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How Residential Rental Income is Taxed 
 
by kmhagen July 11, 2005

How your residential rental income is taxed depends on the type of property you rent out, your personal use of the property, whether the property is considered a dwelling unit used as a home, and your participation in the rental activity. You may be able to claim all your rental expenses, even if you end up with a loss, or your loss may be subject to certain limitations.

In general, all amounts you receive as rent are includible in your income subject to U.S. federal income tax.  You may be able to claim certain expenses you incur in connection with your rental income.

  • If you rent out part of your property, such as a part of your home, you must divide your expenses between rental use and personal use. 
  • Likewise, if you rent out a vacation home part of the year, you must also divide up your total expenses related to the vacation home between rental use and personal use.
  • And, if you change your property from personal use to rental use during the year, you will also need to divide yearly expenses, such as taxes and insurance, between personal use and rental use.

If you do not rent out your property to make a profit, you can deduct your expenses up to the amount of your rental income.

Rental Income

Rental income includes periodic (monthly) rental payments and also includes any amounts your tenant pays you to cancel a lease, any expenses the tenant pays on your behalf, and the fair market value of any property or services you receive as payment of the rent.  A security deposit that you intend to return to the tenant at the end of the lease term is not rental income.  But if the deposit is intended to be used as a final payment of rent, it is advance rent and must be included in income when you receive it.  Also, any part of a security deposit that you keep because the tenant does not live up to the terms of the lease must be included in your rental income.

If you grant the tenant a lease with the option to buy, the payments you receive are considered to be rental income until the tenant exercises the option.  Payments you receive for periods after the date of sale are considered to be part of the selling price.

If you rent property that you also use as your home, and you rent it fewer than 15 days during the year, you do not have to include the rent in your income and you cannot deduct any rent expenses.

When To Report

Rent is included in income when you receive it, if you report on the cash basis, and in the period for which the rent corresponds, if you report on the accrual basis.  But rent paid in advance is included in the period when you receive it, regardless of the period it covers or the basis of reporting you use.

Rental Expenses

You can deduct ordinary and necessary expenses, including depreciation, related to your rental income.  As in the case of rental income, expenses may need to be divided between rental use and personal use of the property.

You can deduct expenses for managing, conserving, or maintaining rental property starting at the time you make it available for rent, and during periods when the rental property is vacant, but you cannot deduct any loss of rental income for the period the property is vacant.  If you sell rental property, you can deduct rent-related expenses until you sell it.  You can start depreciating rental property when it is ready and available for rent.

Repairs and Improvements

You can deduct the cost of repairs, and you can recover the cost of improvements through depreciation.  Repairs keep your property in good operating condition, but do not add to the value of the property or substantially prolong its life.  Improvements, on the other hand, add to the property’s value, prolong its life, or adapt it to new uses.  If you make repairs as part of an extensive remodeling or restoration project, the cost of the whole job should be capitalized and depreciated.

Other Expenses

Other expenses related to rental property that may be deducted include advertising, commissions, cleaning and maintenance, utilities, property taxes, insurance, and mortgage interest.  If you pay rent on property that you in turn rent out, or sublease, you can deduct your rental payments.  If you buy a leasehold, you can amortize the cost over the term of the lease.

Local benefit taxes that are for repairs or maintenance are deductible expenses.  But if the charges are for putting in streets, sidewalks, water and sewer systems, or other improvements that increase the value of your property, they are non-depreciable capital expenditures that must be added to the basis of your property.

You can deduct expenses for traveling away from home if the main purpose of the trip was to collect rental income or manage, conserve, or maintain your property.  Any personal expenses while on the trip should be separated.  You can also deduct local transportation for the same purposes, either based on actual expenses or the standard mileage rate.  To deduct car expenses under either method, you will need to keep the required records and complete Part V of Form 4562, Depreciation and Amortization. Section B, Information on Use of Vehicles.

Condominiums

If you own a condominium and rent it out, your rental expenses can also include the dues you pay to the management association or company.  Assessments for improvements to the condominium are not deductible as expenses, but you may be able to recover the cost through depreciation.

Cooperative Apartments

Rental expenses in the case of a cooperative apartment include all the maintenance fees you pay to the cooperative housing corporation.  But you cannot deduct amounts assessed for capital assets or improvements, or other amounts charged to the corporation’s capital account.  The amount you can deduct for interest and taxes is the amount the corporation allocated to you.  If this amount is not reflected, you can take your proportionate share of the total interest and taxes based on your percentage ownership of the total shares of stock.

