo and living in it for several years, Sue meets Steve, marries him and moves into his house. Because the apartment market in their area is tight and rents are going up, they decide that instead of selling the condo they could make some money by holding onto it and renting it out. But as first-time landlords, they don't know whether they need to report the rent they receive on their tax return and, if so, whether any of the money they spent to get the condo ready to rent is deductible.
Does this story sound familiar? If so, you're not alone. Taxpayers in similar circumstances find themselves asking these questions:
- Is rental income taxable?
- When do I owe taxes on rental income?
- Are security deposits taxable?
- If I rent out my vacation home, can I still use it myself?
- What can I deduct?
- Can I deduct improvements and repairs?
- How do I calculate depreciation?
- How do I report a rental activity on my tax return?
- What are passive activities, and how do they affect me?
Is Rental Income Taxable?
Yes, rental income is taxable, but that doesn't mean everything you collect from your tenants is taxable.
You're allowed to reduce your rental income by subtracting expenses that you incur to get your property ready to rent and then to maintain it as a rental. You report rental income and expenses on Schedule E, Supplemental Income and Loss.
When Do I Owe Taxes on Rental Income?
In general, you must report all income on the return for the year you actually receive it even though it may be credited to your tenant for a different year.
- If you receive rent for January 2008 in December 2007, for example, report the rent as income on your 2007 tax return.
- If you receive a deposit for first and last month's rent, it's taxed as rental income in the year it's received.
- If you receive goods or services from your tenant in exchange for rent, you must value the goods or services at their present worth and report that value on your return for the year that they are received.
You must also report income that you have received constructively. This means the funds are available to you even if you haven't taken possession of them. For example, if your renters place their January checks in your mailbox late in December, you cannot avoid reporting the rent as income simply by not removing the checks from the mailbox until January.
Are Security Deposits Taxable?
Security deposits are not included in income when you receive them if you plan to return them to your tenants at the end of the lease. (Deposits for the last month's rent are taxable when you receive them, because they are really rents, paid in advance.)
What If I Pocket Some of the Security Deposit?
If you eventually keep part or all of the security deposit because the tenant does not live up to the terms of the lease, you must include that amount in the income on your tax return for the tax year in which the lease terminates. Of course if you withhold the security deposit to cover damages caused by the tenant, the cost of repairing such damage will be deductible, and offset the income from the forfeited security deposit.
So you should keep track of the security deposits from year to year. This record-keeping isn't difficult if you only own one rental, but as the number of rentals you own increases, so does the paperwork.
If I Rent Out My Vacation Home, Can I Still Use It Myself?
Only for a very limited amount of time each year, if you want the chance to deduct losses on your rental property. To be treated as a business for tax-loss purposes, your use of the property can't exceed 14 days or 10% of the days the unit is rented during the year, whichever is greater. Ten percent may sound like a lot, but really isn't when you figure that a seasonal rental may only be in demand for two or three months each year. For example: Lorraine, who lives in the city, bought a house at the beach as an investment, planning to rent out the house each summer. This year tenants occupied the house during July and August, for a total of 60 days. Lorraine is allowed to vacation at the house herself for a total of 14 days, which is greater than 10% of the total time the house was rented (0.10 x 60). If you violate the 14-day/10% rule, you can still deduct expenses associated with the rental, but only to the extent that you report rental income. The property can't produce a loss that will reduce your tax bill on other income.
What Can I Deduct?
Costs you incur to place the property in service, manage it and maintain it generally are deductible. Even if your rental property is temporarily vacant, the expenses are still deductible while the property is vacant and held out for rent.
Deductible expenses include, but are not limited to, the following:
- Cleaning and maintenance
- Homeowner's associations dues and condo fees
- Insurance premiums
- Interest expense
- Local property taxes
- Management fees
- Pest control
- Professional fees
- Rental of equipment
- Rents you paid to others
- Trash removal fees
- Travel expenses
- Yard maintenance
All expenses you deduct must be ordinary and necessary, and not extravagant.
You can deduct the cost of travel to your rental property if the primary purpose of the trip is business. If you mix business with pleasure, though, you're required to allocate the travel costs between deductible business expenses and non-deductible personal costs. Be careful not to cheat yourself on the break down.
Consider this example: John, who lives in North Carolina and loves to ski, owns a rental condo in Park City, Utah, which he visits each January to get the place ready for that season's tenants. His travel expenses are deductible if, for example, the primary purpose of his trip is to clean and paint the unit after his tenants have moved out. Let's say that during a five-day visit to the condo, John spends three days cleaning and painting and two days skiing. Some advisors would say he gets to deduct 60% of his cost, since 60% of the time was spent on the business of tending to his rental unit.
But following that advice would be a costly mistake. Since the primary purpose of the trip is business, the full cost of transportation to and from Park City is deductible. It's the costs while there that need to be allocated between business and personal expenses. Sixty percent of the cost of a rental car would be deductible, for example, plus the cost of meals during the three business days. (Another restriction in the law allows you to deduct just 50% of such business meals.)
