Know the Facts about
RESIDENTIAL RENTAL PROPERTY
Rental Income should be included on your tax return, and the expenses of your rental property can be deducted from your rental income.
What is RENTAL INCOME:
You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. You must report rental income for all your properties.
In addition to amounts you receive as normal rent payments, there are other amounts that may be rental income and must be reported on your tax return.
- Advance rent is any amount you receive before the period that it covers. Include advance rent in your rental income in the year you receive it regardless of the period covered or the method of accounting you use. For example, you sign a 10-year lease to rent your property. In the first year, you receive $5,000 for the first year’s rent and $5,000 as rent for the last year of the lease. You must include $10,000 in your income in the first year.
If your tenant pays you January rent on December 31 you must include that rent in your income.
- Expenses paid by tenant occur if your tenant pays any of your expenses. You must include them in your rental income. You can deduct the expenses if they are deductible rental expenses. For example, your tenant pays the water and sewage bill for your rental property and deducts it from the normal rent payment. Under the terms of the lease, your tenant does not have to pay this bill. Include the utility bill paid by the tenant and any amount received as a rent payment in your rental income.
- Property or services received, instead of money, as rent, must be included as the fair market value of the property or services in your rental income. For example, your tenant is a painter and offers to paint your rental property instead of paying rent for two months. If you accept the offer, include in your rental income the amount the tenant would have paid for two months worth of rent.
What Deductions Can I Take as an Owner of Rental Property?
If you receive rental income from the rental of a dwelling unit, there are certain rental expenses you may deduct on your tax return.
These expenses may include
- mortgage interest
- property tax
- operating expenses
- cleaning and maintenance
You can deduct the ordinary and necessary expenses for managing, conserving, and maintaining your rental property. Ordinary expenses are those that are common and generally accepted in the business.
You can deduct the costs of certain materials, supplies, repairs, and maintenance that you make to your rental property to keep your property in good operating condition.
Depreciation on Rental Property
Real estate depreciation is an important tool for rental property owners. It allows you to deduct the costs from your taxes of buying and improving a property over its useful life, and thus lowers your taxable income in the process.
- Rental property owners use depreciation to deduct the purchase price and improvement costs from your tax returns.
- Depreciation commences as soon as the property is placed in service or available to use as a rental.
- By convention, most U.S. residential rental property is depreciated at a rate of 3.636% each year for 27.5 years.
- Only the value of buildings can be depreciated; you cannot depreciate land.
Repairs vs. Improvements: Complicated IRS Rules
Whenever you fix or replace something in a rental unit or building you need to decide whether the expense is a repair or improvement for tax purposes. Why is this important? Because you can deduct the cost of a repair in a single year, while you must depreciate improvements over as many as 27.5 years.
Unfortunately, telling the difference between a repair and an improvement can be difficult. In an attempt to clarify matters, the IRS issued lengthy regulations explaining how to tell the difference between repairs and improvements.
What Is an Improvement Under IRS Rules?
Under the IRS regulations, property is improved whenever it undergoes a:
- Adaptation, or
Think of the acronym B A R = Improvement = Depreciate.
If the need for the expense was caused by a particular event—for example, a storm—you must compare the property’s condition just before the event and just after the work was done to make your determination. On the other hand, if you’re correcting normal wear and tear to property, you must compare its condition after the last time you corrected normal wear and tear (whether maintenance or an improvement) with its condition after the latest work was done. If you’ve never had any work done on the property, use its condition when placed in service as your point of comparison.
An expenditure is for a betterment if it:
- ameliorates a “material condition or defect” in the property that existed before it was acquired or when it was produced—it makes no difference whether or not you were aware of the defect when you acquired the unit of property, or UOP (discussed below)
- results in a “material addition” to the property—for example, physically enlarges, expands, or extends it, or
- results in a “material increase” in the property’s capacity, productivity, strength, or quality.
An expenditure is for a restoration if it:
- returns a property that has fallen into disrepair to its “ordinarily efficient operating condition”
- rebuilds the property to a like-new condition after the end of its economic useful life, or
- replaces a major component or substantial structural part of the property
- replaces a component of a property for which the owner has taken a loss, or
- repairs damage to a property for which the owner has taken a basis adjustment for a casualty loss.
You must also depreciate amounts you spend to adapt property to a new or different use. A use is “new or different” if it is not consistent with your “intended ordinary use” of the property when you originally placed it into service.
Using Safe Harbors to Deduct Repairs and Improvements
As the above discussion shows, it can be difficult to determine whether an expense is for a repair or improvement. Fortunately, landlords may use three “safe harbor” rules to bypass the repair-improvement conundrum and currently deduct many expenses regardless of whether they should be classified as improvements or repairs under the IRS regulations.
- the safe harbor for small taxpayers
- routine maintenance safe harbor, and
- de minimis safe harbor.
