Rental Income and Deductions
A landlord must claim income from property rentals, but will also be able to deduct expenses. Hence, rental properties are much like any other business. However, there are a few special rules that apply specifically to rental properties. There are also some tax strategies that may reduce taxes.
Rental Income Recognition
Rent is recognized when it is received. The advanced payment of rent or fees received to terminate a lease early must also be recognized in the year in which it is received, even if the taxpayer uses the accrual method of accounting. Security deposits must be recognized when received unless the security deposit is held by a third-party, such as an escrow service.
If the tenant provides services or property in exchange for a rent reduction, then the fair market value of the exchange must be includible in income. So if a tenant provides property services at an apartment complex in exchange for free rent, then the amount that should be included in the landlord's income should equal the rent of a comparable apartment.
If the tenant improves the property for his own use, without a reduction in rent, then there is no income to the landlord, so the landlord can neither depreciate the added improvements nor change its tax basis.
If the tenant pays for expenses of the rental, such as repairs, property taxes, or insurance payments for which the landlord was liable, then the landlord must include those payments as income and deduct the same amount as an expense.
As a business, the landlord can deduct expenses from rental income that are necessary or ordinary, meaning that the expenses needed to be paid to operate the unit as a rental or are an expense type customarily paid by landlords. However, to be deductible, the property must be actively rented out or the landlord must be actively seeking tenants for the property. If the property has multiple dwellings, but only some of them are rented out, then the expenses must be apportioned among the different properties, unless the expense specifically applied to only certain properties. For expenses that apply to an entire building or complex, the expenses are generally apportioned according to the square footage. So for a duplex, where each unit has equal square footage and the landlord lives in one of the units while renting out the other, 50% of any expenses are deductible. On the other hand, expenses that apply only to a rented unit, such as fixing it window or replacing a door, are fully deductible.
Some common expenses include advertising, cleaning, yard work, insurance, maintenance, management fees, mortgage interest, property taxes, and any utilities paid by the landlord. The water bill, for instance, is usually paid by the landlord, since any failure to pay the bill will result in a lien on the property.
If the property is rented for less than fair market value, then losses are limited to the extent of the rental income and cannot be carried forward. However, there is an exception that allows larger losses on discounted rent of up to 20% if it is rented to a relative. The rationale for this exception is based on the supposition that the landlord is taking less risk over renting to a stranger.
Deducting Improvements to the Property
Realty is generally depreciated over a period that ranges from 27.5 years for residential property to 39 years for commercial property. Any improvements to the property cannot be deducted in the year paid, but must be depreciated over the same time period as the building itself. Improvements are considered any changes that add value to the property, prolong its life, or change its use. By contrast, repairs are considered any changes that maintain the property. Repair expenses can be deducted when paid, unless they are made as part of the property improvement, in which case, repair expenses will also have to be depreciated over the class life of the property.
The depreciation of realty is much the same as it is for business property except that only straight-line depreciation can be used; there are no accelerated methods available for realty. Moreover, land cannot be depreciated at all, since it is considered to have an unlimited life. Thus, depreciation can only be applied to the property value that exceeds the value of the land. Most county property tax records show the value of the land, and usually it is acceptable to use this value. If this is not available, or if it seems wildly inaccurate, then the value can be determined by a real estate appraisal.
When doing both repairs and improvements, it will often be advantageous to itemize the cost for each item, then depreciating or deducting each cost separately. If repairs are lumped together with improvements, then the cost must be depreciated over the class life of the property. So if the carpet in a residential rental is replaced at a cost of $5000, then it can be depreciated over a 5-year period, allowing the deduction of $1000 for each year. By contrast, if the carpet was replaced as part of an overall improvement, then it must be depreciated over 27.5 years, yielding an annual deduction of $182. However, if the landlord anticipates selling the property before the 5-year period, then it may be better to pay the expenses as part of an overall improvement, since it can be added to the tax basis of the property, simplifying the tax return for that year.
Tax Tip: Renting to Your Business
An effective strategy for reducing taxes exists for those who own a business requiring real estate. In this case, you can rent property to your own business, which allows the business to deduct the expense from both marginal and self-employment taxes. While you must include this income, it is considered passive income, not subject to self-employment taxes, saving about 14.13% (= 15.3% × 92.35%) of the income and it can be used offset passive losses.
