Federal Tax Treatment of Rental Income
The Internal Revenue Service (IRS) defines rental income to include any payment received as a result of the use or occupancy of property. Vacation homes, condominiums, mobile homes, boats, and even portions of property may be a source of rental income.
Examples of Rental Income
All rental income is part of a taxpayer’s total gross income and must be included on the tax return for the year in which it is received. One exception is rental of property that is also used as the taxpayer’s home; if a taxpayer’s home is rented for fewer than 15 days during the tax year, the rent is not included in income. Rent-related income may include:
- “Advance rent” received before the period it is intended to cover.
- A security deposit used to satisfy the terms of the lease, where all or part of the security deposit is kept by the landlord because the tenant did not live up to the terms of the lease. The portion of the security deposit returned to the tenant at the end of a lease is not includable in income.
- Charges to the tenant for canceling a lease.
- Expenses paid by a tenant, such as emergency repairs.
- The fair market value or agreed-upon price of property or services received in lieu of rent, such as when a tenant paints the apartment building in exchange for rent.
- For a lease with option to buy, payments received prior to exercise of the option and actual sale; payments received after are deemed part of the property’s selling price.
- The proportionate share of rental income from property that is co-owned.
Rental Related Tax Deductions That Can Offset Rental Income
The IRS allows for the deduction of certain expenses when calculating taxable rental income for federal tax purposes. Deductions for rental expenses must generally be taken in the year they are paid. Rental expenses typically include repairs a landlord makes to maintain the value of property, as well as the expenses of maintaining a steady tenant base. Deductible expenses may include:
- “Ordinary and necessary” expenses for managing, conserving, and/or maintaining property while vacant and/or prior to rental or after sale, but loss of rental income due to vacancy is not deductible.
- Rental expenses for property that has dual use, both personal and rental. In such cases, personal expenses must be separated from rental expenses. Similarly, if the property is only partly-owned by the taxpayer, only part of the expense may be deducted.
- “Repairs” that keep property in good operating order, but do not materially add to its value or substantially prolong its life may be deductible, e.g., repainting, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows. “Improvements” that add to the property’s value, prolong its useful life, or adapt it to new uses are not immediately deductible, but may reduce the taxpayer’s “basis” in the property and be depreciated.
- Various other expenses, such as rental payments made by the taxpayer for property the taxpayer then rents out, rental costs of equipment used for rental purposes, insurance premiums paid in advance (but only the portion that applies to that tax year), and local benefit charges for maintenance or repair of sidewalks, streets, sewers, etc.
Expenses for property not rented for profit are deductible only up to the amount of rental income.
Gross rental income may thus be reduced by subtracting certain rental expenses. An additional method of reducing taxable income is deducting a portion of the taxpayer’s costs for the acquisition and improvement of the property each year on federal tax returns. When a property is purchased, the price paid, plus additional expenses and the costs of some improvements made to the property, constitutes the taxpayer’s “basis” in the property. If the property is sold, the purchase price minus the basis constitutes the taxpayer’s profit or loss on the sale.
An owner of rental property has the option of “depreciating” the property. This means that a portion of the basis may be deducted from the gross rental income each year. The amount of the deduction decreases the taxpayer’s basis in the property until, eventually, all the basis may be used up. The amount that may be depreciated each year may depend on many factors, including:
- The taxpayer’s basis in the property.
- The recovery period for the property. There are several methods for depreciating property, including setting a depreciation period that theoretically reflects the useful life of the property. The basis is divided by the number of years in the period, and the resulting amount is the amount that may be deducted each year (the amount may change as improvements are made to the property).
- The depreciation method used.
- Whether a “special depreciation allowance” applies.
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