IRS Publication 527: Residential Rental Property Tax Rules

IRS Publication 527, “Residential Rental Property,” is a guide from the Internal Revenue Service (IRS) for taxpayers who own and rent out residential real estate. The publication assists property owners in correctly reporting rental income and identifying all permissible deductions. It details the specific rules that govern how income is recorded and what expenses can offset that income, clarifying the tax treatment of financial events throughout the lifecycle of a rental property.

Reporting Rental Income

All income from a rental property must be reported to the IRS, including regular rent payments. This income is included in your gross income for the year in which it is received, regardless of the period the payment covers. For example, if a tenant pays January’s rent in December, that income is reported in the year it was received.

Advance rent, which is any amount paid before the period it covers, must be included in your rental income in the year you receive it. If you collect both the first and last month’s rent upfront, the entire amount is income in the year of receipt. This rule applies even if the lease extends over multiple years.

Security deposits are not considered income if you intend to return them to the tenant at the end of the lease. The deposit becomes taxable income only when you are no longer obligated to return it, such as when it is forfeited for property damage or a broken lease. The amount you keep is then reported as income for that year.

Other payments from a tenant can also be rental income. If a tenant pays for expenses on your behalf, such as water bills or repairs, the value of those payments is considered rental income. Fees collected for canceling a lease are also treated as rental income in the year they are received.

Deducting Rental Expenses

To be deductible, expenses for your rental property must be both ordinary and necessary. An ordinary expense is common in the business of renting property, while a necessary expense is helpful and appropriate for your rental activity.

Commonly deducted expenses include:

• Advertising costs to find tenants
• Insurance premiums for fire and liability coverage
• Professional fees paid to property managers
• Utilities that you pay for the property, such as water, gas, and electricity
• Mortgage interest on the loan used to acquire the property
• Real estate taxes assessed on the property

A distinction exists between a currently deductible repair and a capital improvement that must be depreciated. Repairs are actions that keep your property in good operating condition but do not add significant value or prolong its life. Examples include repainting a room, fixing a leaky faucet, or replacing a broken window, and these costs are deducted in the year they are paid.

Capital improvements are enhancements that add value to the property, prolong its useful life, or adapt it to new uses. Examples include adding a new roof, installing a new heating system, or building an addition. These costs are not deducted in one year but are instead capitalized and recovered through depreciation.

Understanding and Calculating Depreciation

Depreciation is the annual deduction that allows you to recover the cost of your rental property over its useful life. You can begin to depreciate a rental property when it is placed in service, meaning it is ready and available for rent.

The first step is to determine the property’s basis. For a purchased property, the basis is its cost, including the purchase price and certain settlement or closing costs, such as:

• Legal fees
• Recording fees
• Surveys
• Transfer taxes

You can only depreciate the building and its improvements, not the land, as land does not wear out. You must allocate the property’s total cost basis between the land and the building. This allocation can be based on assessed values for real estate tax purposes or an independent appraisal.

The IRS mandates the use of the Modified Accelerated Cost Recovery System (MACRS) for residential rental property. Under MACRS, the General Depreciation System (GDS) is used, and property is depreciated over a recovery period of 27.5 years using the straight-line method. This means you deduct an equal amount of depreciation each full year the property is in service.

To calculate the annual deduction, divide the building’s cost basis by 27.5. For example, a building basis of $275,000 results in a $10,000 annual deduction. Capital improvements made after you place the property in service are also depreciated over a 27.5-year period, starting from the date the improvement is placed in service.

Rules for Personal Use of a Dwelling Unit

When you use a rental property for personal purposes during the year, you must divide your expenses between rental and personal use. The IRS has specific rules that determine how you can allocate and deduct these expenses.

The IRS defines “personal use” as use by you, your family members, or anyone paying less than a fair rental price. Days spent at the property primarily for repair and maintenance do not count as personal use days. The allocation of expenses depends on the number of personal use days versus the number of days it is rented at a fair market rate.

A threshold determines how you treat rental expenses and potential losses. If your personal use exceeds the greater of 14 days or 10% of the total days it was rented at a fair price, it is considered a “residence.” When this occurs, you cannot deduct a rental loss, and your deductible rental expenses are limited to your rental income.

To divide expenses, you must allocate them based on the number of days used for each purpose. For example, if you use the property for 30 personal days and 120 rental days, you can deduct 80% (120/150) of your direct rental expenses. Expenses like mortgage interest and property taxes are allocated between personal and rental use, with the personal portion potentially deductible as an itemized deduction.

If your personal use does not exceed the 14-day/10% threshold, the property is treated more like a business. You still allocate expenses between personal and rental use, but you are permitted to deduct a rental loss. This loss may be subject to other limitations, such as the passive activity rules.

How to Report Rental Activity

You must report your rental income and expenses to the IRS on Schedule E (Form 1040), Supplemental Income and Loss. On this form, you list your gross rental income and then subtract your categorized expenses, such as advertising, insurance, and repairs. This calculation determines your net rental income or loss for the year.

The depreciation deduction is not entered directly on Schedule E. You must first complete Form 4562, Depreciation and Amortization, to detail the calculation. The total depreciation deduction from Form 4562 is then carried over to Schedule E.

If your rental expenses exceed your income, you will have a net rental loss. The deductibility of this loss may be limited by the passive activity loss rules, calculated on Form 8582, Passive Activity Loss Limitations. Rental real estate is considered a passive activity, and losses may only be deductible against income from other passive activities.