IRS Publication 527: Residential Rental Property

IRS Publication 527, “Residential Rental Property,” is a guide for taxpayers who own and rent out property. It details the proper methods for reporting rental income and identifying all allowable expenses, which are key aspects of managing a rental property’s finances. The publication helps ensure compliance with federal tax law by helping landlords accurately calculate their net rental income or loss. This ensures they meet their tax obligations while taking advantage of the deductions to which they are legally entitled.

Determining Rental Income

All payments received for the use of a rental property are included in your gross rental income, including monthly rent. The timing of receipt determines when you report the income. For instance, if a tenant pays January’s rent in December, you must include that payment in your income for December’s year.

Advance rent is any amount received before the period it covers and must be reported as income in the year you receive it. For example, if you receive the first and last year’s rent upfront on a multi-year lease, the entire amount is income in the year of receipt. This differs from a security deposit, which is not included in your income when you receive it.

A security deposit is a liability because you are expected to return it to the tenant. It only becomes income if you are no longer obligated to return it, such as when a portion is kept to cover unpaid rent or damages. That amount becomes taxable income in the year it is applied. If a payment is designated as the final month’s rent in the lease, it is considered advance rent and included in your income when received.

Rental income is not limited to cash. If a tenant provides services or property in exchange for rent, you must report the fair market value of those items as rental income. For example, if a tenant paints the house in lieu of rent, the value of that service is income. This also applies if a tenant pays for property expenses on your behalf.

Identifying Deductible Rental Expenses

The IRS allows deductions for all ordinary and necessary expenses incurred while operating a rental property. These are costs that are common and accepted for that type of business. You must keep records and receipts to substantiate these deductions at tax time.

Common deductible expenses include:

• Advertising to find new tenants
• Cleaning and maintenance costs
• Insurance premiums
• Professional fees for managers or accountants
• Mortgage interest on the property loan
• Property taxes assessed by local governments
• Utility costs paid by the landlord
• Travel expenses to collect rent or maintain the property

The tax treatment for repairs and improvements differs. Repairs are actions that keep your property in good operating condition without adding to its value or prolonging its life, such as fixing a leak or patching a wall. The costs of repairs are deductible, meaning you can subtract the full cost from your rental income in the year you pay for them.

Improvements are costs that add value to your property, prolong its life, or adapt it to new uses. Examples include replacing a roof or remodeling a kitchen. The costs of improvements cannot be deducted at once; instead, they are capitalized and recovered over time through depreciation.

Understanding Depreciation

Depreciation is an annual, non-cash tax deduction that allows you to recover the cost of your rental property and its improvements over time. This deduction accounts for wear and tear and begins when the property is placed in service, meaning it is ready and available for rent.

Land cannot be depreciated, so you must allocate the property’s total cost between the land and the building. Only the cost basis of the building and capital improvements are subject to depreciation. This allocation can be based on the property’s assessed value from the local tax assessor.

To calculate depreciation, you must determine the property’s basis. The basis is its cost, including the purchase price, settlement fees, and other acquisition costs, plus capital improvements minus casualty losses. For residential rental property in the U.S., the cost is recovered over a period of 27.5 years.

The depreciation method for residential rental property is the Modified Accelerated Cost Recovery System (MACRS). You must use the straight-line method over 27.5 years. For example, if the basis of your rental building is $275,000, the annual depreciation deduction would be $10,000 for a full year of service. The calculation is prorated for the first and last years of ownership based on the month the property is placed in or taken out of service.

Special Rules for Personal Use

Using a dwelling for both rental and personal purposes can limit your deductible rental expenses. These “vacation home rules” apply if your personal use exceeds certain thresholds. A day of personal use is any day the unit is used by you, a family member, or anyone else for less than fair rental price.

The threshold for these rules depends on your personal use of the property. If your personal use is more than 14 days or more than 10% of the total days the property is rented at a fair market price, whichever is greater, it is considered a “dwelling unit used as a home.” When this occurs, you are subject to limitations on the deduction of rental expenses.

If your property is classified as a dwelling unit used as a home, you must allocate expenses between rental and personal use. This allocation is based on the number of days used for each purpose. For example, if the property was rented for 90 days and used personally for 30 days, you would allocate 75% of your expenses to rental use.

When these rules apply, you cannot deduct a rental loss. Your deductible rental expenses are limited to the amount of your rental income for the year. Any expenses not allowed due to this limit can be carried forward to the next year and deducted against that property’s future rental income.

Reporting Rental Activity on Tax Forms

Income and expenses from residential rental property are reported on Schedule E (Form 1040), Supplemental Income and Loss. Landlords use Part I of this form to detail the property’s financial activity for the year.

On Schedule E, you list your total gross rental income. The form provides separate lines for expense categories like advertising, insurance, mortgage interest, and repairs, which are summed to find your total expenses.

The depreciation deduction is reported on Schedule E, but it is calculated on Form 4562, Depreciation and Amortization. On Form 4562, you provide details about the property, including its cost basis, the date it was placed in service, and the depreciation method used. The resulting amount is then carried over and entered on the appropriate line on Schedule E.

After listing all income and expenses on Schedule E, you calculate the net rental income or loss for each property. The totals are combined to determine your overall supplemental income or loss. This final figure from Schedule E is then transferred to your main tax return, Form 1040.