Property Not Rented for Profit

If you do not rent your property to make a profit, you can deduct your rental expenses only up to the amount of your rental income, with no loss carryover to the next year.

Not-for-profit rental income is reported as Other Income on Form 1040.  Related expenses such as mortgage interest and property taxes are taken as itemized deductions.

Property Changed to Rental Use

As mentioned above, if you change your home (or part of it) or other property from person use to rental use during the year, you have to divide your expenses.  You can use any reasonable method to allocate expenses between personal use and rental use.  Two common methods are to allocate based on the number of rooms in your home, or the square footage of the rental and personal portions.  Some expenses, such as water, that depend on personal use may be divided based on the number of persons (tenants and owners) occupying the property.

You can deduct expenses related to rental use, including an allocable portion of home mortgage interest and property taxes, as rental expenses on Schedule E, Supplemental Income and Loss.  The personal portion of mortgage interest and property taxes would be deductible as itemized deductions on Schedule A.  You can also deduct on Schedule E the allocable portion of expenses such as utilities and the cost of painting your house.  Expenses that are specifically for the rental part of the property, such as painting or repairs, can be taken as rent expenses on Schedule E.  You cannot deduct the cost of a first telephone line in your residence, but if you install a second line just for the tenant’s use, the cost is a fully deductible rental expense.  You can start to claim depreciation on the rental property starting from the date it was converted to rental use.

Personal Use of a Dwelling Unit

A dwelling unit for these purposes can include a vacation home.  The importance of defining personal use of a dwelling unit is that it will determine how much of your rental expenses you can deduct:

  • If you used a dwelling unit for personal purposes as well as rental purposes, and the dwelling unit is considered to be a “dwelling unit used as a home” (defined below) you cannot deduct rental expenses that are more than your rental income.
  • If the dwelling unit is not considered your home, you can deduct rental expenses that are more than your rental income, subject to certain limits.  These are the “Passive Activity Limits” and are described below.

Dwelling units include houses, apartments, condominiums, mobile homes, vacation homes, boats, and similar property, provided they have basic living accommodations.

Dwelling units do not include property used solely as a hotel, motel, inn, or similar establishment.  A space, such as a room in your home, that is regularly available for occupancy by paying customers or tenants, would not be considered a dwelling unit.

Dwelling Unit Used as a Home

Once you determine that a property is a dwelling unit, you must then determine if it was used as your home.  It is considered a home during the tax year if you use it for personal purposes for the greater of 14 days, or 10% of the number of days it was rented out at a fair rental price.

You may not have to include as personal use the days before and after you rented the property or offered it for rent, if:

  • You rented or tried to rent the property for 12 or more consecutive months, or
  • The period you rented or tried to rent the property was less than 12 consecutive months because you sold or exchanged the property.

A day of personal use is any day, or part of a day, that the unit was used by:

  • You, for personal purposes;
  • Any other person for personal purposes, if that person owns part of the unit (unless rented to that person under a "shared equity" financing agreement);
  • Anyone in your family (or in the family of someone else who owns part of the unit), unless the unit is rented at a fair rental price to that person as his or her main home;
  • Anyone who pays less than a fair rental price for the unit; or
  • Anyone under an agreement that lets you use some other unit.

Days that you spend working substantially full-time in repairing or maintaining the property do not count as personal use days, even if other family members are using the property for recreational purposes (for example, days you spend working on your vacation home).

Personal Use and Rental Use

Determining the number of days of personal use and rental use is important because this is the basis on which you will determine whether the dwelling unit is considered to be used as a home, which will in turn determine whether you can deduct your rental expenses up to the amount of your rental income, or deduct all your rental expenses, subject to the passive activity limits.

Dividing Expenses

If you used a dwelling unit for both personal and rental purposes, you divide your expenses based on the number of days used for each purpose.  This is not necessarily the same way you consider days of personal use for determining whether the dwelling unit was used as a home.  For dividing expenses, you use the following rules:

  • Any day that the unit is rented at a fair rental price is a day of rental use, even if you used it for personal purposes that day.
  • Any day that the unit is available for rent but not actually rented is not considered a day of rental use.

