How to File a Tax Return for Rental Income

Filing a tax return for rental income involves more than simply reporting tenant payments. Understanding the components that affect taxable income, such as deductions and IRS rules, is crucial. Managing these aspects effectively can significantly impact your tax liability.

This guide will help you navigate key considerations when filing taxes on rental properties.

Classifying Rental Income

Classifying rental income is a critical step in managing tax obligations. Rental income includes payments for property use, such as monthly rent, advance rent, security deposits retained for damages, and unreimbursed tenant expenses. Per IRS rules, these amounts must be reported in the year they are received, even if they pertain to future periods.

Non-monetary exchanges, such as services provided instead of rent, must also be reported by including the fair market value of the services as rental income. Lease cancellation payments are similarly treated as rental income. Payments from tenants for utilities or repairs should be included as income unless reimbursed, as reimbursements directly offset the expenses incurred. Accurately reporting these distinctions ensures compliance with IRS guidelines.

Types of Deductible Expenses

Deductible expenses can significantly reduce taxable rental income. The Internal Revenue Code (IRC) outlines what costs are eligible for deduction.

Mortgage Interest

Mortgage interest is one of the largest deductions available to rental property owners. Interest paid on loans to acquire, construct, or improve rental properties is deductible under IRC Section 163. However, only the interest portion, not principal payments, qualifies. Form 1098 from your lender provides details on the annual interest paid, which should be carefully documented.

Property Taxes

Property taxes paid on rental properties are deductible under IRC Section 164. This includes state, local, and foreign real estate taxes, provided they pertain directly to the rental property. Ensure accurate records, such as receipts and statements, are kept to substantiate these deductions.

Insurance

Insurance premiums for rental properties are deductible under IRC Section 162 as ordinary and necessary business expenses. This includes coverage for fire, theft, flood, and liability. For multi-year policies, premiums must be prorated over the policy’s term. It’s important to distinguish between premiums for rental properties and personal insurance, as only the former is deductible.

Depreciation

Depreciation allows property owners to recover the cost of their investment over time. Using the Modified Accelerated Cost Recovery System (MACRS), residential rental properties are depreciated over a 27.5-year recovery period. For example, a property purchased for $275,000 (excluding land value) would yield an annual depreciation deduction of approximately $10,000.

Land value is excluded from depreciation calculations, as it is considered to have an indefinite useful life. Properly allocating the purchase price between land and building is crucial. Capital improvements, such as roof replacements or HVAC upgrades, must be depreciated separately over their respective useful lives. These improvements should be meticulously tracked, as they increase the property’s depreciable basis.

Depreciation also affects taxes upon sale. Accumulated depreciation is subject to recapture at a 25% tax rate, creating potential tax liability. Maintaining detailed records of depreciation claimed is essential for accurate reporting and calculating recapture taxes.

Passive vs. Non-Passive Treatment

Understanding whether rental activity is classified as passive or non-passive is key for tax planning. Under IRC Section 469, most rental activities are considered passive, limiting the ability to offset other types of income with rental losses.

Non-passive classification depends on material participation in the rental activity. This includes regular, continuous, and substantial involvement, such as managing properties, handling tenant issues, and overseeing maintenance. Taxpayers who qualify as real estate professionals under IRC Section 469(c)(7) can offset rental losses against active income. To qualify, they must spend over 750 hours annually and more than half of their working time on real estate activities.

Recordkeeping Essentials

Effective recordkeeping is vital for accurate tax reporting and preparing for potential IRS audits. Maintain detailed records of all income, expenses, and credits. Lease agreements and tenant correspondence establish rental income, while receipts and invoices substantiate expenses like repairs and maintenance.

Records related to property acquisition and improvements are equally important. Documents such as purchase agreements, closing statements, and appraisal reports establish the property’s cost basis, which is essential for depreciation and capital gains calculations. For improvements, detailed records of costs and work performed are necessary for adjusting the property’s basis. Digital tools like accounting software or cloud storage can simplify organization and ensure accessibility. The IRS generally advises retaining records for at least three years, but longer retention is recommended for property-related documents.

Filing Requirements for Joint Owners

Joint ownership of rental property complicates tax filing, as income, expenses, and deductions must be divided among co-owners based on their ownership percentages. For example, if two individuals own a property equally, each reports 50% of the rental income and expenses on their tax returns.

Married co-owners filing jointly report the property’s financial activity on a single return, simplifying the process. Unmarried co-owners or those filing separately must coordinate to ensure the total income and expenses reported match the property’s actual figures. Any discrepancies could prompt IRS scrutiny.

Depreciation calculations also follow ownership percentages. For instance, if a property with a depreciable basis of $200,000 is owned equally by two individuals, each claims $3,636 annually in depreciation. Passive activity loss rules apply individually, meaning each owner must meet the requirements to deduct rental losses. Consulting a tax professional is advisable to navigate these complexities and ensure compliance.