FAQs on Taxes and Rental Property

When you rent out your own property, you may face two kinds of headaches: tenants and taxes. We can't do much about the tenants, but we can help you with tax questions. TurboTax walks you through rental property issues.

Consider this scenario:

Does this story sound familiar? If so, you're not alone. Taxpayers in similar circumstances find themselves asking these questions:

Yes, income from a rental property is taxable.

But you're allowed to reduce your rental income by subtracting expenses that you incur to manage, conserve, and maintain your rental property.

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As a cash basis taxpayer (which includes nearly all individuals), you must report all income in the year you actually receive it regardless of when it was earned.

• If you receive rent for January 2009 in December 2008, report the rent as income on your 2008 tax return.
• If you receive a deposit for first and last month's rent, it's taxed as rental income in the year it's received.
• If you receive goods or services from your tenant in exchange for rent, you must value the goods or services at their present worth and report that value on your return in the year that they are received.

You must also report income that you have received constructively. This means that you have the opportunity to receive the income. For example, if your renters place their January checks in your mailbox late in December, you cannot avoid reporting it as income simply by not removing it from the mailbox until January.

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Security deposits are not included in income when you receive them if you plan to return them to your tenants at the end of the lease. (Deposits for the last month's rent are taxable, because they are really rents, paid in advance.)

What if I pocket some of the security deposit?

If you eventually keep part or all of the security deposit because the tenant does not live up to the terms of the lease, you must include that amount in the income that you show on your tax return for the tax year in which the lease terminates.

So you should keep track of the security deposits from year to year. This record-keeping isn't difficult if you only own one rental, but as the number of rentals you own increases, so does the paperwork.

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All expenses incurred and paid by you to manage, conserve, and maintain a rental property are deductible in the year paid. Even if your rental property is temporarily vacant, the expenses are still deductible while the property is vacant and held out for rent.

Deductible expenses include, but are not limited to, the following:

• Advertising
• Cleaning and maintenance
• Commissions
• Depreciation
• Homeowner's associations dues
• Insurance premiums
• Interest expense
• Local property taxes
• Management fees
• Pest control
• Professional fees
• Rental of equipment
• Rents you paid to others
• Repairs
• Supplies
• Trash removal fees
• Travel expenses
• Utilities
• Yard maintenance

All expenses deducted must be ordinary and necessary and not extravagant.

If you deduct travel expenses, you must allocate your expenses between rental and non-rental activities. For example:

Keep good records. To deduct any expense, you must be able to document the deduction. That means keeping current and accurate records of your expenses paid, including all receipts, checks, and bank statements.

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Any improvements to the property must be depreciated over their useful lives (which are defined by the IRS), rather than deducted in the year paid.

Improvements are actions that materially add to the value of the property or substantially prolong its life. Examples include:

• Additions to the structure
• Adding a swimming pool
• Installing a water filtration system
• Modernizing a kitchen
• Installing insulation

Repairs, on the other hand, are deductible in the year paid. Unlike improvements, repairs just keep the property in good operating condition. Here are some examples of repairs:

• Minor repainting
• Fixing broken gutters or floors
• Fixing leaks
• Replacing broken windows or doors

For more information see IRS Topic 414: Rental Income and Expenses.

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Depreciation is a deduction taken over several years. You generally depreciate the cost of property that has a useful life of more than a year, but gradually wears out, or loses its value due to wear and tear, or wind and rain, when the property is used in business, or to produce income.

To figure out the depreciation on your rental property:

1. Determine your cost or other tax basis for the property.
2. Allocate that cost to the different types of property included in your rental (such as land, buildings, so on).
3. Calculate depreciation for each property type based on the methods, rates, and "useful lives" specified by the IRS.

1. Determine Your Cost Basis

Your cost basis in the property is generally the amount that you paid for the property (your acquisition cost plus any expenses in making the purchase). Your payment, then, includes any loan proceeds that you used to acquire the property. Review your purchase closing documents to identify any other expenses that you may deduct. Examples include:

• Financing costs
• Interest and taxes
• Homeowner's association dues

If you are converting your property from personal use to rental use, your tax basis in the property is calculated differently. Your basis is the lower of these two:

• Acquisition cost
• The fair market value at the time of conversion from personal to rental use

If the property was given to you or if you inherited it, or if you traded another property for the current property, there are special rules for determining your tax basis in your rental property. Consult IRS Publication 551, Basis of Assets, for more information about computing your tax basis in these situations.

