Reporting Rental Income on the Tax Return: Part 2

As rental income starts flowing in and the initial setup expenses decrease, you may be wondering what the next step is? Well, after your rental property is up and running, you will be tasked with maintenance and tax return reporting.

The IRS requires you to report all income or loss on the annual tax return just like any other business. As a result, understanding qualifying expenses, how your rental is taxed, what to do if you generate a loss, personal stay implications, and tax planning strategies are required for rental property owners to maximize tax savings and ensure accurate reporting.

What are Qualifying Expenses on the Tax Return?

To be a qualifying expense for tax return purposes, the cost must be ordinary and necessary to your rental property. This means a vacation to Florida wouldn’t count as travel for your rental unless your property was located in Florida. There are gray lines in the expenses you can claim, but the basic expenses you can expect to see include:

• Property taxes

• Insurance

• Cleaning

• Mortgage interest

• Maintenance

• Depreciation

Depreciation is a special deduction that many rental business owners don’t fully understand. The general rule is that any asset over $2,500 cannot be immediately expensed and must be capitalized and depreciated over the useful life. The rental property cost, excluding the land, will be depreciated over 27.5 years. Other common items capitalized include windows, roofs, furnaces, and landscaping.

How Is Rental Income Taxed?

The rental income you generate is subject to ordinary income tax rates, which vary based on your filing status and the other items listed on your tax return. These tax rates range anywhere from 10% up to 37% for Federal while each state imposes different taxes. Your rental income is only taxed on the net profit, meaning your income minus all expenses. This greatly reduces your tax liability and may bring it down to zero depending on your depreciation amount.

When your business sells an asset, such as a furnace or piece of furniture, over the cost basis, you may be subject to capital gains taxes as well. Your cost basis in the assets is the amount you paid for the item minus depreciation. Most rental properties won’t have very many assets, making this instance uncommon. The long-term capital gains tax rates range from 0% to 20% while short-term capital gains are taxed at ordinary income rates.

When you claim rental property income and loss on your individual tax return, you will fill out Schedule E. For partnerships and multi-member LLCs, you will need to file a separate business return to report the items and pass the income down through a Schedule K-1.

What if My Rental Generates a Loss?

Many rental properties will generate a loss depending on the cost of the property and expenses. The IRS limits the losses you are able to take on Form 8582 Passive Activity Loss Limitations and Form 6198 At-Risk Limitations. If the rental property is the only passive activity you report, you won’t be able to take any of the losses; however, if you have other passive activities, you may be able to take the loss and offset other income.

There are different rules if you actively participate in a passive rental. If you or your spouse own at least 10% of the rental property and make management decisions, you may be able to take a $25,000 special loss allowance on the nonpassive income. This amount is reduced to $12,500 for taxpayers with a single filing status. There are phaseout limitations that begin at $50,000 for single filers and $100,000 for joint filers. Nevertheless, this can be a great tax-reducing strategy when your rental sustains a loss.

Note, that when you sell the rental or generate income in a future year, you will be able to use the loss and reduce your taxable income. Reporting a loss may also limit other deductions such as the Qualified Business Income Deduction and the Home Office Deduction.

Does Personal Use of a Rental Impact Taxes?

Simply put, yes. The IRS closely monitors rental properties for personal use stating that if the property is used for more than 14 days or 10% of the total days it’s available for rent, it’s considered a personal dwelling. Personal dwelling status limits most expenses associated with the rental and any qualifying expenses, such as mortgage interest and property taxes, will be taken on Schedule A if you itemize.

Be sure you keep accurate records of when you are using your rental property. These dates will need to be reported to the IRS to ensure you have a qualifying rental property. Many rental property owners won’t run into this issue with long-term rentals; however, those with vacation rentals may encounter this situation.

What are Tax Planning Strategies for My Rental?

The good news is that you can implement tax planning strategies and deductions designed for rental business owners to reduce your tax bill. The first tax planning strategy is special depreciation deductions. Under S179 and Bonus Depreciation, you are able to write off the entire cost of the asset in the year placed in service. There are exceptions, but this is a great deduction for rental property owners that have income and assets purchased in the same year.

The deduction that you should plan on taking is the Qualified Business Income Deduction. This is a 20% reduction of your taxable business income. The IRS allows you to take this only when you are generating income, meaning no amount is able to be taken if you have a loss. Additionally, the Home Office Deduction is available for rental business owners who have a designated office in their homes. Certain expenses are able to be taken based on the square footage of the office, further lowering your tax bill.

Planning for tax time takes careful consideration of where you expect your income to fall. Rental property owners don’t have as much leeway compared to regular business owners in the planning strategies they can implement because the property is a passive activity; however, understanding where you expect the income and expenses to fall allows you to pay in estimated tax payments if required. Timely remittances of quarterly estimated tax payments save you on interest and penalties when you file your return.

Summary

Opening up a rental real estate property can be a great way to bring in extra cash and grow your personal wealth. Nevertheless, tax time is something to keep in mind going into the new year. Understanding how your rental is taxed is the first step to finding beneficial credits and deductions.

Selling your rental property opens the door to new taxes and considerations, making it important to check out Part 3 if you plan on selling now or in the near future.