What Type of Income Is Received Through Rent?

Rental income refers to payments received for the use or occupancy of real estate, such as houses, apartments, or land. This income typically encompasses regular rent, advance rent, lease cancellation fees, or expenses a tenant pays on your behalf. Understanding how this income is categorized and treated for tax purposes is important for property owners to ensure accurate reporting.

Understanding Rental Income Classification

Gross rental income includes all money and the fair market value of property or services received from tenants for the use of your rental property. This encompasses regular rent payments, advance rent received for future periods, and fees for canceling a lease. If a tenant pays for expenses you are responsible for, such as a utility bill, and deducts it from their rent, that amount is also considered part of your gross rental income.

Rental real estate activities are generally classified as passive activities for tax purposes. This classification means that any losses generated from these activities can typically only be used to offset income from other passive activities. If passive losses exceed passive income, the excess loss is suspended and carried forward to future tax years until there is passive income to offset or the property is sold.

There are exceptions to the passive activity rules that can allow rental losses to offset non-passive income, such as wages or business income. One such exception is active participation, which allows individuals to deduct up to $25,000 of passive losses from rental real estate against non-passive income. To qualify for active participation, an individual must own at least 10% of the property and make significant management decisions, like approving tenants or expenditures. This allowance is subject to income limitations.

Another exception applies to individuals who qualify as real estate professionals. To meet this status, a taxpayer must perform more than half of their personal services in real property trades or businesses, and spend at least 750 hours during the year in those businesses in which they materially participate. If these criteria are met, their rental activities are not automatically considered passive, allowing them to deduct rental losses against any type of income without passive activity limitations. Additionally, rental income may be considered non-passive or ordinary business income if substantial services are provided to tenants, similar to a hotel, or if the property is “self-rented” to a business in which the owner materially participates.

Allowable Rental Expenses

To determine the taxable net rental income, property owners can deduct ordinary and necessary expenses incurred in managing, conserving, or maintaining the rental property. An ordinary expense is common and accepted in the business, while a necessary expense is appropriate and helpful.

Mortgage interest paid on loans used to acquire or improve the rental property is a significant deductible expense. Property taxes paid on the rental property are also deductible. Other common operating expenses include utilities not paid by the tenant, insurance premiums for coverage like fire, theft, or liability, and advertising costs to find new tenants.

Repairs that keep the property in good operating condition are generally deductible in the year they are incurred. Examples include fixing a broken window or a leaky faucet. Improvements, which add value, prolong the property’s life, or adapt it to a new use, are not immediately deductible but are instead capitalized and recovered through depreciation. For instance, adding a new room or replacing an entire roof would be an improvement.

Depreciation allows property owners to recover the cost of the property and certain improvements over a specific period. The land itself is not depreciable, but the building and its components are. For residential rental property, the cost is typically depreciated over 27.5 years. Management fees paid to a property manager are deductible, as are legal and professional fees paid for services related to the rental activity, such as those for accountants or attorneys. Travel expenses incurred for the primary purpose of collecting rent or managing and maintaining the property, such as transportation and lodging, can also be deducted, though personal travel portions are not.

Reporting Rental Income to the IRS

Individual landlords generally report their rental income and expenses on Schedule E (Form 1040), Supplemental Income and Loss. This form is specifically designed to report income or loss from rental real estate, royalties, partnerships, S corporations, and trusts. Using Schedule E allows property owners to detail their gross rental income and then list all allowable deductions.

The net income or loss calculated on Schedule E is then transferred to the main Form 1040. For taxpayers with multiple rental properties, Schedule E requires each property’s income and expenses to be reported separately.

When completing Schedule E, the gross rental income, as previously determined, is entered on the appropriate line for each property. Similarly, the total of all allowable expenses, such as mortgage interest, property taxes, and depreciation, is entered on their respective lines. This systematic reporting ensures that the final taxable income or loss from rental activities is accurately reflected on the taxpayer’s overall income tax return. While Schedule E is for individuals, partnerships and S corporations typically use Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, to report similar information.