IRS Publication 527: Residential Rental Property

Owning residential rental property introduces a unique set of tax considerations. IRS Publication 527, Residential Rental Property, is the primary guide for navigating these obligations. This publication explains the tax treatment of income and expenses for properties like single-family homes, apartments, and vacation homes rented to tenants. This article will explore how to report rental income, what expenses are deductible, the mechanics of depreciation, and rules for properties used for both personal and rental purposes.

Defining and Reporting Rental Income

The foundation of rental property taxation is that all amounts received for the use of a property are income. This includes regular monthly rent payments, which must be reported in the year they are received. Any rent paid in advance must be included in your income in the year you receive it, regardless of the period it covers or your accounting method. For instance, if you receive the first and last year’s rent upfront, the entire amount is income in the year of receipt.

A true security deposit, which you intend to return to the tenant, is not included in your income. However, if the deposit is used as a final rent payment, it is advance rent and must be reported as income when received. If you keep a deposit because a tenant breaches the lease, such as by damaging the property, the amount you retain becomes taxable income in the year it is forfeited.

Rental income is not limited to cash. If a tenant pays for any of your expenses, such as a property tax bill or a repair, you must include that amount in your income. You can then deduct the expense as if you had paid it yourself. Similarly, if you accept property or services instead of cash for rent, you must report the fair market value of those goods or services as rental income.

Understanding Deductible Rental Expenses

After determining your total rental income, you can deduct the ordinary and necessary costs of managing and maintaining your property. An ordinary expense is common in the business of renting property, while a necessary expense is helpful and appropriate. These deductions reduce your taxable rental income.

A key distinction is between repairs and improvements. A repair keeps your property in good operating condition, and its cost is deductible in the current year. Examples include fixing a leaky faucet or repainting a room. These activities maintain the property but do not add significant value or prolong its life.

In contrast, a capital improvement is an expense that must be capitalized and depreciated over time. An improvement betters, adapts, or restores the property, such as by expanding a room, replacing a roof, or rebuilding the property to a like-new condition. Because improvements provide a benefit that lasts for more than one year, their costs are recovered through depreciation.

Many other common expenses are also deductible. These include:

• Advertising costs to find tenants
• Cleaning and maintenance fees
• Insurance premiums
• Professional fees paid to property managers or accountants
• Mortgage interest and property taxes
• Supplies and utilities that you pay for the property

If you travel to collect rent or perform management duties, the ordinary and necessary costs of that travel can also be deducted.

Depreciating Your Rental Property

Depreciation is an annual tax deduction that allows you to recover the cost of your rental property and its improvements over a useful life. The IRS requires property owners to depreciate rental buildings because they are income-producing assets that lose value over time. You cannot depreciate the cost of land, as it does not have a determinable useful life.

To calculate depreciation, you must first determine the property’s basis, which is generally what you paid for it, including certain settlement fees. You must allocate this cost between the land and the building, using an appraisal or assessed tax values. Your adjusted basis is the cost basis plus the cost of any capital improvements, minus any depreciation already claimed and casualty losses taken.

Residential rental property in the United States is depreciated using the Modified Accelerated Cost Recovery System (MACRS). Under this system, the recovery period for residential rental properties is 27.5 years. This means you will deduct a portion of the property’s basis each year over that period.

Depreciation begins on the “placed in service” date, which is when the property is ready and available for rent. The calculation for a full year is the building’s basis divided by 27.5. For the first and last years of rental service, the IRS uses a “mid-month convention,” which treats the property as being placed in service or disposed of in the middle of the month, regardless of the actual date.

Special Rules for Personal Use of a Dwelling Unit

When a property is used as both a rental and a personal residence, such as a vacation home, specific tax rules may limit your deductions. These rules depend on the number of days the property is used for personal purposes versus the number of days it is rented at a fair market price. A “day of personal use” is any day the unit is used by the owner, the owner’s family, or anyone paying less than a fair rental price.

The primary test is the “14-day rule” or the “10% rule.” If you rent the property for fewer than 15 days during the year, you do not have to report any rental income or deduct any rental expenses. If you use the property for personal purposes for more than the greater of 14 days or 10% of the total days it is rented at fair value, it is classified as a “home,” which limits your ability to deduct a rental loss.

If the property qualifies as a home, you must allocate total expenses between personal and rental use based on the number of days used for each purpose. For example, if you used the property for 30 personal days and rented it for 90 days, you would allocate 75% (90 rental days / 120 total days) of your expenses to the rental activity.

When your property is classified as a home, you must first deduct expenses that are otherwise deductible, like mortgage interest and property taxes. You can then deduct other rental expenses, but only up to the amount of your gross rental income. If your expenses exceed your rental income, you cannot claim a loss, and the excess expenses are carried forward to the next year.

Navigating Loss Limitations and Reporting

Other limitations may prevent you from deducting a rental loss in a given year. For rental property owners, the most significant of these are the passive activity loss rules. Rental real estate is considered a “passive activity,” and losses from passive activities can only be used to offset income from other passive activities. This means if your rental property generates a loss, you cannot use it to reduce taxable income from non-passive sources, like wages.

However, an exception exists for many rental real estate investors. A special allowance permits taxpayers who “actively participate” in their rental activity to deduct up to $25,000 in rental losses against non-passive income. Active participation involves making management decisions like approving tenants and expenditures. This allowance is phased out for taxpayers with a modified adjusted gross income (MAGI) between $100,000 and $150,000 and is unavailable for those with a MAGI above $150,000.

The “at-risk” rules also limit your deductible losses to the amount you have “at risk” in the activity. Your at-risk amount includes cash you have contributed, the adjusted basis of contributed property, and amounts you borrowed for which you are personally liable. This prevents deducting losses that exceed your actual economic investment.

All income, expenses, and losses from residential rental property are reported on Schedule E (Form 1040). The depreciation calculation is made on Form 4562, with the total carried over to Schedule E. If your losses are limited by the passive activity rules, you will also need to file Form 8582.