Tax Season is upon us. When renting out properties taxes can be a real headache. It’s important, especially for anyone new to renting out a property, that tax rules and regulations be understood and followed to avoid serious trouble with the IRS or state agencies. Taxpayers with rental properties often ask questions similar to these:
- Is rental income taxable?
- Are security deposits taxable?
- If I have a rental property, what happens when I choose to use it myself?
- What is deductible?
- How do I account for depreciation?
- How do I report rental income and/or losses and other expenses on my tax return?
These are the most often-asked questions, but there certainly can be many more. I’ll try to briefly address each of these questions one at a time.
Is Rental Income Taxable?
The short answer is yes! But you can reduce your amount of rent proceeds that shows up as income by subtracting any expenses that you incur to get your property ready to rent and then maintain it as a rental. Costs include property management fees. In general, all income must be reported for the year in which you actually received it. Your rental income and expenses are reported on Schedule E, Supplemental Income and Loss. This form is then filed along with your Form 1040.
Are security deposits taxable?
Security deposits are not taxable are not counted as income. If you eventually keep part or all of a security deposit to cover property damage or cleaning at the end of a lease, or to cover a nonpayment of rent, that money would be counted as income for the year in which the lease terminates. Don’t forget that, if the security deposit was withheld to cover damages, the expense of repairing the damage is deductible. Although security deposits are not counted as income, holding the last month’s rent is. Deposits for the last month’s rent are taxable when you receive them, as they are considered rents paid in advance.
If I have a rental property, what happens when I choose to use it myself?
A property can be used by an owner for personal use, but only for a very limited amount of time each year if you want to fully deduct losses or repair costs. Personal use of a rental cannot exceed 14 days or 10% of the days the unit is rented during the year, whichever is greater. Otherwise, for tax loss purposes, you can only deduct expenses equal or less than income. In other words, your property cannot produce a net loss that would potentially offset income from other sources.
What is deductible?
Deductible expenses usually include any cost incurred to get a property ready to rent, maintain it as a rental, and manage it. If a property is vacant, these expenses are still deductible as long as the property is up for rent. Deductible expenses include (but are not limited to): Advertising, cleaning, maintenance, depreciation, HOA dues, condo fees, insurance premiums, pest control, professional fees, equipment rentals, utilities, yard maintenance, supplies, interest expense, management fees, rents you paid to others, etc.
Be sure to note that all expenses must be ordinary as well as necessary. It is also important to keep good records, as any write-off must be documented. It is always a good idea to keep all bank statements, receipts, and cancelled checks.
Be careful in differentiating between improvements and repairs. Expenses from necessary repairs are deductible in the year that they are paid for. Expenses from improvements must be capitalized and depreciated over several years, by following IRS depreciation tables, rather than deducted in the year they are paid. The key in differentiating between improvements and repairs is this: Improvements add materially to the value of the property. Examples include updating a kitchen, installing a water purification system, installing insulation, or adding an additional structure. Repairs, on the other hand, are things that keep the property in good condition. Examples include painting, replacing broken doors or windows, fixing plumbing, etc.
How do I account for depreciation?
Depreciation is a deduction that is spread over a period of years. Depreciation is usually used with property or equipment that has a lifespan or useful life of over a year but gradually loses value due to wearing out, weathering, etc. To figure out depreciation for a rental property, several steps must be followed. First, determine the cost or tax basis for the property. Then allocate the cost to the different types of property which comprise your rental (land, building, outbuildings, etc.). Then, using rates and lifespans specified by the IRS, calculate depreciation for each property type. The IRS provides general information on depreciation of rentals in IRS Publication 527: Residential Rental Property. Depreciation tables for all property types can be found in IRS Publication 946: How to Depreciate Property.
How do I report rental income and/or losses and other expenses on my tax return?
Rental income is typically reported on Form 1040, Schedule E, Part I. Simply list total income, expenses, and depreciation for each rental property. To report expenses, fill out Schedule E and Form 4562. List the total of expenses on Schedule E, line 16. Carry over depreciation deductions from Form 4562 and list it on line 20. On Schedule E you can then deduct the total of all rental expenses from your rental income.
Well, there it is in a nutshell. These things are critical for any property owner to be aware of. Hire a good accountant to make life easier and enjoy the confidence that things are done correctly. But, even if you hire a good accountant, it’s up to you to keep good records. Your records need to support the income and expenses you report to stay out of trouble if you are audited.