Rental Income and Expenses

Do you rent property to others? If so, you’ll want to read the following seven tips from the IRS about rental income and expenses.

You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use of or occupation of property. Expenses of renting property can be deducted from your gross rental income. You generally deduct your rental expenses in the year you pay them.  Publication 527, Residential Rental Property, includes information on the expenses you can deduct if you rent property.

1. When to report income. You generally must report rental income on your tax return in the year that you actually receive it.

2. Advance rent. 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.

3. Security deposits. Do not include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease. But if you keep part or all of the security deposit during any year because your tenant does not live up to the terms of the lease, include the amount you keep in your income in that year.

4. Property or services in lieu of rent.  If you receive property or services, instead of money, as rent, include the fair market value of the property or services in your rental income.  If the services are provided at an agreed upon or specified price, that price is the fair market value unless there is evidence to the contrary.

5. Expenses paid by tenant. If your tenant pays any of your expenses, the payments are rental income. You must include them in your income. You can deduct the expenses if they are deductible rental expenses. See Rental Expenses in IRS Publication 527, for more information.

6. Rental expenses.  Generally, the expenses of renting your property, such as maintenance, insurance, taxes, and interest, can be deducted from your rental income.

7. Personal use of vacation home. If you have any personal use of a vacation home or other dwelling unit that you rent out, you must divide your expenses between rental use and personal use.  If your expenses for rental use are more than your rental income, you may not be able to deduct all of the rental expenses.

Important Note: 

Beware of personal use: If you rent and use a vacation home for personal purposes, your personal use could make the vacation property a home for tax purposes. If it is a home, then the rental is a hobby. As a hobby rental, tax law puts a ceiling equal to rent income on rent deductions. You carry over excess deductions to the next year where you apply them to rental income from that year. But when you sell the property, you lose your carried over (unclaimed) deductions.

Planning tip: Control personal use. Make sure tax law considers your vacation home a rental property that produces deductible losses. Rentals produce tax benefits far better than a combined second home and hobby rental.

Short Term Rentals

More and more property owners are taking advantage of services like AIRBNB, HomeAway and others to find short-term tenants for their residence or other property.  The treatment of income and expenses for such short-term rentals are different than those for "normal" rentals.  Depending upon the circumstances, the rental activity could be deemed as a business (reported on Schedule C with potential liability for self-employment tax) rather than on Schedule E.

Here are some of the more significant rules that relate to short-term rentals.

Rented for Fewer than 15 Days during the Year –

When you rent out your home for fewer than 15 days in total during the tax year, you do not need to report the income received, and you are not allowed to deduct expenses associated with the rental.  Your mortage interest and property taxes are not required to be prorated on account of the short rental period.  In other words, the total paid for qualified mortgage interest and property taxes are deductible as an itemized deduction on Schedule A.  

The 7-Day and 30-Day Rules –

The general rule is that rental activities are treated as passive activities.  All income and expenses are reported on Schedule E vs. Schedule C for businesses.  Any profit from the rental activity generally is not subject to Self-Employment tax. 

As with may Internal Revenue Code Sections, there are often exceptions.  That is no different when it comes to rentals.  If either of the following two conditions exist for the rental activity, then the income and expenses will be reported on Schedule C as a trade or business: 
 

A. The average customer use of the property is for 7 days or fewer—or for 30 days or fewer if the owner or someone on the owner’s behalf provides significant personal services, or

B. The owner or someone on the owner’s behalf provides extraordinary personal services without regard to the property’s average period of customer use.

If the activity is not treated as a rental, then it will be treated as a trade or business, and the income and expenses, including prorated interest and taxes, will be reported on Schedule C. IRS Publication 527 states:

“If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C.”

It is important to note that substantial services do not include the furnishing of heat and light, the cleaning of public areas, the collecting of trash, and such.

Exception to the 30-Day Rule –

If the personal services provided are similar to those that are generally provided in connection with long-term rentals of high-grade commercial or residential real property (such as public area cleaning and trash collection), and if the rental also includes maid and linen services that cost less than 10% of the rental fee, then the personal services are neither significant nor extraordinary for the purposes of the 30-day rule.

Profits and Losses on Schedule C –

Profit from a typical rental activity is not subject to self-employment tax.  By contrast, a profitable rental activity that is reported as a business on Schedule C is subject to this tax.

Most rental activities generally result in a loss in operations (expenses exceeding income).  It is important to note that any loss from this type of rental activity is still treated as a passive-activity loss unless you meet the “material participation” test, generally by providing 500 or more hours of personal services during the year or qualifying as a real estate professional.

Losses from passive activities are only deductible up to the income amount from other passive activities, but unused losses can be carried forward to future years. A special allowance for real-estate rental activities with active participation permits a loss against non-passive income of up to $25,000, which phases out when modified adjusted gross income is between $100K and $150K. However, this allowance does NOT apply when the rental activity is reported on Schedule C.

For more information on rental income and expenses see Publication 527. This publication can be downloaded from http://www.irs.gov or ordered by calling 800-TAX-FORM (800-829-3676).