While some conversions of a residence to rental property are part of a long term plan, often for service members and military families the decision to convert just seems to be the best option when a Permanent Change of Station (PCS) comes up. Most incidental landlords don’t know what to expect for taxes with rental property. This article provides a primer on what to expect and some good tips. NOTE: This article is directed at rental property that is included with an individual tax return along with Form 1040. Also, this article is directed at long term rental properties, not short term rental properties. While much of his information applies in other cases, there can be important differences. This article should not be used alone to determine tax liability or for the tax preparation process. The IRS instructions and procedures should be used for tax prep and determining liability. The article is intended to get you thinking about important topic areas and is a starting point that directs you to resources that would be helpful.
How do rental property taxes work?
If you own rental property as an individual, or as a couple, or as a Single Member Limited Liability Corporation (SMLCC) rental property taxes get filed with your Form 1040. If your intent for the endeavor is profit (immediate or in the future), the base Form for rental property is the Schedule E. It is a good idea to review the form and the form instructions when converting a property to the rental. I recommend with whatever method you track expenses, try to match up the tracking with the Schedule E expense categories as much as possible. However, there is a section for “other”.
We’ll get into more detail, but the basics are that you deduct valid expenses from the rent payments (rental income) and if the result is positive then you have a profit. There is an expense called depreciation which we will talk about later. I mention it now because this depreciation expense is often a big factor that contributes to a rental activity having a loss on the schedule E. It is very common for incidental landlords to have losses each year from a tax perspective, especially for the first few years.
Rental property losses can be particularly helpful for your current tax year in certain situations. Normally passive losses can only offset passive income, so if you have other passive income then passive losses in real estate can reduce your taxable income from the other passive activities. There is an exception that applies to many landlords. There are qualifying criteria for this exception, the three with the biggest impact are active participation is required (which is not the same as material participation), rental property income has to be the only passive income, and being below $150,000 for income (really modified adjusted gross income, or MAGI). The others can be found on page E-4 of the schedule E instructions (2021 version) and they should be met as well. The bar for active participation is relatively low, basically if you make any management decisions you have active participation and more detail can be found in the schedule E instructions page E-4. When your MAGI is $100,000 or less you can deduct up to $25,000 of the passive losses from real estate activity against other income, like W-2 income. This exception phases out from $100,000 to $150,000, dropping from $25,000 to $0 over that range. If a taxpayer is a real estate professional as the IRS defines one, the passive loss rules have differences.
Rental losses or any passive losses which are not used to offset current year income may (and should be) passed to the following years and can be carried forward on an ongoing basis. For rental property, when the property is sold or disposed of then all the rental losses are taken in that year’s tax return- usually, but there are exceptions.
Your schedule E income (or loss if permitted to apply against current income as just stated) transfers from your schedule E to part I of Schedule 1 and then to your 1040 as part of the “Other income” line.
Most landlords just have rental income from rent payments generated from the rental property and that gets reported on the Schedule E (gain income from selling the ;property doesn’t go on the Schedule E).
Deposits do NOT get included as income unless they get used against any fees or valid charges. When this happens the deposit or portion of the deposit gets added to the income, but there should be a corresponding expense. However, a non refundable fee or deposit is income.
Most landlords operate on a cash basis, rather than an accrual basis (accrual basis would rarely make sense for most landlords). Basically this means income is counted as it is received and expenses are counted when they are paid. Advance rent is reported in the year it is received. In some cases this may cause negative tax repercussions due to higher income in the year received.
There are many valid rental expense deductions. Remember a tax deduction doesn’t mean you get all your expenses “covered”. If your marginal tax rate is 22%, then you get a $22 dollar tax savings for a $100 expense deduction-assuming it isn’t part of a loss that is being carried over to the next year. Don’t spend money just because you will get a tax deduction. Here is a list of common deductions:
- Travel- legitimate travel to and from the property for repairs, rent collection, inspections, and other valid business reasons are deductible.
- Advertising and marketing. Common today are costs for advertising on websites.
- Cleaning and maintenance.
- Pest control, lawncare, landscaping
- Property management fees
- Utilities paid by the landlord
- Legal and professional fees -from things like lease writing, tax prep, eviction costs
- Mortgage interest
- Supplies- for cleaning or maintenance are common.
- Subscription services for lease prep and rent collection and other reasons.
- Repairs -this is to fix existing items. There is a difference between repairs and improvements and it isn’t always obvious which is which. How to handle repairs for tax deducting is simple, they get deducted as an expense. Improvements can be more complicated, we’ll get to that shortly.The IRS provides guidance in PUB 527 and elsewhere on what are improvements vs repairs.
- Depreciation of assets- generally speaking assets are depreciated over time based on their lifetime. Assets are items that last longer than a year and in theory get used up or lose value over time. The IRS has guidance on what the lifetimes are to be. We’ll get into more detail on this shortly.
