People often rent out their residential property as a source of income, particularly during the vacation-heavy, warm summer months. Different tax rules apply depending on if the taxpayer renting the property used the property as a residence at any time during the year. To help taxpayers avoid a sweat at tax time, the IRS wants taxpayers to know the facts about reporting rental income.
Residential rental property can include a single house, apartment, condominium, mobile home, vacation home or similar property. These properties are often referred to as dwellings. Taxpayers renting property can use more than one dwelling as a residence during the year.
A dwelling is considered a residence if it’s used for personal purposes during the tax year for more than the greater of 14 days or 10 percent of the total days rented to others at a fair rental value. In general, personal use includes use of the property by:
- Any person who owns an interest in the property,
- A family member of any person who owns an interest in the property (unless it’s the family member’s principal residence and the owner receives fair rental value),
- Anyone who has an arrangement that lets the owner use some other dwelling or
- Anyone using the property at less than fair rental value.
Personal use doesn’t include days of repair and maintenance, if the taxpayer is doing the repairs and maintenance on a largely full-time basis. Publication 527, Residential Rental Property (Including Rental of Vacation Homes) has more details about personal use.
Rental income includes:
- Normal rent payments
- Advance rent payments
- Payments for canceling a lease
- Expenses paid by the tenant
Rental income generally doesn’t include a security deposit if the taxpayer plans to return it to their tenant at the end of the lease. But if the taxpayer keeps part or all the deposit during any year because the tenant doesn’t live up to the terms of the lease, then the taxpayer includes the amount kept as rental income in that year.
If a taxpayer has any personal use of a dwelling that they rent, they must divide their expenses between rental use and personal use. They must divide expenses even if the dwelling doesn’t meet the definition of a residence. They may deduct only rental expenses on Schedule E (Form 1040). They may be able to deduct some of their personal expenses on Schedule A (Form 1040) if they itemize deductions.
Furthermore, the amount of rental expenses that a taxpayer can deduct may be limited if the dwelling is considered a residence.
Publication 527 has more details about dividing expenses and deduction limitations.
Ordinary and necessary expenses. Taxpayers can deduct the ordinary and necessary expenses for managing, conserving and keeping their rental property. Ordinary expenses are common and generally accepted in the business, such as depreciation and operating expenses. Necessary expenses are appropriate, such as interest, taxes, advertising, maintenance, utilities and insurance.
If the taxpayer includes expenses paid by a tenant, the fair market value of the property or services given by a tenant in their rental income, then normally they can deduct that same amount as a rental expense.
Improvements. The taxpayer may not deduct the cost of improvements to better, restore or change the property to a different use. The taxpayer recovers the cost of improvements through depreciation. They use Form 4562 to report depreciation beginning in the year they first place their rental property in service and beginning in any year they make an improvement or add furnishings. The taxpayer can only deduct a percentage of these expenses in the year that they incur them. The Tangible Property Regulations – Frequently Asked Questions on IRS.gov have for more information about improvements.
Depreciation. The general recovery period for residential rental property is 27.5 years. The Tax Cuts and Jobs Act changed the alternative depreciation system recovery period for residential rental property from 40 years to 30 years. Under the new law, a real property trade or business electing out of the interest deduction limit must use the alternative depreciation system to depreciate any of its residential rental property. These changes apply to taxable years beginning after Dec. 31, 2017.
For more information about new rules and limitations for depreciation and expensing under the Tax Cuts and Jobs Act go to the Tax Reform page on IRS.gov.
Special rules apply if the taxpayer rents out a dwelling that’s considered a residence fewer than 15 days during the year. In this situation, the taxpayer doesn’t report the rental income and doesn’t deduct rental expenses. Publication 527 has more information about these rules.
In most cases, a taxpayer must report all rental income on their tax return. In general, they use Schedule E (Form 1040) to report income and expenses from rental real estate.
If a taxpayer has a loss from rental real estate, they may have to reduce their loss or it may not be allowed. Taxpayers must refer to rules for personal use of a dwelling that they rent, at-risk rules and passive activity loss rules. These rules tell them if they can take the loss against other income. For detailed information about these rules, see Publication 925, Passive Activity and At-Risk Rules, and Publication 527.
Net investment income tax may apply to net rental income. Taxpayers use Form 8960, Net Investment Income Tax Individuals, Estates and Trusts, to figure the amount of this tax.