Depreciation

You can claim a deduction for depreciation on the rental part of your property, if you own the property, you use it as rental property, the property has a determinable useful life (more than one year), and it is not specifically excluded as depreciable property for tax purposes (property placed in service and disposed of in the same year).

There are three methods for calculating depreciation.  The method you use for rental property depends on when it was placed in service. 

  • MACRS (Modified Accelerated Cost Recovery System) for property placed in service after 1986
  • ACRS (Accelerated Cost Recovery System) for property placed in service after 1980 but before 1987
  • Straight-line, declining balance, or other method for property placed in service before 1981.

The MACRS system, in turn, consists of two separate systems – the General Depreciation System (GDS) and the Alternative Depreciation System (ADS).  Rental property is generally depreciated under GDS.  Under this system, each item of property is assigned to a property class.  Residential real property is in a class of its own.

You may need to use Form 4562 to figure your depreciation deduction.

Figuring Rental Income and Deductions

If you determine that the dwelling unit was not used as a home, based on the criteria indicated above, you report all the rental income and deduct all the rental expenses.  You could have a loss, subject to certain limits.

If you determine that the dwelling unit was used as a home, you figure your rental income and expenses based on how many days the unit was rented at a fair rental price.

  • If it was rented out for fewer than 15 days, you do not have to report any rental income and you cannot deduct any rental expenses.
  • If it was rented out for 15 days or more, you report all your rental income.  If you have a net profit from the rental activity, you can deduct all your rental expenses.  But if you have a net loss, your deduction for rental expenses may be limited.  There is a worksheet in the instructions for figuring the limit on rental deductions for a dwelling unit used as a home.

Limit on Deductions

In the second case above, where your expenses exceed your income, you cannot use the excess expenses to offset other income reported on your tax return.  But you may be able to carry the excess expenses over and use them to offset rental income from the same property in the following year.

Limits on Rental Losses

Rental real estate activities are generally considered to be passive activities for tax purposes, and you can deduct real estate rental losses only to the extent you have other passive income.  But if you materially or actively participated in the rental activity, you may be able to deduct a loss.  And, in the case of a dwelling unit used as a home, the passive activity rules do not apply.

At-Risk Rules

If the passive activity rules apply, any losses are first subject to the at-risk rules.  These rules are intended to limit losses from activities that are considered to be tax shelters.  The rules basically limit the loss to the amount that is at risk in the activity; that is, the amount of cash and the adjusted basis of property contributed to the activity, and certain amounts borrowed for the activity.  If the at-risk rules apply, you will generally have to complete Form 6198 to figure your allowable loss if you have a loss from an activity that you carry on as a trade or business or for the production of income, and you have amounts in the activity for which you are not at risk.

Passive Activity Rules

Losses that are deductible after considering the at-risk rules are then subject to the passive activity loss rules.  Under these rules, as indicated above, you can generally deduct losses only to the extent you have offsetting income from other passive activities.

Rental activities in which you actively participated as a real estate professional are not considered to be passive activities and are not subject to the passive activity limits.  You are considered a real estate professional if:

  • More than half of the personal services you performed were in real property trades or businesses in which you materially participated, and
  • You performed more than 750 hours of services in real property trades or businesses in which you materially participated.

Material and Active Participation

If you are not a real estate professional, you will need to determine if you materially and actively participated in the rental activity, to see whether the passive activity limits apply.  Material participation means you were involved in rental operations on a regular, continuous and substantial basis.  Active participation means you (and your spouse) owned at least a 10% interest in the rental property and you made management decisions in a significant and bona fide sense.

How To Report

If your rental activity is not for profit, you would report your rental income as other income on Form 1040.  You can deduct your mortgage interest (for your main home or second home), your real estate taxes, and any casualty losses on the appropriate lines of Schedule A, as itemized deductions.  You can deduct other rental expenses as other miscellaneous itemized deductions.

If you rent buildings, apartments, or rooms, and provide only the basic services, such as light, heat, and trash collection, you would normally report your rental income and expenses in Part I of Schedule E, Supplemental Income and Loss.

If you provide significant services, such as regular cleaning or maid service, the activity would probably be considered a business, and you would report your rental income and expenses on Schedule C, Profit or Loss from Business, or Schedule C-EZ, Net Profit from Business.

You will need to complete Form 4562, Depreciation and Amortization, if you are claiming depreciation on property placed in service during the year, or on any listed property, such as a vehicle, or if you are claiming expenses for the use of a vehicle.


 




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