How to File a Tax Return for a Rental Property
If you are the owner of rental real estate, it is important to understand your federal tax obligations. It is crucial to report all rental income on your tax return, and typically, you can deduct the associated expenses from your rental income.
For taxpayers who operate on a cash basis, rental income should be reported in the tax return for the year it is received, regardless of when it was earned.
As a cash-basis taxpayer, you generally deduct rental expenses in the year you actually pay them. Conversely, if you follow the accrual method, you report income when it is earned, not when it is received, and you deduct expenses when they are incurred, not when they are paid. However, most individuals opt for the cash method of accounting. Here are some valuable suggestions regarding tax reporting, recordkeeping obligations, and information on deductions for rental properties that can assist you in avoiding errors.
Property or services received instead of monetary rent should be included in your rental income as the fair market value of the property or services. For instance, if your tenant is a painter and offers to paint your rental property in exchange for two months' worth of rent, include in your rental income the amount the tenant would have paid for two months worth of rent.
If the rental agreement grants your tenant the option to purchase the rental property, it qualifies as a lease with an option to buy. The payments you receive under such an agreement are generally considered rental income.
In the case of owning a partial interest in rental property, you must report your share of the rental income derived from the property.
What Qualifies as Rental Income?
All payments received as rent must generally be included in your total income. Rental income encompasses any payment you receive for the use or occupancy of a property. It is important to report rental income for all properties you own. Apart from regular rent payments, there are other types of payments that may qualify as rental income and should be reported on your tax return.
Advance rent refers to any amount received before the period it covers. Include advance rent in your rental income for the year you received it, regardless of the period covered or your chosen accounting method. For instance, if you sign a 10-year lease for your property and receive $5,000 for the first year's rent and $5,000 as rent for the last year of the lease in the first year, you must report $10,000 as income for that year.
Security deposits used as the final payment of rent are treated as advance rent. Include it in your income when you receive it. However, if you plan to return the security deposit to your tenant at the end of the lease, you don't need to include it in your income when you receive it. But if you retain part or all of the security deposit during any year due to your tenant's failure to comply with the lease terms, include the amount retained in your income for that year.
Payments received for canceling a lease occur when your tenant pays you to terminate a lease. The payment you receive is considered rent and should be included in your income for the year you receive it, regardless of your accounting method.
If your tenant pays any of your expenses, those payments should be included in your rental income. You can deduct these expenses if they are eligible rental expenses. For example, if your tenant pays the water and sewage bill for your rental property and deducts it from the regular rent payment, include the amount of the utility bill paid by the tenant and any rent received in your rental income.
What Expenses Can I Deduct as a Rental Property Owner?
If you earn rental income from a dwelling unit, there are specific rental expenses that you can deduct when filing your tax return. These deductible expenses may include mortgage interest, property taxes, operating costs, depreciation, and repairs.
You are eligible to deduct ordinary and necessary expenses associated with managing, preserving, and maintaining your rental property. Ordinary expenses refer to those that are common and widely accepted in the rental business. Necessary expenses are considered appropriate and can include items such as interest, taxes, advertising, maintenance, utilities, and insurance.
Furthermore, you can deduct the costs incurred for materials, supplies, repairs, and maintenance necessary to keep your rental property in good operating condition. If your tenant pays for certain expenses that are deductible rental expenses, you can deduct them as well. In cases where you include the fair market value of property or services in your rental income, you can also claim the same amount as a rental expense.
It's important to note that you cannot deduct the cost of improvements. A rental property is only considered improved if the payments made are for enhancements, restoration, or adaptation to a new or different use. The cost of improvements can be recovered through depreciation.
You can recoup a portion or the entirety of your improvement costs by reporting depreciation on Form 4562. This process begins in the year your rental property is first put into service and continues in any subsequent year when you make an improvement or add furnishings. However, it's essential to understand that only a percentage of these expenses are deductible in the year they are incurred.
If you have any personal use of a dwelling unit that you rent out, including vacation homes or residences where you rent out a room, it's important to note that your rental expenses and loss may be limited.
How to Report Rental Income and Expenses
When it comes to renting out real estate, such as buildings, rooms, or apartments, reporting your rental income and expenses is typically done using Form 1040 or 1040-SR, Schedule E, Part I. On the appropriate line of Schedule E, you should list the total income, expenses, and depreciation for each rental property. To determine the amount of depreciation to enter on line 18, refer to the Instructions for Form 4562. Similarly, use the Instructions for Form 4562 to determine the amount of depreciation to enter on Form 1040 or 1040-SR, Schedule E, line 18.
If you own more than three rental properties, you need to complete and attach as many Schedule E forms as necessary to list all the properties. Fill out lines 1 and 2 for each property, including the street address of each property. However, only complete the "Totals" column on one Schedule E. The figures in the "Totals" column on that particular Schedule E should represent the combined totals of all the Schedule E forms.
In situations where your rental expenses exceed your rental income, there may be limitations on the amount of loss you can deduct. The deductibility of your loss may be restricted by the passive activity loss rules and the at-risk rules. To determine if your loss is subject to limitations, refer to Form 8582, Passive Activity Loss Limitations, and Form 6198, At-Risk Limitations.
Which Records Should I Maintain?
Maintaining proper records is essential for effectively managing your rental property. It helps you monitor its progress, prepare financial statements, track income sources, record deductible expenses, complete accurate tax returns, and provide evidence for items reported on those returns.
It is crucial to maintain comprehensive records related to your rental activities, including rental income and expenses. Having documented evidence becomes vital if your tax return is selected for an audit. Failure to provide supporting documentation during an audit may result in additional taxes and penalties.
To claim deductions for certain expenses, you must substantiate them with appropriate documentation. Generally, you should keep records such as receipts, canceled checks, or bills to support your expenses. Additionally, it's important to track any travel expenses incurred for rental property repairs.
Having good records is also crucial for accurately preparing your tax returns. These records must support the income and expenses you report. Typically, the same records you use to monitor your real estate activity and prepare financial statements can serve this purpose as well.