What Is Rental Income for Tax Purposes?

Rental income, for tax purposes, is the payment you receive for the use or occupation of property you own. This income must be reported to the Internal Revenue Service (IRS) and is subject to federal taxation. The government views this revenue as a form of regular income, similar to wages. Consequently, specific regulations dictate what qualifies as income and which related costs can be subtracted to determine your taxable amount.

Components of Gross Rental Income

Gross rental income is the total revenue generated by a property before any expenses are subtracted. This figure is the starting point for calculating your net taxable income and includes more than just monthly rent. Other items classified as rental income include:

• Advance Rent: Rent a tenant pays in advance is income in the year you receive it, not the year it applies to. For example, if a tenant pays the first and last month’s rent upon signing a lease, the entire amount is income for that tax year.
• Security Deposits: A deposit is not income if you intend to return it to the tenant. It becomes income only when you keep a portion or all of the deposit to cover unpaid rent or to pay for repairs.
• Tenant-Paid Expenses: If a tenant pays for an expense that is your responsibility, such as a utility bill or a repair, the amount they paid is considered rental income.
• Services or Property: If you accept services or property instead of rent, the fair market value of those goods or services is reported as income. For instance, if a painter paints the property for a month’s rent, the value of that service is taxable.

Allowable Rental Expense Deductions

To determine your net rental income, you can subtract certain expenses from your gross rental income. The IRS permits the deduction of costs that are both ordinary and necessary for managing and maintaining your rental property. An ordinary expense is common in the business of renting, while a necessary expense is helpful for your rental activity.

Allowable deductions include operating expenses like landlord-paid utilities, property insurance, advertising, and property management fees. Maintenance and repair costs are also deductible, such as fixing a plumbing leak or patching a wall. You can also deduct property taxes and the mortgage interest paid on the loan used to purchase or improve the rental property.

Depreciation is a deduction that allows you to recover the cost of the property itself over time. You cannot deduct the entire cost of a residential rental building in the year you buy it; instead, you deduct a portion of its cost each year over its 27.5-year useful life. The value of the land cannot be depreciated, only the structure. A repair keeps the property in its current condition and is expensed in the year it occurs, whereas an improvement that adds value, like a kitchen remodel, must be depreciated.

How to Report Rental Activities

The primary form for reporting your rental income and expenses to the IRS is Schedule E (Form 1040), Supplemental Income and Loss. This form is used to summarize all the financial activities related to your rental real estate for the tax year. You will use it to list your total gross rental income and to categorize and total all of your deductible expenses.

Certain deductions require their own specific forms. The deduction for depreciation, for example, is calculated on Form 4562, Depreciation and Amortization. On this form, you will detail the property’s cost basis, the date it was placed in service, and the depreciation method used to calculate the annual deduction before entering the total on Schedule E.

After you have completed Schedule E, the net income or loss figure is carried over to your main Form 1040, where it is combined with your other sources of income. If you have a net rental profit, this amount may also be subject to the Net Investment Income Tax (NIIT). The NIIT is a 3.8% tax on the lesser of your net investment income or the amount by which your modified adjusted gross income exceeds certain thresholds.

These income thresholds are $250,000 for married couples filing jointly, $125,000 for married couples filing separately, and $200,000 for single filers and heads of household.