What Is Rental Real Estate and How Is It Taxed?
Unpack the core concepts of rental real estate, covering its nature as an investment and the nuances of its taxation.
Rental real estate involves owning property with the intent of generating income through rent. Understanding the tax implications is important for individuals considering or already engaged in rental property ownership.
Characteristics of Rental Real Estate
A property qualifies as rental real estate when it is primarily held for generating rental income. This means the owner’s main purpose is to rent it out, rather than using it for personal enjoyment or for quick resale. The rental activity involves payments received for the use of tangible property, such as a house or apartment.
Personal use of a rental property can affect its tax classification. If a dwelling is rented for fewer than 15 days during the tax year, the rental income does not need to be reported, and associated rental expenses are not deductible.
However, if the property is rented for 15 days or more, and personal use exceeds the greater of 14 days or 10% of the total days rented at a fair rental price, the property is considered a “residence” for tax purposes. In such cases, deductible rental expenses are limited to the amount of gross rental income, meaning losses cannot be claimed. Expenses must be allocated between rental and personal use based on the number of days used for each purpose. Personal use includes days the property is used by the owner, family members, or anyone paying less than fair market rent.
Rental Activities as Passive Activities
Most rental activities are classified as “passive activities” by default. A passive activity is a trade or business in which the taxpayer does not materially participate. This classification applies to rental properties even if the owner is actively involved, unless an exception, such as qualifying as a real estate professional, applies.
Passive activity classification impacts how losses are treated. Losses generated from passive activities can only be deducted against income from other passive activities. These passive losses cannot be used to offset “active income,” such as wages, or “portfolio income,” like interest or dividends.
If passive losses exceed passive income, they are not immediately deductible in the current tax year. Instead, these disallowed losses are suspended and can be carried forward to future tax years. They can then be used to offset passive income or when the activity is fully disposed of. Active participants in rental real estate activities may deduct up to $25,000 of passive losses against non-passive income. This special allowance begins to phase out when the modified adjusted gross income (MAGI) exceeds $100,000 and is completely phased out at $150,000.
Reporting Rental Income and Expenses
Amounts received for the use or occupation of rental property must be included in gross income. This includes regular rent payments, advance rent (taxable when received regardless of the period it covers), and payments received from a tenant for canceling a lease. If a tenant pays expenses that are the landlord’s responsibility, those payments must be included in rental income. Security deposits are not included in income if there is an obligation to return them, unless a portion is kept due to a lease breach.
Owners of rental property can deduct ordinary and necessary expenses for managing and maintaining the property. Common deductible expenses include mortgage interest and property taxes. Operating expenses like utilities, insurance premiums, and advertising costs are deductible.
Repairs, which keep the property in good operating condition, are deductible in the year incurred. Improvements that add to the property’s value or prolong its useful life are not immediately deductible but are recovered through depreciation. Depreciation is a non-cash deduction that accounts for the wear and tear of the property over its useful life; only the building can be depreciated, not the land. Management fees and professional fees are also deductible. Record-keeping of all income and expenses is essential for tax reporting on Schedule E (Form 1040).