Now, if John spent three days skiing and two days working on the condo, none of his travel expenses would be deductible, although the direct costs of working in the apartment (the cost of paint and cleaning supplies, etc.) would be deductible rental expenses.
Keep good records. To deduct any expense, you must be able to document the write-off. So hold on to all receipts, checks, and bank statements.
Can I Deduct Improvements and Repairs?
Ah, there's a big difference between improvements and repairs. The cost of improvements to the property must be depreciated over their useful lives (which are defined by the IRS), rather than deducted in the year paid. The cost of repairs can be written off in the year you pay them.
Improvements are actions that materially add to the value of the property or substantially prolong its life. Examples include:
- Additions to the structure
- Adding a swimming pool
- Installing a water filtration system
- Modernizing a kitchen
- Installing insulation
Repairs, on the other hand, just keep the property in good operating condition. Examples of repairs:
- Minor repainting
- Repairing appliances
- Fixing leaks
- Replacing broken windows or doors
For more information see IRS Topic 414: Rental Income and Expenses.
How do I Calculate Depreciation?
Depreciation is a deduction taken over several years. You generally depreciate the cost of business property that has a useful life of more than a year, but gradually wears out, or loses its value due to wear and tear, weather damage, etc. To figure out the depreciation on your rental property:
1. Determine Your Cost Basis
- Determine your cost or other tax basis for the property.
- Allocate that cost to the different types of property included in your rental (such as land, buildings, so on).
- Calculate depreciation for each property type based on the methods, rates, and useful lives specified by the IRS.
Your cost basis in the property is generally the amount that you paid for the property (your acquisition cost plus any expenses), including any money you borrowed to buy the place.
If you are converting your property from personal use to rental use, your tax basis in the property is calculated differently. Your basis is the lower of these tw
- Acquisition cost
- The fair market value at the time of conversion from personal to rental use
If the property was given to you or if you inherited it, or if you traded another property for the current property, there are special rules for determining your tax basis in your rental property. If you were given the property, for example, your basis is generally the same as the basis of the generous soul who gave it to you; if you inherited it, your basis is generally the property's value on the day the previous owner died. Consult IRS Publication 551, Basis of Assets, for more information about these situations.2. Allocate the Cost by Type of Property
After determining the cost or other tax basis for the rental property as a whole, you must allocate the basis amount among the various types of property you're renting. When we speak of types of property, we refer to certain components of your rental, such as the land, the building itself, any furniture or appliances you provide with the rental, etc.
If your rental is a condo or other property that shares property within a community, you're deemed to own a portion of that property. A portion of the land and a portion of the purchase price must be allocated to the land upon which the building is built.
Why this effort to divide your tax basis between property types? They are each depreciated using different rules and different lives.3. Calculate the Depreciation for Each Type of Property
Here are the most common divisions of tax basis for a rental property, followed by explanations of the different methods of depreciation.
|Type of Property
||Method of Depreciation
||Useful Life in Years|
|Residential rental real estate (buildings or structures and structural components)
|Nonresidential rental real estate
|Shrubbery, fences, etc.
||150% declining balance
|Furniture or appliances
||Double (200%) declining balance
In straight-line depreciation, the cost basis is spread evenly over the tax life of the property.
A residential rental building with a cost basis of $150,000 would generate depreciation of $5,455 per year ($150,000 / 27.5 years).
In the year that the rental is first placed in service (rented), your deduction is prorated based on the number of months that the property is rented or held out for rent, with 1/2 month for the first month. If the building in the example above is placed in service in August, you can take a deduction for 4-1/2 months of $2,046 ($5,455 x 4.5 / 12).
Declining Balance Depreciation
This kind of depreciation is calculated by multiplying the rate, 150% or 200%, by the straight-line depreciation calculated based on the adjusted balance of the property at the start of the year over the remaining life of the property. To make matters somewhat easier, the IRS and others publish tables of percentages that can be applied to the original cost to determine yearly depreciation. Here's the five-year property table as an example:
Declining balance depreciation on $2,400 worth of furniture used in a rental would be $461 in Year 3 ($2,400 x 19.20%).
Tables for all types of properties can be found in IRS Publication 946: How to Depreciate Property. For general information on depreciation of rentals, see IRS Publication 527: Residential Property.
How do I Report a Rental Activity on My Tax Return?
As an individual, you report the income and deductions for rental properties on Schedule E, Supplemental Income and Loss. The total income or loss computed on Schedule E carries to Form 1040.
Report the depreciation of rentals on Form 4562: Depreciation and Amortization. The instructions for these forms explain in detail how to complete these forms.
TurboTax products assist you with compiling rental data and reporting the information on the appropriate lines of the appropriate forms.
You may need to complete Form 8582: Passive Activity Loss Limitations, following the published IRS instructions.
If you work in real estate, you may be considered a real estate professional. The passive activity rules don't apply to real estate activities for many properties owned and managed by real estate professionals. For more information regarding this important exception, consult IRS Publication 527: Residential Rental Property.
For more on passive activities, see Tax Topic 425: Passive Activities-Losses and Credits.
Updated for tax year 2007
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