Property values are at an all time low and many investors are taking advantage of this opportunity to purchase rental properties. Probably for the first time in history, investors can enjoy positive cash flow as well as anticipate a future increase in equity. If this is the year you become a landlord, you will want to pay attention to the tax rules governing this investment.
Part I Real Estate as an Investment: What it Means for Your Taxes
Your rental income and expenses are listed on your individual tax return on Schedule E, available for your perusal at www.irs.gov. The profit or loss from the activity is included in income and taxed at your ordinary income tax rate. It sounds pretty straightforward, but it can get tricky fast.
First of all, what is rental income? If a prospective tenant pays first and last month’s rent and a security deposit when moving into the property, not all of that is included in current year taxable income. Or is it? Here’s how it breaks down:
1. First and last month’s rent are included in the current year income even if the last month’s rent will be applied in a future year.
2. Advance rent (e.g. payment of next year’s today) is all included in income for the current year, regardless of what year the payments are for.
3. Non-refundable deposits are included in current year rent, even if a fee, for example, a non-refundable cleaning fee, won’t be used until the tenant moves out in a future year.
4. Security deposits need not be claimed as income if you intend to return the deposit to the tenant at the end of the lease term.
5. Barter is income. If, for example, as part of the rent, your tenant agrees to maintain the gardens and pool, you must show the value of these services as rental income. By the same token, you may also deduct the same amount as a rental expense. I know it’s a push, but the IRS loves to see us sharpening our pencils and doing extra paperwork.
6. Expenses paid by your tenant. See barter income above. Say you’re jet setting through Europe and the pipes in the rental spring a leak; your tenant pays the plumber then deducts it from his rent. You must include the full rent in income and write off the plumbing expense against it. Yes, again, it’s a push.
7. Lease cancellation. If your tenant pays you to cancel the lease, include the payment as rental income.
8. Option payments. If your tenant signs a lease with an option to buy, the option payments are generally rental income. But once the tenant exercises the right to buy the property, all payments received after the sale are considered part of the selling price.
9. Here’s a little tax break for you: If you rent out part of your personal residence for fewer than 15 days, you need not include the rent you receive in your income.
10. If you are renting space in your personal residence (including a vacation home) for more than 15 days, you must declare the income. But you should consult with your tax pro to determine how to properly allocate your rental expenses against the income you receive.
Make sure you keep all lease/rental agreements and tenant applications. When under audit, the IRS likes to look at these documents as part of the verification that this is indeed a rental property. Also keep all cancelled checks and credit card receipts for all rental expenses deducted on your tax return.
Check back next week when I will discuss deducting rental expenses.
Bonnie Lee is an Enrolled Agent admitted to practice and representing taxpayers in all fifty states at all levels within the Internal Revenue Service. She is the owner of Taxpertise in Sonoma, CA and the author of Entrepreneur Press book, “Taxpertise, The Complete Book of Dirty Little Secrets and Hidden Deductions for Small Business that the IRS Doesn't Want You to Know,” available at all major booksellers.