Listing remarks
- Residential rental buildings are depreciated over 27.5 years; land is never depreciated, so the purchase price must be split between them.
- If you rent a home you also use for fewer than 15 days in a year, the rent is not taxable and the expenses are not rental expenses.
- Unrecaptured section 1250 gain from depreciation is taxed at a maximum 25 percent rate when you sell.
Taxes are where many new landlords get their first unpleasant surprise, sometimes in the good direction. A rental can show a loss on paper while producing cash, and a sale years later can bring a bill for deductions you took long ago. This guide summarizes the federal rules in IRS Publication 527 and related IRS topics. It is general information; state rules differ, and a tax professional can apply them to your situation.
What counts as rental income
You generally report rental income and expenses on Schedule E of Form 1040. Rental income is more than the monthly rent. According to the IRS it also includes:
- Advance rent, in the year you receive it, whatever period it covers;
- Lease cancellation payments a tenant pays you to end a lease;
- Expenses paid by the tenant on your behalf, such as a bill you owed;
- Security deposits you keep because the tenant did not meet the lease. A deposit you plan to return is not income when you receive it, but a “deposit” that will be used as the last month’s rent is advance rent.
Expenses you can deduct
The IRS lets you deduct the ordinary and necessary expenses of managing, conserving and maintaining a rental, starting when it is available for rent. Common examples include mortgage interest, property tax, insurance, repairs, utilities you pay, advertising, management and fees for accountants, attorneys and other contractors. Expenses can still be deducted while a property is vacant and held for rent, though you cannot deduct the rent you did not receive.
Repairs vs. improvements
This distinction matters more than most beginners expect. A repair that keeps the property in working order can generally be deducted. But you must capitalize an expense that is an improvement, meaning one that:
- results in a betterment, such as fixing a pre-existing defect, enlarging the property or increasing its capacity or quality;
- restores the property, such as replacing a substantial structural part or rebuilding to like-new condition; or
- adapts it to a new or different use.
The IRS’s examples of improvements include a new roof, a furnace or central air conditioning, a water heater, kitchen modernization, wall-to-wall carpeting, a deck, a fence and landscaping. Capitalized improvements are depreciated rather than deducted all at once. Safe harbors for small purchases and routine maintenance can let you deduct some costs that would otherwise be capitalized.
Depreciation
Depreciation lets you recover the cost of the building over time. Key points from Publication 527:
- You begin depreciating when the property is placed in service, meaning ready and available for rent.
- Land cannot be depreciated, so you must separate the cost of the land from the building. The IRS’s own example: a $185,000 house where the contract shows $160,000 for the building and $25,000 for the land gives a depreciable basis of $160,000.
- Residential rental property is depreciated over 27.5 years under the general depreciation system, using a mid-month convention for the first and last year.
- Improvements are generally depreciated as if they were separate property, from the date they are placed in service.
Tip: Keep your closing statement and every invoice for improvements. They establish your basis, and you will need them for depreciation every year and again when you sell.
Losses and the passive activity rules
Rental activity is generally passive, and losses from passive activities can usually offset only passive income. There is a special allowance: if you actively participated in a rental real estate activity, you may be able to deduct up to $25,000 of loss against nonpassive income such as wages. Active participation means you owned at least 10 percent of the property and made management decisions, such as approving new tenants, deciding on rental terms or approving expenditures, or arranged for others to provide services such as repairs.
| Modified adjusted gross income | Special allowance (single or married filing jointly) |
|---|---|
| $100,000 or less | Up to $25,000 |
| Between $100,000 and $150,000 | Reduced by 50% of the amount over $100,000 |
| $150,000 or more | None |
Married people filing separately have lower thresholds. Losses you cannot use are carried forward to later years.
When you also use the property
Vacation homes and rooms in your own house follow special rules. If you use a dwelling as a home and rent it for fewer than 15 days in the year, the rent is not taxable and the expenses are not rental expenses. You use a dwelling as a home if your personal days exceed the greater of 14 days or 10 percent of the days it is rented at a fair price. In that case, rental expenses are limited and must be divided between personal and rental use. Living in one unit of a duplex is covered in House Hacking a Duplex: Living in One Unit, Renting the Others.
When you sell
Depreciation reduces your basis, which increases your gain at sale. The part of the gain that comes from depreciation on real property, called unrecaptured section 1250 gain, is taxed at a maximum 25 percent rate. The rest of a long-term gain, on property held more than one year, is taxed at capital gains rates. A like-kind exchange can defer the tax if you buy other investment real property; see 1031 Exchanges Explained: Deferring Tax When You Trade Up.
The bottom line
Report all rent, deduct ordinary expenses, capitalize improvements, depreciate the building over 27.5 years and keep every record. Understand the passive loss rules before you count on a tax loss, and remember that depreciation comes back at sale. For the full picture of costs, see Rental Property Math: Cash Flow, NOI and Cap Rate Explained.