3.   Reporting Rental Income, Expenses, and Losses

Figuring the net income or loss for a residential rental activity may involve more than just listing the income and deductions on Schedule E (Form 1040). There are activities which do not qualify to use Schedule E, such as when the activity is not engaged in to make a profit or when you provide substantial services in conjunction with the property.

There are also the limitations which may need to be applied if you have a net loss on Schedule E. There are two: (1) the limitation based on the amount of investment you have at risk in your rental activity, and (2) the special limits imposed on passive activities.

You may also have a gain or loss related to your rental property from a casualty or theft. This is considered separately from the income and expense information you report on Schedule E.

Which Forms To Use

The basic form for reporting residential rental income and expenses is Schedule E (Form 1040). However, do not use that schedule to report a not-for-profit activity. See Not Rented for Profit , in chapter 4. There are also other rental situations in which forms other than Schedule E would be used.

Schedule E (Form 1040)

If you rent buildings, rooms, or apartments, and provide basic services such as heat and light, trash collection, etc., you normally report your rental income and expenses on Schedule E, Part I.

List your total income, expenses, and depreciation for each rental property. Be sure to enter the number of fair rental and personal use days on line 2.

If you have more than three rental or royalty properties, complete and attach as many Schedules E as are needed to list the properties. Complete lines 1 and 2 for each property. However, fill in lines 23a through 26 on only one Schedule E.

On Schedule E, page 1, line 18, enter the depreciation you are claiming for each property. To find out if you need to attach Form 4562, see Form 4562 , later.

If you have a loss from your rental real estate activity, you also may need to complete one or both of the following forms.

Page 2 of Schedule E is used to report income or loss from partnerships, S corporations, estates, trusts, and real estate mortgage investment conduits. If you need to use page 2 of Schedule E, be sure to use page 2 of the same Schedule E you used to enter your rental activity on page 1. Also, include the amount from line 26 (Part I) in the “Total income or (loss)” on line 41 (Part V).

Form 4562.   You must complete and attach Form 4562 for rental activities only if you are claiming:
  • Depreciation, including the special depreciation allowance, on property placed in service during 2013;

  • Depreciation on listed property (such as a car), regardless of when it was placed in service; or

  • Any other car expenses, including the standard mileage rate or lease expenses.

Otherwise, figure your depreciation on your own worksheet. You do not have to attach these computations to your return, but you should keep them in your records for future reference.

  See Publication 946 for information on preparing Form 4562.

Schedule C (Form 1040), Profit or Loss From Business

Generally, Schedule C is used when you provide substantial services in conjunction with the property or the rental is part of a trade or business as a real estate dealer.

Providing substantial services.   If you provide substantial services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C (Form 1040), Profit or Loss From Business, or Schedule C-EZ (Form 1040), Net Profit From Business. Use Form 1065, U.S. Return of Partnership Income, if your rental activity is a partnership (including a partnership with your spouse unless it is a qualified joint venture). Substantial services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc. For information, see Publication 334, Tax Guide for Small Business. Also, you may have to pay self-employment tax on your rental income using Schedule SE (Form 1040), Self-Employment Tax. For a discussion of “substantial services,” see Real Estate Rents in Publication 334, chapter 5.

Qualified Joint Venture

If you and your spouse each materially participate (see Material participation under Passive Activity Limits, later) as the only members of a jointly owned and operated real estate business, and you file a joint return for the tax year, you can make a joint election to be treated as a qualified joint venture instead of a partnership. This election, in most cases, will not increase the total tax owed on the joint return, but it does give each of you credit for social security earnings on which retirement benefits are based and for Medicare coverage if your rental income is subject to self-employment tax.

If you make this election, you must report rental real estate income on Schedule E (or Schedule C if you provide substantial services). You will not be required to file Form 1065 for any year the election is in effect. Rental real estate income generally is not included in net earnings from self-employment subject to self-employment tax and generally is subject to the passive activity limits.

If you and your spouse filed a Form 1065 for the year prior to the election, the partnership terminates at the end of the tax year immediately preceding the year the election takes effect.

For more information on qualified joint ventures, go to IRS.gov and enter “qualified joint venture” in the search box.

Limits on Rental Losses

If you have a loss from your rental real estate activity, two sets of rules may limit the amount of loss you can deduct. You must consider these rules in the order shown below. Both are discussed in this section.

  1. At-risk rules. These rules are applied first if there is investment in your rental real estate activity for which you are not at risk. This applies only if the real property was placed in service after 1986.

  2. Passive activity limits. Generally, rental real estate activities are considered passive activities and losses are not deductible unless you have income from other passive activities to offset them. However, there are exceptions.

At-Risk Rules

You may be subject to the at-risk rules if you have:

  • A loss from an activity carried on as a trade or business or for the production of income, and

  • Amounts invested in the activity for which you are not fully at risk.

Losses from holding real property (other than mineral property) placed in service before 1987 are not subject to the at-risk rules.