Safe Harbor for Small Taxpayers
The safe harbor for small taxpayers (SHST) allows landlords to currently deduct all annual expenses for repairs, maintenance, improvements, and other costs for a rental building. However, the SHST may only be used for rental buildings that cost $1 million or less. And the annual SHST deduction is limited to the lesser of $10,000 or 2% of the unadjusted basis of the building. This limit is determined on a building-by-building basis—for example, if you own three rental homes, you apply the limit to each home separately.
Routine Maintenance Safe Harbor
Expenses that qualify for the routine maintenance safe harbor are automatically deductible in a single year, even if they would otherwise qualify as improvements that ordinarily must be depreciated over several years. Routine maintenance consists of recurring work a building owner does to keep an entire building, or each system in a building, in ordinarily efficient operating condition. It includes:
- inspection, cleaning, and testing of the building structure and/or each building system, and
- replacement of damaged or worn parts with comparable and commercially available replacement parts.
Routine maintenance can be performed and deducted under the safe harbor any time during the property’s useful life. However, building maintenance qualifies for the routine maintenance safe harbor only if, when you placed the building or building system into service, you reasonably expected to perform such maintenance more than once every ten years. Moreover, the safe harbor may not be used for expenses for betterments or restorations of buildings or other business property in a state of disrepair.
De Minimis Safe Harbor
Landlords may use the de minimis safe harbor to currently deduct any low-cost property items used in their rental business, regardless of whether the item would constitute a repair or an improvement under the regular repair regulations. The safe harbor can be used for personal property and for building components that come within the deduction ceiling. For example, it could be used for the cost to replace a building component like a garage door or bathroom sink. For most landlords, the maximum amount that can be deducted under this safe harbor is $2,500 per item, as shown on the invoice.
All expenses you deduct using the de minimis safe harbor must be counted toward the annual limit for using the safe harbor for small taxpayers (the lesser of 2% of the rental’s cost or $10,000).
ADDITIONAL RULES FOR REAL ESTATE INVESTMENT INCOME
The 20% pass through tax deduction: FAQs
As real estate investors, you may have heard about the tax benefit for our businesses referred to as the 20% pass-through deduction. Simply put, this incentive allows you deduct 20% of your business income.
What is the 20% pass-through deduction?
The Tax Cuts & Jobs Act of 2017 introduced a new 20% pass-through deduction allowing certain business owners to deduct 20% of qualified business income if your taxable income is below $157,500 if single or $315,000 if married. Should your taxable income be above these thresholds, a complicated calculation will be used to determine the amount of this deduction.
What does safe harbor mean?
If you still have taxable income from your rental properties after following the strategies explored in this guide, you may qualify for the 20% pass-through deduction under the following safe harbor, which requires that ALL conditions are met:
- The property is held directly by the individual or through a disregarded entity by the individual or passthrough entity seeking the pass-through deduction (e.g., a person who owns a single-member LLC that holds a rental property qualifies).
- Commercial and residential real estate may not be part of the same enterprise.
- Separate books and records are maintained to reflect income and expenses for each rental real estate activity or enterprise (a separate real estate enterprise may constitute multiple properties as long as it is all commercial or all residential).
- 250+ hours of rental services are performed for the enterprise (see details below).
- You maintain contemporaneous records, including time reports or similar documents, regarding:
- a) hours of all services performed,
- b) description of all services performed,
- c) dates on which such services are performed, and
- d) who performed the services.
What qualifies as rental services?
Rental services include advertising to rent, negotiating and executing leases, verifying tenant applications, collection of rent, daily operation and maintenance, management of the real estate, purchase of materials, and supervision of employees and independent contractors. Services performed by owners or employees, agents, or contractors all count toward the 250 hours.
What if I don’t meet the safe harbor criteria?
Note that even if your rentals don’t meet the criteria for the above safe harbor, that doesn’t necessarily mean they won’t qualify for the 20% pass-through deduction. Regardless of whether your activity qualifies for the described safe harbor, if you plan on taking this deduction, you’ll have to issue Form 1099 for all independent contractors to which you paid over $600 during the year.
Note: Rental property owners are generally not required to file or send 1099s to independent contractors unless you plan to take the 20% pass-through deduction, provide substantial services to guests, or qualify as a real estate professional for tax purposes.
AM I A REAL ESTATE PROFESSIONAL AND WHAT DOES THAT MEAN?
Real Estate Professional: FAQs
Under Sec. 469, a real estate investor taxpayer may only offset losses from a passive activity (real estate in this example) against income from a passive activity. A passive activity generally includes any trade or business of a taxpayer in which the taxpayer does not materially participate and any rental activities of a taxpayer, regardless of the level of participation.
