Income and Deductions
Generally, you report income and deduct expenses related to real estate rental property on a Schedule E. Rental income can be cash or the fair market value of property you receive in exchange for the use or occupation of your own property. If you partially own a rental property, report your percentage of the rental income from it. If you sometimes use your rental property for personal purposes, divide your expenses between rental and personal use. There are special rules relating to the rental of real property that you also use as your main home or your vacation home.
If you use the cash method of accounting, you report the income for the tax year in which it is received and deduct expenses in the year they are paid. This includes any rent you receive in advance. You cannot deduct uncollected rents as an expense because the rents have not been reported as income. If you use an accrual method of accounting, report the income when you earn it. Uncollected rent may qualify as a business bad debt deduction if you use this method.
A payment to cancel a lease is also considered rental income. However, a security deposit is not considered income if you plan to return it to the tenant at the end of the lease. But if any of it is kept due to damaged property or a broken lease, this money is taxable income to be reported when assessed. A deposit to be used as the tenant’s final month’s rent is reportable when received, not when applied to the last month’s rent.
You can deduct your ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent. If a property held for rental purposes is vacant, you may still be able to deduct these expenses until it is rented. However, you cannot deduct any loss of rental income for the period the property is vacant. If you sell property you held for rental purposes, you can deduct the same expenses you would ordinarily deduct until the property is sold.
Deductible expenses can include depreciation, insurance, taxes, interest, repair costs, maintenance and other operating expenses including rental equipment. The following is a short list of other common expenses: advertising, commissions, legal fees, local transportation and travel expenses related to your rental income or property, mortgage or rental payments and points, tax return preparation fees, and utilities.
Mortgage points (also called loan origination fees or premium charges) are prepaid interest. These are generally not wholly deducted in the year paid, but over the term of the loan. Certain mortgage expenses such as mortgage commissions, abstract fees, and recording fees, are capital expenses and can be amortized over the life of the mortgage.
Repairs and Improvements
It is important to keep separate the costs of your repairs and improvements. Repairs keep your property in good operating condition but do not materially add to the value of your property, substantially prolong its life, or prepare it for other uses. Examples of repairs are repainting walls or fixing broken windows or plumbing. Repair costs can be deducted as rental expenses.
Improvement costs, on the other hand, must be capitalized. They can generally be depreciated as if the improvement were separate property. For example, the cost of a new roof is an improvement. And if you make repairs as part of an extensive remodeling or restoration of your property, the whole job is an improvement.
Examples of improvements are generally obvious, such as storm windows, heating and insulation, septic tanks, security systems, swimming pools and landscaping, and room additions. Some examples are not so evident, such as flooring or wall-to-wall carpeting. For example, replacing an already existing carpet might be considered a repair or even a casualty loss depending on the reason for the replacement.
Use Form 4562 to report depreciation of your acquisitions and improvements in order to recover some of your original costs, beginning the year in which they occur. If you use your personal vehicle for rental activities, you can deduct the expenses using the actual expenses or the standard mileage rate; keep accurate records and report these expenses on Form 4562, as well.
Additional information can be found at www.irs.gov in Publication 527 (Residential Rental Income), Publication 535 (Business Expenses), Publication 946 (How To Depreciate Property), and Topic 415 (Renting Residential and Vacation Property).