Own a rental property? As you know, the Internal Revenue Service (IRS) requires you to report the rent you collect and pay income tax on those amounts. Luckily, however, you can deduct qualifying expenses from your rental property income. Wondering which deductions you can claim? Curious about your reporting obligations? Trying to figure out if your rental property is a win or a loss? Then, keep reading for the essentials.

What Is Rental Property Income?

Rental property income refers to all the funds you collect as rent on properties you own. This can include rent you receive for a single family home, a group of apartments, or even a room in your own home. You also report rental income if you own commercial buildings and you lease space to businesses.

For instance, if you own a duplex and you rent out half of the property to someone for $1,000 per month for 12 months, you have $12,000 in rental income to report for the tax year. But as explained above, you don't necessarily face income tax on this entire amount.

What Deductions Can You Claim for Your Rental Properties?

When you're a landlord, the IRS basically considers you to be a small business owner. As a business owner, you have to report your revenue (the rent you collect), but you also get to deduct your business expenses. That refers to any costs you incur while running your rental property.

Generally, these expenses fall into two different categories: operating expenses and capital costs. Operating expenses are immediate costs that you incur throughout the year, while capital costs refer to large expenses that you often pay over time. In most cases, you deduct operating expenses the year they occur, but you deduct capital expenses incrementally over a period of several years. However, there are exceptions to this rule.

What Are Rental Property Operating Expenses?

Common operating expenses for rental properties include the following:

  • Advertising to find new tenants
  • Interest on loans for your rental property
  • Cost of office supplies used when managing your rental property
  • Fees for services such as lawn care or legal assistance for your rental property
  • Buying supplies such as rakes, lawn mowers, tools, grass seed etc to take care of your rental property
  • Maintenance costs such as hiring a plumber
  • Insurance for your rental property
  • Fees paid to property management companies

What Are Capital Expenses for Rental Properties?

Capital expenses include the property itself and significant upgrades such as putting in a new HVAC system or replacing the roof. Basically, you depreciate expenses related to business items that have a useful life of longer than a year. The IRS has schedules that determine the portion of these expenses you can write off each year. For example, you can depreciate the cost of a rental property over 30 years. In 2018 and previous years, you deducted these expenses over a 40 year period.

The exact time period varies based on the type of item and its value. That said, the Section 179 deduction allows you to write off the entire cost of certain capital expenses during the year of purchase. As of tax year 2019, you can use this deduction on equipment purchases worth up to $1 million.  

Personal and Business Expenses

In a lot of cases, landlords and other small business owners purchase items that are both for personal and professional use. In these situations, you should only deduct the portion of the item used for your rental properties as a deduction.

For example, say you spend $300 on a laptop. You use the laptop 40% of the time to track rental income and expenses, to contact tenants, and to advertise vacant properties. The other 60% of the time, you use the laptop for personal use. To find your deduction, you simply multiply $300 by 40% which results in a $120 deduction.

How the Last Month's Rent Affects Rental Income

In addition to reporting the rent you receive, you may also need to report a few additional items as rental income. In particular, if you take the last month's rent as part of the security deposit, you have to report that amount as income, but you don't have to report the security deposit.

To explain, imagine you find a new tenant. The rent is $2,000 per month. Before moving in, they pay you $2,000 for the first month's rent, $2,000 for the last month's rent, and $2,000 as a security deposit. You report $4,000 (first and last month's rent) as rental income, but you don't report the $2,000 security deposit.

Security Deposits and Rental Income

However, if you end up keeping part of the security deposit when your tenant moves out, you do have to report that amount as income, but again, you can deduct expenses from that amount. To continue with the above example, say your tenant moves out, but they leave the rental a mess and put holes into the walls.

You spend $300 hiring cleaners and $100 fixing holes in the walls. As a result, you decide to keep $400 of the security deposit, and you return the remaining $1,600 to your tenant.

At this point, you have to report the $400 you kept as rental income, but you get to deduct the $400 you spent on cleaning and repairs. The two amounts are a wash, and you don't end up facing any tax on this part of your rental income.

Tenant-Covered Expenses

If your tenant covers any expenses that are not part of the rental agreement, you also have to report those amounts as rent. For instance, say you agree to pay the water bill as part of your tenant's rental agreement. However, one month, you are out of town, so you ask your tenant to cover the water bill. They pay $100 to the water company, and you report that amount as rental income.

But in this situation, you also let your tenant knock $100 off their monthly rent. So, ultimately, your monthly rental income ends up being the same amount. In contrast, if the rental agreement specifies that your renters have to pay for electricity, for example, you don't have report your renter's electricity payment as income.

To give you another example, imagine your renter buys a new bedroom door for your rental property, but they also give you the receipt for the door. In this situation, you report the amount they paid as rental income, but at the same time, you claim a deduction for the cost of the door.

How Do You Report Rental Income?

You can report your rental income and expenses on Schedule E, Part 1 of Form 1040. To figure out how much to depreciate for capital expenses, you should use Form 4562. Then, you transfer the numbers to line 18 of Schedule E.

Schedule E has room for income and expenses for up to three properties. If you have more than that number of properties, you need to fill out multiple Schedule E's. Then, you total everything and note the cumulative amounts on just one of the schedules.

You do not have to submit proof of your rental income or expenses with your tax return, but you need to keep those details in case you get audited. By law, you should keep your records for seven years. This includes proof of how much rent was paid, receipts or invoices for expenses, copies of mortgage contracts, and any other records related to income or expenses. Ideally, you may also want to keep copies of your accounting records.

Is Your Rental a Win or a Loss?

In business, a win is when you walk away with a profit, and a loss is when your expenses exceed your income. With rental property income, you can quickly figure out if you're running at a profit or a loss by adding up all your income and subtracting your expenses. If you get a positive number, you have a profit, and with a negative number, you have a loss.

The IRS actually allows you to claim a loss on some rental properties. Depending on the situation, you may be able to deduct your loss from current year's earnings or from rental income earned in future years. However, there are a lot of rules and limitations on losses from rental properties, so you may want to check with a financial advisor or accountant to ensure you get the most benefits possible from any losses and that you minimize your tax burden as much as possible on any profits.

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