With the favorable new tax provisions for real estate professionals and businesses, and recent regulatory updates, it’s likely that the number of people investing in rental property will grow in the next few years. If you’re thinking about making the leap, you need to understand the basic federal income tax rules for rental income and expenses.
What is rental income?
Rental income is defined as any payment received for the use or occupation of property, and can encompass sums beyond just regular rent payments. For example, rental income also includes advance rent—any amounts paid before the period it covers. Security deposits used as the final rent payment are considered advance rent, unless you plan to return a deposit at the end of the lease.
When you keep part, or all, of a deposit because the tenant breaches the lease, include the amount in your income for that year. This also applies to payments for lease cancellation payments.
If a tenant provides property or services as rent, rather than money, include the fair market value of the property or services in your rental income. For example, if your tenant paints your building in exchange for two months’ rent, include the amount he or she would have paid for those two months in your rental income.
What about expenses paid by a tenant? A tenant, for instance, might pay the water bill on the building, although not required to by the lease. Include the water bill amount as a rent payment.
You generally must report all amounts received as rent in your gross income in the year received. You can deduct such amounts if they’re deductible rental expenses.
Which expenses are deductible?
Once you receive rental income for a dwelling, you can deduct certain “ordinary and necessary” rental expenses, subject to some limitations. Deductible expenses generally include mortgage interest, property taxes, operating expenses (for example, maintenance, utilities, insurance and advertising costs) and depreciation.
You can’t, however, immediately deduct your costs for “improvements,” meaning the amounts paid for a betterment or restoration of the property or adaptation to a new or different use. You can recover these costs only over time through depreciation.
The passive activity loss rules or the at-risk rules may limit the amount of deductible loss if your rental expenses exceed your rental income. Your expenses and loss may be further limited if you personally use a property that you rent (for example, a vacation home or a residence where you rent out a room).
Look before you leap
Investment rental properties can bring some significant financial benefits, but you must consider the tax implications and ensure regulatory compliance. Your local Armanino expert can help you devise the best path forward.
