Understanding the income tax code is a necessary part of being a real estate investor. This page will give you an overview of how the tax code works for Schedule E (titled Supplemental Income and Loss) filers. Using Schedule E applies to most small real estate investors who have rental property.
Income and Accounting Method
First, all rental income must be included in gross income. There are two reporting methods used: cash basis and accrual basis. Cash basis, being the easier method, means that you report income when you actually receive it. Under this method, uncollected rent is not reported.
Accrual basis, on the other hand, means that you report income when you earn it. If income is earned and cannot be collected, you can deduct bad debt as an expense. Under the accrual method, you generally deduct expenses when you incur them.
Do NOT include security deposits as income if planning to return to tenant at the end of the lease. However, if a tenant fails to fulfill the terms of the lease, then the amount kept must be included in income.
If there is a payment made for canceling a lease, that amount is taxable income and must be reported in the year it was received.
Expenses Paid by Tenant
If a tenant pays any of the property’s expenses, these payments are considered rental income. This is usually a wash because you can deduct these expenses if they are valid rental property expenses.
A common scenario in which this occurs is when the property owner forms an agreement with a tenant to repair something in exchange for rent. (As a side note, if you’re a landlord, you generally should think twice before doing this.)
Payments received under a lease option are rental income. If the tenant exercises his/her right to purchase the property, payments made after the sale date are part of the selling price.
What if My Property is Vacant?
If the property is available for rent but sitting empty, you can still deduct the property’s expenses. This includes expenses related to management, maintenance, advertising, depreciation, and more.
If a property was used for a personal use and as an income property during the tax year, you must divide the expenses between each use.
The personal use portion of some expenses, including mortgage interest and real estate taxes, may be deducted on Schedule A if used as a first or second home. According to the IRS, a dwelling unit is used as a home if you used more than the greater of: 14 days, or 10% of the total days it’s rented to others at fair market value.
Repairs vs. Improvements
This is something that is frequently misunderstood. Repairs and improvements have big differences in how they are reported. Repairs are generally deductible at the time they are paid for and consist of fixing single items (a remodel is NOT considered a repair).
An improvement adds to the value of the property, extends the property’s useful life, or adds functionality. Improvements may include adding a room, a remodel, or a new roof. The cost of the improvement adds to the cost basis of the property and is nut fully deductible when paid. You can, however, depreciate the cost of the improvement every year as if it were a separate property.
You cannot deduct charges and assessments that add value to your property. Examples of local benefits include putting in new streets and sidewalks. This is a nondepreciable capital improvement and is added to the cost basis of the property. These are only deductible if they are for repairs and maintenance.
Interest expenses generally include mortgage interest, points paid to get a mortgage, and loan origination fees. The following are NOT deductible as interest: mortgage commissions, abstract fees, and recording fees. These are, however, expenses that are added into the cost basis of the property.
Travel expenses are deductible if your primary purpose is related to taking care your property. This may include collecting rent, repairs, maintenance, or management.
If the travel expenses were for making an improvement, this is reported as being part of the cost of the improvement. You must deduct these through depreciation.
Rental property is subject to depreciation expense. This is a non cash expense that reduces the cost basis of the property. Depreciation is determined by the useful life of the property (27.5 years for residential real estate, 39 years for commercial real estate). This is for the vale of the improvements only. Land is never depreciable. You must separate the value of the land and improvements before calculating depreciation.
If you are a tenant-stockholder of a cooperative, you can deduct the depreciation based on the stock you have in the corporation.
Limits on Rental Losses
Rental real estate is generally considered a passive investment. This means that you cannot offset losses from income (other than other passive income) with losses from passive investments. There are exceptions to this rule.
Real estate losses are deductible if you are a real estate professional or you actively and materially participated in your rental property. If you meet this criteria AND the total losses amount to less than $25,000, the limits on taking a loss do not apply. If you do not meet this criteria, then losses cannot exceed passive income. You can, however, carry the loss forward to offset future passive income.
Real Estate Professionals
To be considered a real estate professional, you must meet both of the following: 1) Greater than half of the work you performed in ALL trade during the tax year involved participating in real estate activity AND 2) You spent more than 750 hours of work during the year in real estate activities. You must own at least 5% of the properties in which you worked on. The work described includes construction, development, acquiring, converting, renting, repairing, managing real property.
Material Participation Defined
Material participation requires that you were involved with the operations of the property on a regular an continuous basis during the year.
Active Participation Defined
Active participation requires that you own at least 10% of the property or properties and that you made management decisions in a significant and bone fide sense. Examples of management decisions include approving new tenants, deciding on rental terms, and approving expenses.
If you actively participated, you can deduct up to $25,000 in losses.
This is a general overview of how rental property is taxed for Schedule E filers. For more information, see IRS Publication 527.
Source: IRS Publication 527, 2009.
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