A rental activity of a taxpayer that qualifies as a real estate professional under Sec. 469(c)(7) is not presumed to be passive and will be treated as nonpassive if the taxpayer materially participates in the activity.
Do you qualify?
A taxpayer qualifies as a real estate professional if
(1) more than one-half of the personal services the taxpayer performs in trades or businesses during the tax year are in real property trades or businesses in which the taxpayer materially participates, and
(2) hours spent providing personal services in real property trades or businesses in which the taxpayer materially participates total more than 750 during the tax year.
- A real estate professional taxpayer generally must establish material participation in each rental activity separately. However, the taxpayer may elect to aggregate all of his or her interests in rental real estate for purposes of determining material participation.
- Passive income, including from rental activities, is generally subject to the net investment income tax (provided other criteria are met) unless the taxpayer is a qualifying real estate professional and the income is derived in the ordinary course of a trade or business.
- A safe harbor in such cases provides that 500 hours in the rental activity either in the tax year or in any five years (whether or not consecutive) of the immediately previous 10 years constitutes services in the ordinary course of a trade or business.
If you rent a dwelling unit to others that you also use as a residence, limitations may apply to the rental expenses you can deduct. You’re considered to use a dwelling unit as a residence if you use it for personal purposes during the tax year for more than the greater of:
Rental Property / Personal Use
- 14 days, or
- 10% of the total days you rent it to others at a fair rental price.
It’s possible that you’ll use more than one dwelling unit as a residence during the year. For example, if you live in your main home for 11 months, your home is a dwelling unit used as a residence. If you live in your vacation home for the other 30 days of the year, your vacation home is also a dwelling unit used as a residence unless you rent your vacation home to others at a fair rental value for 300 or more days during the year in this example.
A day of personal use of a dwelling unit is any day that the unit is used by:
- You or any other person who has an interest in it, unless you rent your interest to another owner as his or her main home and the other owner pays a fair rental price under a shared equity financing agreement
- A member of your family or of a family of any other person who has an interest in it, unless the family member uses it as his or her main home and pays a fair rental price
- Anyone under an agreement that lets you use some other dwelling unit
- Anyone at less than fair rental price
Minimal Rental Use
There’s a special rule if you use a dwelling unit as a residence and rent it for fewer than 15 days. In this case, don’t report any of the rental income and don’t deduct any expenses as rental expenses.
Dividing Expenses between Rental and Personal Use
If you use the dwelling unit for both rental and personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. You won’t be able to deduct your rental expense in excess of the gross rental income limitation (your gross rental income less the rental portion of mortgage interest, real estate taxes, casualty losses, and rental expenses like realtors’ fees and advertising costs). However, you may be able to carry forward some of these rental expenses to the next year, subject to the gross rental income limitation for that year. If you itemize your deductions on Schedule A (Form 1040), Itemized Deductions, you may still be able to deduct your personal portion of mortgage interest, property taxes, casualty losses, and rental expenses from federally declared disasters on that schedule.
Schedule E vs. Schedule C
Generally, Schedule E should be used to report rental income/loss.
Schedule C is used when you provide substantial services [i.e., hotel like services] in conjunction with the property or the rental is part of a trade or business as a real estate dealer
What is Schedule C?
Schedule C is a form for reporting your business profit or loss if you are taxed as a sole proprietor. They explain that you would use Schedule C along with your 1040 if your primary purpose in the business is to gain income and if you are involved in the work of the business regularly.
What is Schedule E?
The IRS explains that Schedule E is specifically for reporting rental income or losses pursuant to real estate. You can also use it for reporting the same in relation to royalties, partnerships, S corporations, estates, trusts and residual interests in real estate mortgage investment conduits (REMICs). If you are unsure whether you should be using Schedule C or Schedule E, you can consult your tax professional.
If, however, you offer more services to tenants, like housekeeping, dry cleaning, meals, or maid services, you will need to report your rental income on Schedule C. This is the main difference between Schedule C and E. This is less applicable to most landlords and is more relevant to those running a hotel, boarding house, bed and breakfast or sometimes a rental like an Airbnb or VRBO. Again, if you have questions or it is not exceptionally clear to you which schedule you should complete come tax time, your best bet is to consult a tax professional.
The above rules are for real estate owned by single owner.
What Is A Real Estate Partnership?
A real estate partnership is an investment strategy that integrates the strengths of two or more investors into a single investment property. Typically, partnerships are categorized as either active, where all parties are equally responsible for day-to-day management, or passive, as a means to raise capital from investors who are not as involved.
Real estate partnerships are one of the most common types of pass-through entities. Unlike corporations, pass-through entities are not required to pay corporate income tax or any other entity-related tax. Instead, their owners pay individual income taxes based on their shares of profit.
Partnerships differ from sole ownerships, as they are required to file an entity-level tax return (Form 1065) and report the income of each individual partner with a K-1.