A Guide to Understanding Rental Income Taxes
Do you own a rental or investment property? If so, it is crucial that you declare the rent collected from tenants as rental income when filing your taxes. It is important to note that you are able to deduct expenses incurred for maintaining your investment property. For first-time landlords, the additional tax declarations can be intimidating. While your tax filing will undoubtedly be a bit more complicated, hopefully this guide will help you understand rental income taxes.
What Constitutes Rental Income?
According to the IRS, any payment that is received for the use or occupation of property is considered rental income.
Depending on the method of accounting you use, the calculation of rental income may slightly vary. Most individuals utilize the cash basis accounting method, in which you report payments and expenses as they happen. In other words, you would declare your rental income as you receive it. This is different from the accrual method, in which income is calculated by when it is “earned” rather than when it is actually received.
For most landlords there are a few additional amounts that are considered to be rental income in addition to the rental payments themselves. These additional income sources include things like:
- Advance rent— Any rent that is paid by a tenant for a period of time in the future. If you receive advance rent be sure to declare it as a form of rental income. It is important that you declare the amount in the year that you receive it. The actual period of time the rent is paid in advance for is irrelevant. Let’s say for example your tenant signs a 5-year lease on your rental property with an annual rent of $10,000. As the landlord, you require the tenant to pay 2 years of rent upfront. When declaring your taxes, you would list your rental income as $20,000 for the first year.
- Security Deposits—Landlords often use security deposits to protect their property. If you take a part or all of a security deposit from your tenant, be sure to include this in your rental income calculation. However, if you intend on returning the security deposit, then do not include it.
- Tenant paid expenses— If your tenant pays any expenses on the property you own, that is likewise a form of rental income. For example, if your tenant pays the electricity bill for your property, and the lease does not require that the tenant to pay said bill, be sure to include the bill payments in your calculations as rental income.
- Services or property received as rental payments instead of money—If services or other forms of property besides money are exchanged, you must include this in your calculations based on its “fair-market value”. Let’s say, for example, that your tenant is a contractor that lives in your rental property for $1000/month. If your tenant offers to renovate your rental property bathroom in exchange for 6 months of rent, the fair market value of that exchange would be equivalent to $6000.
- Partial ownership— If you have a partial ownership of a rental property, any income that is received from your portion of ownership must be included.
Deduct, Deduct, Deduct:
When calculating the total amount that you will declare as rental income, it is important to remember that certain expenses spent on your investment property are tax deductible. Declaring valid deductions will help lower your overall tax liability. Example expenses that are valid include depreciation, property tax, mortgage interest, operating costs and repairs.
Now that we have a basic understanding of what qualifies as rental income, lets take a look at how and when you should file for deductions.
What qualifies as a valid deduction?
The IRS evaluates whether or not a deduction is valid based on the “ordinary and necessary expenses” standard. This standard applies to the management, conservation, and maintenance of a rental property.
Ordinary expenses are expenses that are generally accepted when owning a property. For example, if you have a property superintendent, the salary paid is considered as an ordinary expense. On the other hand, necessary expenses are expenses that are considered appropriate to owning a rental property. For example, if you pay a real estate firm to advertise your property, those expenses would be considered as a necessary expense. Other necessary expenses include insurance, maintenance, or utility costs of your property. Within maintenance costs, certain materials, supplies, and repair expenses are likewise deductible when used to keep your property in good condition.
One big caveat of rental income deductions is that any improvements or renovations to a rental property are not valid deductions. Improvements that are not necessary to keep the property in good operating condition cannot be declared as a deduction. This means if you decide to install a beautiful new kitchen and bathroom in your rental property, you would not be able to deduct those respective expenses while calculating your total rental income.
However, you would be able to recoup some of these costs through depreciation deductions. In order to do this, you will need to use Form 4562 to declare the depreciation of your property in the first year you start to rent out the property, or within the year that you had the improvements placed.
Time to report: Where to actually declare rental income and expenses
After you’ve calculated what your total rental income will be and its associated deductions, you will need to actually file those taxes!
For real estate investment properties (i.e. Buildings, rooms, apartments), you will need to report the income generated and expenses on Form 1040 Schedule E, Part I. Within this section, you can list out the total rental income received, any expenses incurred, and depreciation value for a specific property.
If you intend to add a depreciation value, it is important to remember that you will need to use Form 4562 to declare the depreciation value in the first place. This form allows you to report for up to three properties. If you have more than three properties, you would first fill out as many Schedule E’s as necessary to list all properties. For each additional Schedule E, fill in lines one and two for each property. The main difference is that you will only need to fill in the “totals” column one time on only one Schedule E form. The total should be the sum of all your properties that you have included within your Schedule E forms.
If you have any personal usage of your rental property (e.g. renting out a vacation home or a spare bedroom in your own home), there are a different set of standards that you must follow to properly calculate your rental income amount.
You will first need to split the expenses between rental usage and your personal usage. In general, you first need to figure out how many days you actually rented your property out. Next, you will need to divide the total number days the property is used by the number of days you rented the property. Lastly, multiply the total of your rental expenses by the factor you calculated above. This final amount is what can be declared as your rental expense on the 1040 Schedule E form.
Keep those Records:
Keeping good records of your rental property is just as important as properly declaring your rental income when tax filing. If you keep good track of your rental property and keep all appropriate documentation (i.e. Receipts for expenses) related to it, preparing your taxes will be significantly easier.
This is especially important if your tax filing is selected for an audit. During an audit, you will need to provide document evidence to substantiate your rental income and expense values. For example, if you have listed in your expenses travel costs for repairs to your rental property, be prepared to provide documented evidence. This could be specific gas station receipts for the times you needed to fill your tank to make a repair on your property, or taxi and car share service receipts.
If you are unable to provide the necessary documentation to validate an expense, you could be subjected to additional taxes and penalties. In order to protect yourself, always remember to save receipts or another form of documentary evidence (i.e. Invoices, bills, checks, contracts, etc.) for any expense you plan to declare. You will not only have a better sense of what is being spent on your rental property, but you will also be proactively protecting yourself in the event that you are audited.
For many, investing in a rental property is a solid option for boosting financial security and stability. While it can be a great way to generate additional income, it is important to recognize the responsibilities that come with it. In addition to all the activities required to maintaining a property in good operating condition, you must make sure that you are properly filing and declaring your rental income. Hopefully this guide has helped make that process just a bit easier.