- Amortized or capitalized items. Some costs are treated in a similar manner as depreciated items in that their costs are spread out over a period of time. Two examples of this are refinance costs for a rental property and potentially start up costs for a rental property.
Always track expenses that may be valid rental expenses, since you can always determine that they shouldn’t be included later when filing your tax return if it turns out that they aren’t valid expenses.
Note that in the year you convert a residence to a rental property items like mortgage interest, insurance, and taxes will have to be split between personal expenses and rental property expenses. Generally expenses are deductible as rental property expenses from the first day it was available for rent -the date you advertised that it was available for the first move in/lease starting. This is called the placed in service date.
For any spending before the placed in service date, there are several ways that spending is handled. Most prior to in-service expenses in the case of a conversion are classified as personal expenses and can’t be deducted on the schedule E. This is because they are done while you were living there and you received a personal benefit.If they were an improvement, they may be added to your adjusted basis for depreciation.
Expenses that occur after you move out and before the property is service are typically added to the adjusted basis as well. In most cases there is not a choice. It gets added to adjusted basis and not deducted directly.
Occasionally there are valid startup or organizational expenses (separate categories of costs) that are handled under special rules, but that isn’t common for rentals, especially conversions. Some can be expensed up to a limit and the remainder (or the total if elected or required) can be amortized over 15 years (deduction spread out over 15 years). Pub 535 discusses startup costs in more detail.
Now, let’s return to depreciation and improvements.
Depreciation and Improvements
These are the basic rules that apply in most cases, particularly for incidental landlords.
The tax code often refers to houses and other buildings as improvements. Improvements are depreciable. Land is not depreciable. Land value should NOT be included in the depreciation basis, although it is part of the overall basis. Even a condo apartment may have some land value associated with it.
Depreciation for a converted rental property starts on the placed in service date. For residential rental property (not a short term rental or STR) the asset life is 27.5 years. If the total basis of the property is $125,000 and the land value portion is $25,000, then $100,000 is depreciated over 27.5 years. Or in other words the deduction is spread over 27.5 years, a bit more than a $3600 deduction each year. Great, what is the basis?
For a converted rental property the basis is the lower of the adjusted basis or the Fair Market Value (FMV) at the time of the conversion. FMV can be determined by market comparisons. In most cases FMV at time of conversion is higher than the adjusted basis, so the adjusted basis is most often used.
The adjusted basis starts with the original basis. This is typically what was paid for the property plus SOME closing costs. Pub 523 is a good starting point to determine the original basis. Don’t forget to separate out land value from the depreciation basis. Some appraisals when purchasing will provide a break out of land value, some do not. One way to get land vs improvements ratio is often from the annual tax assessment for the year of purchase. Any additional improvements made before the placed in service date can be added to the depreciation basis, things like a kitchen remodel, a new roof, and a new shower. Remember repairs are not improvements. Some things reduce basis. One example is depreciation. For example, if you depreciated due to business use of home you’ll have to factor that into the adjusted basis.
Getting the basis right is important since it impacts every tax return for that rental property and is used to help determine your gain when you sell.
Do not skip out on basis and depreciation because it is too hard or because you don’t want to worry about it. When you sell, the IRS wants to “get back” the tax benefit you got for depreciation and requires that depreciation recapture be applied on depreciation taken or allowed. Even if you didn’t take the depreciation, depreciation recapture applies and that means you’ll get the tax hit on most sales (if you do have gains and even if capital gains are excluded for other than a 1031 exchange) whether you took the benefit of depreciation or not.
Whenever you add new assets or new improvements to the property they are generally supposed to be depreciated, except when they are not. The depreciation life time (or recovery period) varies depending on the nature of the asset or improvement. Generally a kitchen remodel would be depreciated over 27.5 years and a stove over 5 years. Some lower cost items may be expensed or deducted in full the year purchased. Some items may have accelerated depreciation. For some options to apply you have to formally make an election that is written on your tax return.
This area of the tax code has many complications. Error rates are high, so tread carefully. Pub 946 is a good starting point to get the handling of assets and improvements with depreciation and to find the options available.
NOTE: Depreciation and amortization schedules are generated (as applicable) when preparing tax returns, but are not normally submitted to the IRS as part of your tax return. Make sure you retain copies each year. I mention this because rebuilding these schedules can be time consuming and painful. Also, some tax professionals do not provide clients with this work product as a method to make it harder for them to switch to another tax professional. I view that as unethical, since the client paid for the work. But in most cases it doesn’t violate a law.
But what about when I sell?
This wasn’t the focus of this article, but here is one that covers the capital gains considerations fairly well.
I hope the article helped you understand rental property taxes better. This article does not come close to covering it all. You can rely on luck to get the taxes right or you can rely on diligence. Diligence means reading and researching using IRS instructions and publications. I recommend the diligence approach or hiring a tax professional who is diligent and knowledgeable.
Happy tax prep!