When you buy rental properties and lease to tenants, you hope to collect rent that will cover the cost of the mortgage and home repairs, while also allowing you to own the property with little to no out-of-pocket expense. That's the goal.
The reality, however, is property can be costly and complicated.
Rental property may be part of your portfolio for passive income and growth of your net worth. If so, you need to be smart about the tax rules. Properly reporting rental income and expenses on your tax return is key.
Here are the basics to get you started and if your tax pro isn't up to date on these, find someone who is. Here's the least you need to know:
1. Rental Reporting
Rental income and expenses are generally reported on Schedule E, Supplemental Income and Loss. Rental income must be reported in the same year in which it is received.
In general, if your rental doesn't make a profit, you can only deduct your expenses up to the amount of rental income.
The IRS website has more information on reporting rental income and expenses,as well as special tax rules that apply to condominium owners and rent paid for cooperatives.
2. Income vs. Expenses
Rental income can include the following payments:
- Rent paid and advance rent payments (such as first and last month's rent)
- Security deposits not returned to the tenant
- Payment for canceling a lease
- Rental expenses paid by tenant in lieu of rent
- Property or services you receive in lieu of rent, at fair market value
Rental expenses may include the following and are deductible in the year in which they were paid:
- Advertising for renters
- Cleaning, maintenance and utilities
- Commissions or management fees
- Insurance premiums
- Local transportation expenses to oversee the property
- Depreciation of rental property
- Legal expenses concerning rental property
- Mortgage interest
- Travel expenses
- Real estate taxes
- Repairs and supplies
- Tax return preparation for rental forms
Rental expenses can be deducted from the time the property is made available for rent. The expenses incurred and paid in connection with managing and maintaining the property while it is vacant are deductible.
You cannot, however, deduct the loss of rental income during the period in which the property is vacant.
3. Repairs vs. Improvements
You can deduct the cost of repairs that you make to your rental property. However, you may not deduct the cost of improvements. This cost is recovered through depreciation. We'll get to that.
So what's the difference? A repair keeps your property in good operating condition and does not materially add value to the property, such as painting, fixing leaks and cracks, and replacing broken doors or windows.
An improvement adds to the value of your property, prolongs its useful life, or adapts it to new uses. An improvement would include adding a room, deck, fence or new roof.
4. Depreciation of Rental Property
Depreciation is based on the expected life of the item. Depreciating the propertymeans you deduct some of the cost on your tax return each year. You can recover the cost of income-producing property through depreciating the property. Check with a tax pro to make sure your circumstances apply to current regulations.
For example, residential rental buildings have a 27.5 year life, while business and office building rentals have a 31.5 or 39 year life.
In general, most improvements that are building components - such as a furnace or a new roof -will have the same life as the building, with depreciation starting when the individual improvement is placed in service.
Furniture and appliances used in rentals have a 5-year life starting when they were placed in service. Generally, stuff like furniture and appliances are NOT eligible to be written off all in one year.
Learning the rules now - or hiring a tax pro to do it for you - now could save you thousands of dollars in tax mistakes in the future.