Tips on Rental Real Estate Income, Deductions and Recordkeeping
If you own rental real estate, you should be aware of your federal tax responsibilities. All rental income must be reported on your tax return, and in general the associated expenses can be deducted from your rental income.
If you are a cash basis taxpayer, you report rental income on your return for the year you receive it, regardless of when it was earned. As a cash basis taxpayer you generally deduct your rental expenses in the year you pay them. If you use an accrual method, you generally report income when you earn it, rather than when you receive it and you deduct your expenses when you incur them, rather than when you pay them. Most individuals use the cash method of accounting.
Below are some tips about tax reporting, recordkeeping requirements and information about deductions for rental property to help you avoid mistakes.
What is Considered Rental Income?
You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. You must report rental income for all your properties.
In addition to amounts you receive as normal rent payments, there are other amounts that may be rental income and must be reported on your tax return.
Advance rent is any amount you receive before the period that it covers. Include advance rent in your rental income in the year you receive it regardless of the period covered or the method of accounting you use. For example, you sign a 10-year lease to rent your property. In the first year, you receive $5,000 for the first year's rent and $5,000 as rent for the last year of the lease. You must include $10,000 in your income in the first year.
Security deposits used as a final payment of rent are considered advance rent. Include it in your income when you receive it. Do not include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease. But if you keep part or all of the security deposit during any year because your tenant does not live up to the terms of the lease, include the amount you keep in your income in that year.
Payment for canceling a lease occurs if your tenant pays you to cancel a lease. The amount you receive is rent. Include the payment in your income in the year you receive it regardless of your method of accounting.
Expenses paid by tenant occur if your tenant pays any of your expenses. You must include them in your rental income. You can deduct the expenses if they are deductible rental expenses. For example, your tenant pays the water and sewage bill for your rental property and deducts it from the normal rent payment. Under the terms of the lease, your tenant does not have to pay this bill. Include the utility bill paid by the tenant and any amount received as a rent payment in your rental income.
Property or services received, instead of money, as rent, must be included as the fair market value of the property or services in your rental income. For example, your tenant is a painter and offers to paint your rental property instead of paying rent for two months. If you accept the offer, include in your rental income the amount the tenant would have paid for two months worth of rent.
Lease with option to buy occurs if the rental agreement gives your tenant the rights to buy your rental property. The payments you receive under the agreement are generally rental income.
If you own a part interest in rental property, you must report your part of the rental income from the property.
What Deductions Can I Take as an Owner of Rental Property?
If you receive rental income from the rental of a dwelling unit, there are certain rental expenses you may deduct on your tax return. These expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs.
You can deduct the ordinary and necessary expenses for managing, conserving and maintaining your rental property. Ordinary expenses are those that are common and generally accepted in the business. Necessary expenses are those that are deemed appropriate, such as interest, taxes, advertising, maintenance, utilities and insurance.
You can deduct the cost of repairs that you make to your rental property. A repair keeps your property in good operating condition and does not materially add value to the property. Examples are painting, fixing leaks and replacing broken doors or other parts of the rental property.
You can deduct the expenses paid by the tenant if they are deductible rental expenses. When you include the fair market value of the property or services in your rental income, you can deduct that same amount as a rental expense.
You may not deduct the cost of improvements. An improvement adds to the value of your property, prolongs its useful life, or adapts it to new uses. Examples are adding a deck, a new fence or roof. The cost of improvements is recovered through depreciation.
You can recover some or all of your improvements by using Form 4562 to report depreciation beginning in the year your rental property is first placed in service, and beginning in any year you make an improvement or add furnishings. These expenses must be depreciated over the useful life of the property. Only a percentage of these expenses are deductible in the year they are incurred.
How Do I Report Rental Income and Expenses?
If you rent buildings, rooms or apartments, and provide only heat and light, and trash collection, you normally report your rental income and expenses on Form 1040, Schedule E, Part I. List your total income, expenses, and depreciation for each rental property. Be sure to answer the question on line 2.
If you have more than three rental properties, complete and attach as many Schedules E as are needed to list the properties. Complete lines 1 and 2 for each property, including the street address for each property. However, fill in the “Totals” column on only one Schedule E. The figures in the “Totals” column on that Schedule E should be the combined totals of all Schedules E.
Sum up your receipts and canceled checks for your repairs. All of these costs are deductible in the year they were incurred. Fill out Schedule E and Form 4562. List the total of your expenses for repairs on Schedule E, line 16. Carry over your depreciation deduction from Form 4562 and list it on line 20. Complete Schedule E and deduct the total of all of your rental expenses from your rental income.
If your rental expenses exceed rental income you may report a loss up to $25,000 on your tax return, limited for adjusted gross incomes above $100,000.
What Records Should I Keep?
Good records will help you monitor the progress of your rental property, prepare your financial statements, identify the source of receipts, keep track of deductible expenses, prepare your tax returns and support items reported on tax returns.
Maintain good records relating to your rental activities, including the rent and the rental repairs. You must be able to document this information if your return is selected for audit.
Keep track of any travel expenses you incur for rental property repairs. Separate receipts for minor repairs like plumbing, fixing a broken door or minor repainting from receipts for capital improvements like adding a new roof, remodeling a kitchen or installing insulation.
You must be able to substantiate certain elements of expenses to deduct them. You generally must have documentary evidence, such as receipts, canceled checks or bills, to support your expenses.
If you are audited and cannot provide evidence to support items reported on your tax returns, you may be subject to additional taxes and penalties. For example, if you cannot substantiate the rental real estate expenses of replacing the door locks, with appropriate records, the IRS may disallow that expense which may mean that you incur additional taxes and penalties.
You need good records to prepare your tax returns. These records must support the income and expenses you report. Generally, these are the same records you use to monitor your real estate activity and prepare your financial statements.
- Publication 527, Residential Rental Property
- Publication 946, How to Depreciate Property (PDF)
- Form 4562, Depreciation and Amortization (PDF)
- Tax Topic 414 - Rental Income and Expenses