Publication 527 for Residential Rental Property

For landlords of residential rental properties, understanding the associated tax responsibilities is a fundamental part of the investment. The Internal Revenue Service provides a comprehensive guide, Publication 527, Residential Rental Property, to assist property owners with their tax obligations. This publication serves as the authoritative resource for navigating the complexities of rental income and expenses, detailing the tax treatment for various situations a landlord might encounter.

Reporting Rental Income

The IRS has a broad definition of rental income, which includes more than just the monthly checks from tenants. All payments received for the use or occupation of the property are generally considered gross rental income and must be reported on your tax return for the year you receive them, regardless of your accounting method. This principle applies even if the payment covers a future period.

A common example is advance rent. If you sign a lease and receive payment for the first and last month’s rent, the entire amount is considered income in the year it was received. You cannot defer reporting the last month’s rent until the final month of the lease. This rule ensures that income is recognized when the cash is in hand.

Security deposits, however, are treated differently. A security deposit is not included in your income when you receive it if you plan to return it to the tenant at the end of the lease. The deposit only becomes taxable income if you keep a portion of it for damages or to cover a tenant’s failure to pay rent. At that point, the amount you keep is reported as income.

Rental income can also come in non-cash forms. If your tenant pays for a utility bill or a repair that is your responsibility, the amount they paid is considered rental income to you. For instance, if a tenant pays a $150 water bill on your behalf, you must include that $150 in your rental income. You can then deduct the expense as if you had paid it yourself. Similarly, if you accept property or services in exchange for rent, you must report the fair market value of those goods or services as income. Payments received for canceling a lease are also taxable rental income.

Categorizing and Deducting Rental Expenses

The IRS permits landlords to deduct all ordinary and necessary expenses for managing, conserving, and maintaining their rental property. Common operating expenses include advertising, cleaning and maintenance, insurance premiums, property management fees, and utilities that you pay for. You can also deduct mortgage interest paid on the loan for your rental property, which is reported to you by your lender on Form 1098. Property taxes paid to local governments are another significant deduction, as are legal and professional fees, supplies, and travel expenses incurred while managing your property.

A distinction landlords must make is between a repair and an improvement. A repair is an expense that keeps your property in good operating condition; it does not materially add to the value of your property or substantially prolong its life. Examples include fixing a leaky faucet, patching a hole in a wall, or replacing a broken windowpane. These costs are considered current expenses and can be fully deducted in the year they are paid.

An improvement, on the other hand, is a cost that betters, restores, or adapts the property to a new or different use. These are capital expenditures and are not fully deductible in the current year. Examples of improvements include replacing an entire roof, installing a new heating system, or adding a new room. The cost of improvements must be capitalized and recovered over time through depreciation.

Depreciating Rental Property

Depreciation is the process of deducting the cost of your rental property over a specific period, accounting for the wear and tear, deterioration, or obsolescence of the asset. You can begin to depreciate your rental property when it is placed in service, meaning it is ready and available for rent. The building itself, any equipment used in the rental activity, and capital improvements are all depreciable, but land is never depreciable.

To calculate depreciation, you first need to determine the basis of your property. The basis is typically its cost, which includes the purchase price, as well as certain settlement fees and closing costs like legal fees, recording fees, surveys, and transfer taxes. You must separate the cost of the building from the cost of the land, as only the building’s cost can be depreciated, which can often be done based on the assessed values provided by the local real estate tax assessor.

You must use the Modified Accelerated Cost Recovery System (MACRS) to depreciate residential rental property. Under MACRS, residential rental property is depreciated using the General Depreciation System (GDS) over a recovery period of 27.5 years. The depreciation method used for this type of property is the straight-line method, which means the depreciation deduction is the same for each full year.

For a practical example, imagine you purchase a residential rental property for $300,000. After the purchase, you determine that the value of the building is $220,000 and the value of the land is $80,000. Your basis for depreciation is $220,000. To find the annual depreciation deduction, you divide the basis by the recovery period ($220,000 / 27.5 years), which equals $8,000 per year. For the first year you place the property in service, you must use a specific convention based on the month you started, resulting in a partial year’s deduction.

Calculating Gain or Loss on Sale

When you sell your rental property, you must calculate whether you have a taxable gain or a deductible loss. This calculation begins with determining the property’s adjusted basis. The adjusted basis is your original cost basis (purchase price plus certain settlement costs), plus the cost of any capital improvements you made, minus the total depreciation you were allowed to take during the years you owned it.

The total gain or loss is then found by taking the selling price and subtracting your selling expenses and the adjusted basis. Selling expenses can include real estate commissions, advertising fees, legal fees, and other costs associated with the sale. If the result is a positive number, you have a capital gain; if it is a negative number, you generally have a capital loss, though the deductibility of that loss can be subject to certain limitations.

A component of the gain calculation is depreciation recapture. The depreciation deductions you took over the years reduced your ordinary income. When you sell the property, the portion of your gain that is attributable to the depreciation you claimed must be “recaptured.” This means it will be taxed at a maximum rate of 25 percent, which may be higher than the standard long-term capital gains rates of 0%, 15%, or 20%.

Consider a property with an adjusted basis of $150,000 that is sold for $250,000, resulting in a $100,000 gain. If you had claimed $40,000 in depreciation over the years, that $40,000 of the gain would be subject to the 25 percent depreciation recapture tax rate. The remaining $60,000 of the gain would be treated as a long-term capital gain, taxed at the applicable lower rates.

Key Rules for Specific Situations

One common scenario involves the personal use of a dwelling unit, often referred to as the “vacation home rules.” If you use your rental property for personal purposes for more than the greater of 14 days or 10% of the total days it is rented to others at a fair rental price, your deductions may be limited. You must allocate your expenses between the rental use and the personal use, and you generally cannot deduct rental expenses in excess of your rental income.

Rental real estate activities are typically considered passive activities by the IRS. This means that if your expenses exceed your income, the resulting loss may be limited by the passive activity loss (PAL) rules. These rules generally prevent you from deducting passive losses against nonpassive income, such as wages. There is a special allowance for rental real estate activities that may permit you to deduct up to $25,000 in losses if you actively participate in the rental, but this allowance begins to phase out when your modified adjusted gross income reaches $100,000 and is completely phased out at $150,000.

Finally, maintaining thorough and accurate records is a requirement for all landlords. You must be able to document your reported income and expenses. This includes keeping bank statements, receipts, invoices, and lease agreements. For expenses, your records should show the amount paid, the date, and a description of the item or service purchased.