Rental Income and Expense

By Dr. John L. Stancil
Tax Analyst, WebTaxCenter.com

If you have rental property, you probably have to include the income on your tax return. You are allowed, however, to deduct any expenses incurred in the rental activity. Rental income is classified by the IRS as income, meaning it is subject to restrictions in deducting losses from these activities.

If more than one person owns the rental property, each person reports his/her share of the income and expenses. Rental activities are reported on Schedule E.

Rental Income

Rental income includes any payment you receive for the use or occupancy of property. This can be a house, an apartment, or even a room in your home. Since most individuals are cash basis taxpayers, the income is included on your tax return in the year you receive the payment. For example, if you sign a five-year lease to rent your property for $12,000 a year, and receive the first and last year's rent in advance you have $24,000 in reportable income for the year. Rental income does not have to be in cash, if you receive property or services instead of cash, you must report the value of what you received as income.

Security Deposits are not considered income if you plan to return it to the tenant at the end of the lease. Any portion of the security deposit that you keep because the tenant did not live up to the terms of the lease is included in income in the year you decide not to refund the deposit.

Lease Cancellation Payments that your tenant pays you to end a lease are income to you in the year you receive the payment.

Improvements or Expenses Paid by the Tenant are considered income to you. For example, if the tenant paints the walls and you grant him a $500 credit on his rent, you must report the $500 as income. However, if the expenses are deductible rental expenses, you may expense the amount.

Rented for Less Than 15 Days - If you rent property that is also your home (such as a bedroom in the house) and rent it for fewer than 15 days you do not have to report the income and no rental expenses are deductible.

Rental Expenses

Rental expenses are deducted in the year in which they are paid. If the property is held for rental, but is vacant, you can still deduct expenses that are incurred. You can also deduct expenses incurred in preparing the property for rental. The IRS states that ordinary and necessary expenses for managing, conserving, and maintaining the property are deductible.

Loss of rental income when the property is vacant is not considered a deductible expense. If you are a cash basis taxpayer, you may not treat uncollectible rent as a deductible expense.

Personal Use - If you use the rental property for personal reasons, you must allocate the expenses between the rental and personal portion. For example, if you have a mountain cabin that you use for one month each year while renting it the other 11 months, you may only deduct 11/12ths of the expenses.

Repairs and Improvements - You can deduct the cost of repairs to your property. Improvements, however, cannot be deducted. You recover the cost of improvements by depreciating them over their useful life. A repair keeps the property in good condition and does not materially increase the value of your property. Painting the house, repairing gutters, patching sheet rock, and replacing broken windows are examples of repairs.

You have an improvement and should capitalize the expenditure when it:

• Materially adds to the value
• Appreciably prolongs the life
• Is a replacement that halts deterioration
• Adapts the asset to a new or different use
• Is a part of a general plan to renovate

You have a repair and should expense the expenditure when:

• It restores ordinary efficient operation
• It does not materially add value
• Does not appreciably prolong the life
• Is due to an unforeseen event
• Is a piecemeal repair

Examples of Other Expenses - Other expenses that are typically incurred in the rental activity include:

• Rent you pay on the property
• Property and liability insurance premiums
• Property taxes
• Travel expenses to collect rental income or manage the property
• The part of your tax return preparation fee that you pay to have Schedule E completed.
• Advertising
• Utilities you pay
• Interest on the mortgage or on other items you buy for the rental property

Depreciation - You recover your cost of the property, improvements, or appliances used in the rental unit through periodic depreciation. The value of the land is not depreciated. You can usually depreciate residential rental property over a 27.5 year period. Most other property is depreciated over 3, 5, or 7 years depending on its classification. You should always include a depreciation deduction because the IRS will reduce the basis in your property even if you do not take the deduction. However, if you have not taken depreciation, you may file Form 3115 and recoup at least some of the depreciation deduction.

Not Rented for Profit

If you do not rent your property with an intent to make a profit, you can only deduct your rental expenses equal to your rental income. Examples of not renting for profit include renting to relatives or others at a below market rate.

If you are not renting for profit, the income is reported as Other Income on Line 21 of the 1040. Your mortgage interest and taxes are deductible on Schedule A. If the property qualifies as your main or second home, these are fully deductible. Any additional deductible expenses are treated as miscellaneous itemized deductions subject to the 2% limitation.

Changing to Rental Use

If you change property from personal to rental use during the year, you must allocate the expenses between the personal and rental uses.

Renting Part of the Property

If you only rent a portion of the property, such as renting one room in the house, you must allocate the expenses between the personal and rental use. A depreciation deduction is allowed only for the rental portion. Expenses that are specific to the rental activity can be fully deducted.

Limits on Losses from Rental Activities

There are two restrictions on deducting losses from rental activities: At-Risk Rules and Passive Activity Limits.

At-risk rules limit your loss deduction to the extent that you have at risk in the activity. Your risk is generally considered to be the cash and basis of property you contribute to the property.

All rental activities, other than for a real estate professional, are considered passive activities. A rental activity for this purpose is defined as an activity from which you receive income for the use of tangible property, rather than services.

The general rule is that passive activity losses can only be deducted against passive gains. Passive losses that you cannot deduct can be carried forward to a future year and can be taken when you completely dispose of the property.

There is an exception to the general rule. If you or your spouse actively participate in the passive rental real estate activity you can deduct up to $25,000 in losses and meet the modified adjusted gross income limits.

You actively participate in an activity if you own at least 10% of the rental property and you make management decisions in a significant sense. This includes approving new tenants, deciding on rental terms, and approving expenditures.

If your modified adjusted gross income (MAGI) is $100,000 or less, you may deduct up to $25,000 in losses. Between $100,000 and $150,000 you lose $1 in deductible losses for every two additional dollars of MAGI.

For this purpose MAGI is defined as your Adjusted Gross Income as shown on Line 38 adjusted by not counting the following:

• Taxable social security
• Deductible contributions to an IRA or certain other retirement plans
• The exclusion of savings bond interest used for higher education expenses
• The exclusion of any employer-provided adoption benefits
• Any passive activity income or loss on Form 8582
• Any passive income or loss allowable to a real estate professional
• Any overall loss from a publicly traded partnership
• The deduction for one-half of self-employment taxes
• The deduction for interest on student loans
• The deduction for qualified tuition and other higher education expenses
• The deduction for income attributable to domestic activities.

________________________________________
Dr. John L. Stancil, a tax analyst for WebTaxCenter.com, has been a member of the Florida Southern College faculty since 1998. He received his bachelors degree from Mars Hill College and holds a M.B.A. from the University of Georgia. He later earned his doctorate in accounting from the University of Memphis. He holds four professional certifications, including CPA, CMA, CFM and CIA. Stancil has received the Florida Institute of CPAs 2005 Outstanding CPA in Public Service Award. (This award is given annually to a Florida CPA who has demonstrated significant contributions through community and civic activities.) He has also been recognized as the Expert of the Month on several occasions by allexperts.com.

• File Your Return Online! Free Online Tax Preparation! FreeTaxUSA.com 100% Accuracy Guarantee Safe & Secure Free Federal, State Only $9.95 learn more...