In most cases, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year. You are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity. Any loss that is disallowed because of the at-risk limits is treated as a deduction from the same activity in the next tax year. See Publication 925 for a discussion of the at-risk rules.

Form 6198.   If you are subject to the at-risk rules, file Form 6198, At-Risk Limitations, with your tax return.

Passive Activity Limits

In most cases, all rental real estate activities (except those of certain real estate professionals, discussed later) are passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services. For a discussion of activities that are not considered rental activities, see Rental Activities in Publication 925.

Deductions or losses from passive activities are limited. You generally cannot offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities. Any excess loss or credit is carried forward to the next tax year. Exceptions to the rules for figuring passive activity limits for personal use of a dwelling unit and for rental real estate with active participation are discussed later.

For a detailed discussion of these rules, see Publication 925.

Real estate professionals.   If you are a real estate professional, complete line 43 of Schedule E.

  

  You qualify as a real estate professional for the tax year if you meet both of the following requirements.
  • More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.

  • You perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate.

If you qualify as a real estate professional, rental real estate activities in which you materially participated are not passive activities. For purposes of determining whether you materially participated in your rental real estate activities, each interest in rental real estate is a separate activity unless you elect to treat all your interests in rental real estate as one activity.

  Do not count personal services you perform as an employee in real property trades or businesses unless you are a 5% owner of your employer. You are a 5% owner if you own (or are considered to own) more than 5% of your employer's outstanding stock, or capital or profits interest.

  Do not count your spouse's personal services to determine whether you met the requirements listed earlier to qualify as a real estate professional. However, you can count your spouse's participation in an activity in determining if you materially participated.

Real property trades or businesses.   A real property trade or business is a trade or business that does any of the following with real property.
  • Develops or redevelops it.

  • Constructs or reconstructs it.

  • Acquires it.

  • Converts it.

  • Rents or leases it.

  • Operates or manages it.

  • Brokers it.

Choice to treat all interests as one activity.   If you were a real estate professional and had more than one rental real estate interest during the year, you can choose to treat all the interests as one activity. You can make this choice for any year that you qualify as a real estate professional. If you forgo making the choice for one year, you can still make it for a later year.

  If you make the choice, it is binding for the tax year you make it and for any later year that you are a real estate professional. This is true even if you are not a real estate professional in any intervening year. (For that year, the exception for real estate professionals will not apply in determining whether your activity is subject to the passive activity rules.)

  See the Instructions for Schedule E for information about making this choice.

Material participation.   Generally, you materially participated in an activity for the tax year if you were involved in its operations on a regular, continuous, and substantial basis during the year. For details, see Publication 925 or the Instructions for Schedule C.

Participating spouse.   If you are married, determine whether you materially participated in an activity by also counting any participation in the activity by your spouse during the year. Do this even if your spouse owns no interest in the activity or files a separate return for the year.

Form 8582.    You may have to complete Form 8582 to figure the amount of any passive activity loss for the current tax year for all activities and the amount of the passive activity loss allowed on your tax return. See Form 8582 not required , later in this chapter, to determine if you must complete Form 8582.

  If you are required to complete Form 8582 and are also subject to the at-risk rules, include the amount from Form 6198, line 21 (deductible loss) in column (b) of Form 8582, Worksheet 1 or 3, as required.

Exception for Personal Use of Dwelling Unit

If you used the rental property as a home during the year, any income, deductions, gain, or loss allocable to such use shall not be taken into account for purposes of the passive activity loss limitation. Instead, follow the rules explained in chapter 5, Personal Use of Dwelling Unit (Including Vacation Home).

Exception for Rental Real Estate With Active Participation

If you or your spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you may be able to offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

Example.

Jane is single and has $40,000 in wages, $2,000 of passive income from a limited partnership, and $3,500 of passive loss from a rental real estate activity in which she actively participated. $2,000 of Jane's $3,500 loss offsets her passive income. The remaining $1,500 loss can be deducted from her $40,000 wages.

The special allowance is not available if you were married, lived with your spouse at any time during the year, and are filing a separate return.

Active participation.   You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and other similar decisions.

Example.

Mike is single and had the following income and losses during the tax year:

  Salary $42,300  
  Dividends 300  
  Interest 1,400  
  Rental loss (4,000)  

The rental loss was from the rental of a house Mike owned. Mike had advertised and rented the house to the current tenant himself. He also collected the rents, which usually came by mail. All repairs were either made or contracted out by Mike.

Although the rental loss is from a passive activity, because Mike actively participated in the rental property management he can use the entire $4,000 loss to offset his other income.

Maximum special allowance.   The maximum special allowance is:
  • $25,000 for single individuals and married individuals filing a joint return for the tax year,

  • $12,500 for married individuals who file separate returns for the tax year and lived apart from their spouses at all times during the tax year, and

  • $25,000 for a qualifying estate reduced by the special allowance for which the surviving spouse qualified.