Depreciation defers tax, but does not eliminate it. When the property is sold, the depreciation is recaptured: the income must be reported as depreciation recapture and will be subject to the lower of the taxpayer's marginal tax rate or 25%. Note that this provision benefits the wealthy more than taxpayers in the 25% bracket or lower, because the deduction equals the depreciation multiplied by their higher marginal tax rate, so when they sell the property, the depreciation recapture will only be subject to the 25% rate instead of their higher marginal rate. So, for every $1000 in claimed depreciation, a Donald J Trump can write off $370 from current income, but will only have to repay $250 when the property is sold, probably years afterwards. The rich really do have a better!
20% Qualified Business Income Deduction
The new tax law passed at the end of 2017, Tax Cuts and Jobs Act (TCJA), includes a significant deduction for certain businesses with what the tax code refers to as qualified business income (QBI). This qualified business income deduction (QBID) is detailed in IRC §199A. Qualified business income is income earned by typical pass-through business entities, such as partnerships, limited liability companies and S corporations, but also sole proprietorships. Additionally, qualified income received from qualified real estate investment trusts (REITs) and publicly traded partnerships (PTPs) are also eligible for the deduction, but slightly different rules apply to this deduction, so they must be calculated separately. The deduction equals 20% of qualified business income. However, this deduction is deemed a below-the-line deduction, meaning that adjusted gross income (AGI) and self-employment tax are not reduced by the deduction. The QBID is limited to tax liability, so net operating losses cannot be increased by the deduction. The QBID is deducted from AGI along with the standard deduction or itemized deductions to calculate taxable income.
Because the new tax code uses the term pass-through entities slightly differently from other parts of the tax code, since the usual definition of this term does include sole proprietorships, the new tax code groups all businesses that qualify for the QBID as relevant pass-through entities (RPEs), which includes sole proprietorships. RPEs cannot claim the QBID directly: only the business owners can claim the deduction. Thus, a partnership or S corporation will report the owners' share of QBI, W-2 wages, UBIA, qualified REIT dividends, and qualified PTP income on the schedules K-1. Only the entity determines whether the partner or shareholder is engaged in an SSTB or not: the individual owners may not make that determination. Any losses will be carried forward to reduce future QBI.
Revenue Procedure 2019-38 provides a safe harbor for some interests in rental real estate, including mixed-use property, to qualify for the QBID as a trade or business. The taxpayer or RPE must hold each interest directly or through an entity disregarded as an entity separate from its owner, such as a limited liability company with a single member.
To claim the safe harbor, these requirements must be satisfied:
- Separate books and records must be kept to reflect income and expenses for each rental real estate enterprise.
- For rental real estate enterprises existing for less than 4 years, taxpayers must provide at least 250 hours of rental services annually. For longer duration enterprises, at least 250 hours of rental services must have been performed in 3 of the past 5 years.
- The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, showing: hours, description, and dates of the services and who performed the services.
- The taxpayer or RPE attaches a statement asserting the use of the safe harbor to the tax return.
Owners of rental properties may still claim the QBID even if all requirements of the safe harbor are not satisfied, as long as the business would otherwise qualify under IRC §199A.
Renting a Primary Residence or Vacation Home
Some people live in desirable vacation spots; others live near facilities, like football stadiums, that periodically bring in many people. To take advantage of these opportunities, some people rent out their primary residence to earn extra money, or they swap their homes or vacation homes with someone else living where they want to take a vacation. Though in years past, it would've been difficult to match demand with supply, the Internet has greatly facilitated these types of transactions.
Special tax rules apply to the rental of a vacation home or a residence, which can include motor homes, trailers, and even boats if they provide at least a minimum of living accommodations, such as a bathroom. If a primary residence is rented for no more than 15 days annually, then the income earned is tax-free, but since it is tax-free, no deductions can be claimed on the income.
If a home is rented for more than 15 days during the tax year, then the income must be reported, but deductions are also allowed. The 1st step is to count the number of personal-use days and the number of days that the property was rented. Personal-use days include any days, or a portion thereof, in which the taxpayer or any relatives lived in the home. Not counted are the number of days used to repair or prepare the facilities for tenants. Personal-use days are also not counted if the property is sold within 12 months of the personal use. If the number of personal-use days exceed 14 days or 10% of all the days that it was occupied, then expenses can only be deducted to the extent of income. Any other expenses, such as the mortgage interest expense or property taxes can still be deducted as a personal expense on Schedule A, Itemized Deductions. In any case, the deduction of business expenses must be prorated according to the number of days that it has been rented out compared to the number of days that it has been occupied:
Deductible Expense = Days Rented at Fair Market Value ÷ (Total Days of Rental + Personal Use)
Rental days do not include days while the property was held out for rent. However, any days in which the property is rented at fair market value, even if to relatives, is counted as a rental day. So if you rent the property out for 80 days of the year and occupied it for 20 days, then only 80% of any deductible expense can be claimed.