Americans are used to paying income taxes. Most taxpayers claim the standard deduction, file a quick 1040 and get a refund from the IRS.
But what if you have a slightly more complicated tax future ahead of you? For example, how should you handle income if you rent out a property?
Classify the Property
The first question is whether your property is formally a rental property or a personal residence that you sometimes rent out. There are three categories:
Tax Free Rental
You rent the property for 14 days or fewer in a year.
You're in luck! None of the rest of this article applies to you. The IRS even gives a specific break for short-term rentals. You don't have to claim this income on your taxes at all as long as you rented the property for fair market rate. (So, no working for free then giving your boss an $80,000 overnight "rental." That would fall under our section for tax fraud.) It can only be a property that you live in for more than 15 days a year.
You use the property for more than 14 days OR 10% of the total days it was rented, whichever is greater.
The IRS considers this property a personal residence, not a full rental property. So, for example, take a property you rent for 180 days. In that case you can use it for 18 days or fewer before the property is classified as a personal residence (180 / 10 = 18).
On the other hand, say you rent a beach house during the summer. People stay there for three months per year, so 92 days. In this case you can use it for up to 14 days per year. If your family stays there for 15 days, it becomes a personal residence.
As we'll discuss further below, expenses and losses on a residence are restricted to rental income. If you spend more money than you make on this property you can't deduct the losses from your personal income.
You rent the property for 15 days or more and use it for less than the residency cutoff (14 days/10% as described above).
You have yourself a bone fide rental property. You must report all rental income and can deduct all related expenses on the property. If you happen to lose money renting this property you can carry those losses over to your personal income subject to the rules we're about to explain below.
Note - When determining personal use days any time that you spend maintaining the property doesn't count. This is true even if your family recreationally uses the property at the same time. So, say you rent a beach house, and in between each tenant you spend a day on the property cleaning it and making repairs. Even if your family comes and has fun in the house while you're working, even if you take a break to go swimming, that day does not count as personal use.
Determine Rental Status
Another important question is whether your rental classifies as "passive" or "non-passive" business activity. While you can find a more comprehensive overview here, it's very likely that your rental will qualify as a passive activity according to the IRS.
Non-passive real estate rental means that you engage in property development, construction, acquisition or leasing and operation on a professional level. If actively managing and renting this property makes up a majority of your personal income then you might qualify for non-passive status. Consult a tax professional if you believe this to be the case.
Most property rentals are considered passive income. However, under passive income the IRS distinguishes for active participation. If you have a qualified rental property (see above where we classified your property), then the question is whether you make active management decisions. This involves activities like finding and approving a new tenant, maintaining the property, setting terms of a lease and more.
Doing this will qualify you as an active participant in the rental property.
Passive losses with an inactive participant can only be written off against passive gains. You can only deduct the expenses of your rental property from the money you make on it. You can't deduct any losses from your personal income. You can, however, carry the losses forward to the next year as a deduction on income from the same property.
If you're an active participant in your property then you can deduct losses from personal income up to $25,000. Losses exceeding that cap have to carry over into the next year. Note that this amount can change based on income and marital status, potentially all the way down to zero, so be sure to read the linked IRS guidance.
Example of Active Status
Let's say Helen works a full-time job for $75,000 per year. She also owns a vacation house, which she uses for one week per year and rents the rest of the summer. It therefore qualifies as a rental property. This year she collected $5,000 in rentals but spent $6,000 in maintenance. (We'll disregard percentage of business use, discussed below.) She has two possibilities:
If Helen has a management company do all of the renting, cleaning and maintenance, she probably qualifies as a non-active, passive participant. In this case she can deduct her expenses from her rental income. She can then carry over the remaining $1,000 in losses to any money she makes from the vacation home next year.
Helen manages the property and finds the tenants herself, so she gets the IRS' active participant carve out. She deducts her expenses from the rental income then deducts the $1,000 in losses from her wages, reducing them to $74,000 in taxable income.
Helen does not carry flood insurance. The property suffers a catastrophic loss during a major storm requiring $40,000 worth of repairs. If Helen is an active participant in the property she can first deduct this from her rental income, reducing the loss to $35,000. She can now deduct $25,000 from her wages, reducing her taxable income to $50,000. The remaining $10,000 she can carry forward from her rental income next year.
Percent Business Use
If you use the rental property for personal reasons at any time during the year you must reduce your claimed expenses by the percent of time you used the property for yourself. The easiest way to do this is to divide the number of days the property was rented by the number of days the property was in use. Then apply that percentage to your expenses.