  If your modified adjusted gross income (MAGI) is $100,000 or less ($50,000 or less if married filing separately), you can deduct your loss up to the amount specified above. If your MAGI is more than $100,000 (more than $50,000 if married filing separately), your special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately) and your MAGI.

  Generally, if your MAGI is $150,000 or more ($75,000 or more if you are married filing separately), there is no special allowance.

Modified adjusted gross income (MAGI).   This is your adjusted gross income from Form 1040, U.S. Individual Income Tax Return, line 38, or Form 1040NR, U.S. Nonresident Alien Income Tax Return, line 37, figured without taking into account:
  1. The taxable amount of social security or equivalent tier 1 railroad retirement benefits,

  2. The deductible contributions to traditional individual retirement accounts (IRAs) and section 501(c)(18) pension plans,

  3. The exclusion from income of interest from Series EE and I U.S. savings bonds used to pay higher educational expenses,

  4. The exclusion of amounts received under an employer's adoption assistance program,

  5. Any passive activity income or loss included on Form 8582,

  6. Any rental real estate loss allowed to real estate professionals,

  7. Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships (PTPs) in the Instructions for Form 8582),

  8. The deduction allowed for one-half of self-employment tax,

  9. The deduction allowed for interest paid on student loans,

  10. The deduction for qualified tuition and related fees, and

  11. The domestic production activities deduction (see the Instructions for Form 8903).

Form 8582 not required.   Do not complete Form 8582 if you meet all of the following conditions.
  • Your only passive activities were rental real estate activities in which you actively participated.

  • Your overall net loss from these activities is $25,000 or less ($12,500 or less if married filing separately and you lived apart from your spouse all year).

  • If married filing separately, you lived apart from your spouse all year.

  • You have no prior year unallowed losses from these (or any other passive) activities.

  • You have no current or prior year unallowed credits from passive activities.

  • Your MAGI is $100,000 or less ($50,000 or less if married filing separately and you lived apart from your spouse all year).

  • You do not hold any interest in a rental real estate activity as a limited partner or as a beneficiary of an estate or a trust.

  If you meet all of the conditions listed above, your rental real estate activities are not limited by the passive activity rules and you do not have to complete Form 8582. On lines 23a through 23e of your Schedule E, enter the applicable amounts.

Casualties and Thefts

As a result of a casualty or theft, you may have a loss related to your rental property. You may be able to deduct the loss on your income tax return.

Casualty.   This is the damage, destruction, or loss of property resulting from an identifiable event that is sudden, unexpected, or unusual. Such events include a storm, fire, or earthquake.

Theft.   This is defined as the unlawful taking and removing of your money or property with the intent to deprive you of it.

Gain from casualty or theft.   It is also possible to have a gain from a casualty or theft if you receive money, including insurance, that is more than your adjusted basis in the property. Generally, you must report this gain. However, under certain circumstances, you may defer paying tax by choosing to postpone reporting the gain. To do this, you generally must buy replacement property within 2 years after the close of the first tax year in which any part of your gain is realized. In certain circumstances, the replacement period can be greater than 2 years; see Replacement Period in Publication 547 for more information. The cost of the replacement property must be equal to or more than the net insurance or other payment you received.

More information.   For information on business and nonbusiness casualty and theft losses, see Publication 547.

How to report.    If you had a casualty or theft that involved property used in your rental activity, figure the net gain or loss in Section B of Form 4684, Casualties and Thefts. Follow the Instructions for Form 4684 for where to carry your net gain or loss.

Example

In February 2008, Marie Pfister bought a rental house for $135,000 (house $120,000 and land $15,000) and immediately began renting it out. In 2013, she rented it all 12 months for a monthly rental fee of $1,125. In addition to her rental income of $13,500 (12 x $1,125), Marie had the following expenses.

Mortgage interest $8,000
Fire insurance (1-year policy) 250
Miscellaneous repairs 400
Real estate taxes imposed and paid 500
Maintenance 200

Marie depreciates the residential rental property under MACRS GDS. This means using the straight line method over a recovery period of 27.5 years.

She uses Table 2-2d to find her depreciation percentage. Because she placed the property in service in February 2008, she continues to use that row of Table 2-2d. For year 6, the rate is 3.636%.

Marie figures her net rental income or loss for the house as follows:

Total rental income received  
($1,125 × 12)
$13,500
Minus: Expenses    
Mortgage interest $8,000  
Fire insurance 250  
Miscellaneous repairs 400  
Real estate taxes 500  
Maintenance 200  
Total expenses 9,350
Balance $4,150
Minus: Depreciation ($120,000 x 3.636%) 4,363
Net rental (loss) for house ($213)
     

Marie had a net loss for the year. Because she actively participated in her passive rental real estate activity and her loss was less than $25,000, she can deduct the loss on her return. Marie also meets all of the requirements for not having to file Form 8582. She uses Schedule E, Part I, to report her rental income and expenses. She enters her income, expenses, and depreciation for the house in the column for Property A and enters her loss on line 22. Form 4562 is not required.


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