(For the articles on wages, salaries, and tips; interest; dividends and other distributions; or other income click here, here, here, or here respectively.)

This article deals with the ins and outs of rental income. For our purposes, rental income is derived from the leasing of real property on a short or long term basis. The aggregate of money collected from these rental periods for the year is tallied and reported as taxable income. In my experience, the average taxpayer with rental income most commonly derives it from renting a single family starter home in the realm of one to two thousand square feet. Another common type of rental property is a condo or apartment, which is less common but treated in exactly the same manner in terms of taxability and reporting.

When you think of rental income, there is an initial thought that it’s just cash paid monthly as rent under a lease, but this is an oversimplification. Rental income also includes advance rent, which is reported in the year it’s received regardless of whether it’s for a future year. Furthermore, when a tenant pays you money to legally cancel a lease, you have to include this amount paid to you as rent. Additionally, if your tenant pays expenses associated with the upkeep of your rental property, then that amount is also counted as taxable rent to you, but these expenses may also be deducted if they are generally deductible. On a different note, the security deposit paid by your tenant is not taxable and therefore should not be included in gross income. However, if part of the security deposit is kept due to some contingency in the lease, then include that portion in your gross income.

Deductible rental expenses encompass such categories as advertising, auto and travel, cleaning and maintenance, commissions, insurance, legal and other professional fees, management fees, mortgage interest paid to banks, repairs, supplies, taxes, utilities, and depreciation. Also, other expenses are deductible as long as they are directly related to the rental property, articulated on the return, and not specifically non-deductible. A note on depreciation, residential rental property is deductible over a recovery period of 27.5 years, under the straight line method and mid-month convention, while commercial rental property is recoverable over 39 years, also straight line and mid-month. This means that for a rental house, it takes 27.5 years to completely depreciate, in other words deduct the entire basis of the property.

Also be aware that if you repair a portion of your rental property, that repair is fully deductible in the year the repair was made. However, if you completely replace a portion of the property, then that expense must be depreciated over a 27.5 year recovery period, using the straight line method and mid-month convention. So, for example, if you patch the roof of your rental house, you can deduct the entire price of the repair in the year it was performed. But if you totally replace the roof, then you must depreciate the price you paid for the roof over 27.5 years.

If you change the purpose of your real property from personal use to investment rental, then you can only deduct the proportion of expenses that were incurred during the rental period. In a similar vein, if you rent only part of your house, like a single room, then you can only deduct the expenses that are proportionate or attributable to the portion rented. A common method for delineating between personal and rental expenses is based on the number of rooms in your home or its square footage.

A major issue with rental property is losses. When you tally mortgage interest, property taxes, and depreciation, along with all other expenses, many landlords have a loss associated with their rental activity, especially if the property is a single family home. As tempting as it may be to just write off this entire loss against income, there are two major rules that limit these rental losses. The first are at-risk rules. These rules basically stipulate that you can only deduct losses to the extent of your own personal investment in the property in the form of cash, basis, and loans for which you are personally liable. So this rule basically states that if you don’t have skin in the game, you can’t deduct the loss.

The other rule potentially limiting losses are passive activity loss limitations. This rule pretty much allows rental losses only to the extent they are matched by other gains from passive activities. What is a passive activity? Well, rental real estate activities are, along with trade or business activities that you don’t materially participate in. In this context, material participation means that you engaged in the activity of the business consistently, and as much as any other person in that business, for at least 100 hours, or for more than 500 hours in the activity regardless of any other person’s participation in the business.    

There are two exceptions to the passive activity loss limitation rule. The first is for real estate professionals. If you are a real estate professional and you materially participated in renting your real property, then the losses aren’t considered associated with passive activities, and those losses are not limited. The other exception comes when you or your spouse actively participates in the rental business of your residential property. In that case, you can deduct up to $25,000 ($12,500 if married filing separately) in losses from your residential rental activities. Active participation, not to be confused with material participation, can be thought of as, more or less, management decisions in the realm of setting rental terms, including deciding to whom you should rent. Be careful though because there’s an income phase out to this $25,000 loss allowance between $100,000 and $150,000 (between $50,000 and $75,000 for married filing separately). The reduction pertaining to the phase out is figured by taking the $25,000 allowance and subtracting half the difference between the taxpayer’s modified adjusted gross income and $100,000.       

Finally, rental income is reported on Schedule E, with the depreciation of the rental property reported on Form 4562.

For more information on income, including rental income, see IRS Publication 17.

If you are having problems accounting for your rental income, including figuring the amount of deductible losses, or you have any tax problem or question, don’t hesitate to call Dino Tax Co today at (713) 397-4678 or email us at davie@dinotaxco.com. The initial consultation over the phone is always free. Also, consider liking us on Facebook: www.facebook.com/dinotaxco.