Note that "in use" means occupied. A day that the property is available but not actually rented does not count as a day of use.
For example, Helen threw in the towel on her beach house and now rents an apartment in the city. She rented it for 120 days last year and used it herself for 10, bringing total days of use up to 130. Her percent business use for expenses would be: 120 / 130 = 92%. She can therefore deduct 92% of all expenses on this property.
If you never use the property for personal use you can deduct all expenses.
Claim Expenses on Rental Property
To file taxes on a rental property you will use IRS Schedule E: Supplemental Income and Loss. This schedule lets you deduct as a business expense virtually every penny that you spend on the rental property. While the IRS keeps an extensive guide here, common expenses include:
- Mortgage interest (NOT the mortgage payment itself)
- Property taxes
- Travel expenses to and from your property if the primary purpose is to manage the rental property
- Cleaning, repairs and maintenance
- Realtor commissions
- Depreciation (see below)
- Legal and professional fees
- Advertising expenses
- Necessary supplies
This is just a list of examples. As a general rule, any money you spend owning, operating and maintaining your rental property can be deducted from that property's income. Reduce that by any percent of time that you used the property for personal reasons and this is the amount you can reduce your taxable income by.
Claim Income on Rental Property
On Schedule E you will also report your property's income. There are actually several forms of income that you must claim in addition to the rent that a tenant pays. You must claim any and all payments related to the property that you keep for personal or business use. Security deposits do not count as income if returned to the tenant. Withholding a deposit transforms it to income.
Other examples of income include:
- Advance rent
- Expenses or utilities paid by the tenant
- In-kind payment (if the tenant performs a service in exchange for rent, you must claim that as an equivalent to payment for property at its standard rate)
Once you have calculated your total income you then will deduct your total expenses. This final figure is your net taxable income or loss from the property.
Depreciation on Rental Property
When it comes to expenses, this is usually the big one.
As a rental property owner you don't get to write off your payments on the property other than interest. However, you do get to write off its value in a process called depreciation. Here's how:
Depreciation is based on the value of the property, using the lesser of either current market value or what you paid for it. If you paid nothing for the property, for example, if you received it as an inheritance, consult a tax professional for your options. You will then reduce that value by the value of the land the property sits on, as depreciation does not apply to land.
Finally, divide this number by 27.5. This is your annual depreciation amount, which you can apply to your expenses each full year that you rent the property for 27.5 years of renting it. After this period the property is considered fully depreciated and the deduction falls off.
For example, Helen's city apartment burns down. After the trial she uses her insurance money to buy another beach house. Two years later she converts it to a rental property.
Helen bought the house for $150,000. The assessed value has gone up to $175,000. The land is worth $30,000. Her annual depreciation, then, is: $150,000 (the lesser value) - $30,000 (the land value) = $120,000 / 27.5 = $4,363. Each year Helen can deduct $4,363 from her rental income as a depreciation expense.
Qualified Business Income on Rental Property
Finally, you may be eligible for a new provision in the 2017 tax bill. This is called a Qualified Business Income deduction, or QBI.
Under the QBI you can deduct 20% of income from a qualified business from your taxable income. It applies to businesses such as S corporations and sole proprietorships. Real estate and rentals commonly fall under this category.
Before attempting to take a QBI deduction we recommend that you consult a tax professional. This provision is new, 2018 will be the first taxable year in which it is applied, and the IRS has only recently set forth any guidance as to how it will apply. While it can result in significant savings, there is sufficient ambiguity here that you should approach it with caution.
How Tax Fraud Relates to Rental Property
Don't have your friend charge $100,000 for cleaning services that you never pay. Do not report the unit as professionally rented when you just let some college buddies stay there for free. Do not attempt to claim that you've never set foot on the property when your family actually spends all winter there.
Many, if not most, areas of rental income tax depend on reasonable use and honest reporting by the landlord. This is why it has become an area with such significant tax concerns, and the IRS accordingly pays particular scrutiny to Schedule E filings.
Misreporting your earnings, expenses or use of the property is a felony. If you make an honest mistake that's one thing. You'll simply get a letter from the IRS saying that you miscalculated. (You should, in fact, expect these as a regular course of business.) As long as you honestly write down what you did, what you collected, what you spent and what you spent it on, you're fine.
Anything else and you can find yourself in some very serious trouble.