How to Calculate and Report Income From One Rental Property

Owning a single rental property comes with its own set of tax responsibilities. The Internal Revenue Service (IRS) views this as a source of income that must be properly tracked and reported. Understanding the fundamental components of how this income is taxed is a primary step for any landlord. This involves knowing what constitutes income, which expenses can be deducted, and how to account for the property’s depreciation.

Determining Your Gross Rental Income

The first step is to calculate your total, or gross, rental income for the year. This figure includes all payments received for the use or occupation of the property. The most apparent component is the regular, monthly rent payments, but other payments must also be included for the year they are received. This approach is known as the cash basis method of accounting.

Advance rent is considered income in the year you receive it. If a tenant pays for January’s rent in December, that amount must be reported as income for the year it was received. Similarly, if a tenant pays a fee to cancel their lease, that payment is rental income and must be reported in the year of receipt.

A security deposit is not included in your income if you intend to return it to the tenant at the end of the lease. It becomes income if you keep a portion to cover unpaid rent or to pay for damages. If you use the deposit for repairs, you must include the amount as income, but you can then deduct the cost of the repair as an expense. If a deposit is designated to be used as the final month’s rent, it is treated as advance rent and is included as income when it was received.

Gross rental income also includes payments a tenant makes on your behalf. If your tenant pays a utility bill or a repair cost that is your responsibility, the amount they paid is considered rental income to you, and you can then claim a corresponding rental expense. If a tenant provides services, such as painting, in exchange for a reduction in rent, the fair market value of those services is taxable rental income.

Identifying Deductible Rental Expenses

After calculating gross income, the next step is to identify all ordinary and necessary expenses incurred to manage and maintain the rental property. Common deductible expenses paid during the year include:

• Mortgage interest, reported on Form 1098
• Local and state property taxes
• Premiums for landlord insurance policies
• Advertising for tenants
• Property management fees
• Utility bills not paid by the tenant

A significant area for consideration is the distinction between repairs and improvements, as the tax treatment for each is different. Repairs are activities that keep your property in good operating condition but do not materially add to its value or prolong its life. Examples include fixing a leaky faucet, patching a wall, or replacing a broken window pane. The costs for these maintenance activities are fully deductible in the year they are incurred.

Improvements are investments that better, restore, or adapt the property to a new use. These are costs that add value to the property or extend its useful life, such as replacing an entire roof, remodeling a kitchen, or adding a new deck. Unlike repairs, the costs of improvements cannot be deducted all at once. Instead, they must be capitalized, meaning they are added to the property’s cost basis and recovered over time through depreciation.

You must separate the costs of repairs from improvements. Keeping detailed receipts categorized by repair or improvement is necessary for annual tax filings and for calculating gains or losses when you eventually sell the property.

Understanding Depreciation

Depreciation is a non-cash deduction that allows landlords to recover the cost of their income-producing property over its useful life. It accounts for the gradual wear and tear or obsolescence of the building. The IRS allows you to take an annual depreciation deduction even if the property’s market value is increasing.

You can only depreciate the value of the building and any improvements, not the land itself. Land does not wear out, so you must separate the property’s total cost into the value of the building and the value of the land. This allocation can be done using the property’s real estate tax assessment or a professional appraisal.

For a purchased property, the basis is its purchase price plus certain settlement and closing costs, minus the land’s value. Improvements made after the purchase are added to this basis and depreciated separately.

For residential rental properties in the United States, the cost is recovered using the Modified Accelerated Cost Recovery System (MACRS). Under this system, the basis of the building is depreciated over a recovery period of 27.5 years. The annual deduction is calculated by dividing the building’s basis by 27.5. For example, if the building’s basis is $220,000, the annual depreciation deduction would be $8,000. The first year of service requires a prorated calculation based on a mid-month convention, meaning you can only claim a partial month’s depreciation for the month the property was placed in service.

Calculating and Reporting Your Net Income or Loss

The final step is to determine your net rental income or loss. This calculation follows the formula: Gross Rental Income minus your total Deductible Expenses and your annual Depreciation allowance. The result is the final figure that is subject to income tax or may be deductible against other income.

This information is reported to the IRS on Form 1040, Schedule E (Supplemental Income and Loss). On Schedule E, you will list your total gross rental income and then itemize your expenses into categories such as insurance, mortgage interest, taxes, and repairs. The form also has a dedicated line for the depreciation deduction.

Rental real estate is generally a passive activity, and special rules can limit your ability to deduct losses. If your expenses and depreciation exceed your income, you have a net rental loss. The passive activity loss (PAL) rules may prevent you from deducting this loss against non-passive income, like your salary. Any disallowed loss is carried forward to offset future passive income.

An exception exists for landlords who actively participate in the rental activity by making management decisions like approving tenants. This special allowance may permit you to deduct up to $25,000 in rental losses against non-passive income. The allowance phases out if your modified adjusted gross income (MAGI) is over $100,000 and is eliminated once your MAGI exceeds $150,000.