2. Allocate the Cost by Type of Property

After determining the cost or other tax basis for the rental property as a whole, you must allocate the basis amount among the various types of property you're renting. When we speak of types of property, we refer to certain components of your rental, such as the land it is built on, the building itself, any furniture or appliances you provide with the rental, etc.

If your rental is a condo or other property that shares property within a community, you're deemed to own a portion of that property. Therefore, even a third floor condo is deemed to own a portion of the land and a portion of the purchase price must be allocated to the land upon which the building is built.

Why this effort to divide your tax basis between property types? The different types of property are each depreciated using different rules and different lives.

3. Calculate the Depreciation for Each Type of Property

Here are the most common divisions of tax basis for a rental property, followed by explanations of the different methods of depreciation.

Straight-Line Depreciation

In straight-line depreciation, the cost basis is spread evenly over the tax life of the property. For example:

Declining Balance Depreciation

This kind of depreciation is calculated by multiplying the rate, 150% or 200%, by the straight-line depreciation calculated based on the adjusted balance of the property at the start of the year over the remaining life of the property. To make matters somewhat easier, the IRS and others publish tables of percentages that can be applied to the original cost to determine yearly depreciation. Here's the five-year property table as an example:

For example:

Declining balance depreciation on furniture used in a rental with a cost of $2,400 in Year 3 would be $461 ($2,400 x 19.20%).

Tables for all types of properties can be found in IRS Publication 946: How to Depreciate Property. For general information on depreciation of rentals, see IRS Publication 527: Residential Property.

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As an individual, you report the income and deductions for rental properties on page 1 of Form 1040, Schedule E, Supplemental Income and Loss. The total income or loss computed on Schedule E carries to Form 1040.

Report the depreciation of rentals on Form 4562: Depreciation and Amortization. The instructions for these forms explain in detail how to complete these forms.

TurboTax products assist you with compiling rental data and reporting the information on the appropriate lines of the appropriate forms.

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Rental properties are, by definition, passive activities and are subject to passive activity loss rules. These rules are quite complex. In general, the passive activity rules limit your ability to offset other types of income with net passive losses.

In other words, if you have losses from a passive activity, such as a rental property you own, you can't always take those losses on your tax return in the current year to reduce income from non-passive activities such as wages, salary, interest, dividends, or gains from sales of stocks. Passive losses can offset income from other passive activities. If you have a net passive loss in any year, that loss is generally suspended (delayed to a later year) until either you have passive income or you completely dispose of the passive activity.

But if you actively participate in a rental activity you can deduct up to $25,000 of the rental loss. To actively participate means that you own at least 10 percent of the property and you make management decisions in a significant and bona fide sense, such as approving new tenants, setting rental terms, approving improvements, and so forth.

This exception isn't available to everyone. If you have modified adjusted gross income over $100,000, your maximum loss available decreases by $0.50 for every dollar over $100,000. The maximum loss is completely phased out when your modified adjusted gross income reaches $150,000. Modified adjusted gross income is determined by calculating adjusted gross income without regard to deductions for IRA contributions or pensions, taxable social security benefits, adoption assistance payments, income excluded from U.S. savings bonds used to pay higher education tuition and fees, interest on qualified student loans, the tuition fees deduction, and any passive activity loss of taxpayers in a real property business. For example:

If you're married and you file a separate tax return from your spouse, and if you lived apart from your spouse at all times during the year, the maximum rental loss deduction under the exception is $12,500. Your loss begins to phase out at $50,000 instead of $100,000.

If you're married, file separately, but you did not live apart from your spouse at all times during the year, the active rental real estate loss allowance is not available to you at all.

You may need to complete Form 8582: Passive Activity Loss Limitations, following the published IRS instructions.

If you earn your living working in a real estate arena, you may be considered a real estate professional. The passive activity rules don't apply to real estate activities for many properties owned and managed by real estate professionals. For more information regarding this important exception, consult IRS Publication 527: Residential Rental Property.

For more on passive activities, see Tax Topic 425: Passive Activities-Losses and Credits.

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