Rental property taxes: Income, deductions, and reporting rules 

What is considered rental income?

The IRS considers rental income to be any payment you receive for the occupation or use of a property you own. This obviously means regular monthly rental income, but it also includes:

• Advance rent: If you collect first and/or last month’s rent upfront, it counts.
• Security deposits: If you keep them, they count. (More on that later.)
• Tenant fees: Any fees you charge your tenant, like late fees, pet fees, parking fees, cleaning fees, lease cancellation fees, etc., count.
• The value of property or services in lieu of rent: If your tenant pays you for rent through property or services, the value of it counts.
• Tenant-paid expenses in exchange for discounted rent: If your tenant pays for something you are responsible for, like a repair, and in return you discount their rent for that amount, it counts.

As you can see, there are many types of rental income you must report to the IRS when you file. Make bookkeeping a top priority and keep good records throughout the year to ensure you account for all of it.

Are security deposits taxable rental income? 

It depends on whether you keep the security deposit(s) or return it to your tenant. If you keep your tenant’s security deposit to collect on unpaid rent or for a repair, the IRS considers it to be rental income. If, on the other hand, you return your tenant’s security deposit back to them when they move out, the IRS does not consider it to be income.

What rental property expenses can you deduct?

You can offset your taxable rental income by deducting expenses that are related to managing and maintaining your property, including:

• Advertising and signage
• Cleaning supplies
• Real estate taxes
• Mortgage and other interest paid for the property
• Insurance – hazard, flood, fire, or liability
• Maintenance services, like lawn care, pest control, and sanitation
• Accounting or financial advice related to your property
• New locks and keys
• Commissions paid
• Necessary transportation
• Repairs
• Equipment
• Depreciation of the property (not including land)
• Long-distance calls associated with the property
• Legal fees
• Utilities
• Mileage and vehicle expenses (if you drive to manage the property or for another business reason)

Can I deduct mortgage payments on a rental property? 

You can deduct the interest part of your mortgage payments on your rental property, as well as the property tax portion if your lender bundles it into an escrow account or if you pay the tax directly. However, you cannot deduct the principal portion.

Why can’t you deduct the principal portion of your mortgage? Because when you make principal payments, you’re simply transferring your money from your bank account into your equity. The value stays with you. It’s not a cost that you won’t recoup when you sell the property.

Are rental property repairs tax deductible? 

Yes, rental property repairs are fully tax deductible, and unlike improvements (more on that later), you can deduct the full cost of repairs immediately instead of over time. The IRS considers deductible repairs to be anything that helps keep the property in good working condition but does not add extra value or new uses to the property, such as:

• Fixing a leaky faucet or pipe
• Patching a hole in the wall
• Repainting the inside or outside
• Fixing a broken appliance
• Repairing floor damage

Don’t forget to keep close track of your receipts and other documentation for repairs. They will come in handy when it’s time to file your return.

How does depreciation work for rental property? 

Depreciation works for rental properties by letting you deduct the value of the property, as well as improvements, over time rather than all at once. Homes and their components wear out gradually, and this is the IRS’s way of helping you recoup some of those costs.

A few important things to know about depreciation for rental properties:

• You can only depreciate the building, not the land: While the value of the land may change, the land itself doesn’t wear out. That’s why you can only depreciate the value of the structure (house, duplex, townhome, condo, etc.), and not the land it sits on.
• Residential rental property depreciates over 27.5 years: This is the standard recovery period the IRS uses for the main structure of a residential rental.
• The IRS has different depreciation schedules for different property improvements: Most improvements you make to your rental property depreciate over time; however, not all improvements depreciate at the same rate. For example, the depreciation period for a new fence is 15 years; whereas the depreciation period for a new refrigerator is 5 years. (See the chart below to learn more.)
• Depreciation starts when you make the property available for tenants: You don’t start depreciating your property until you “place it in service,” or, in other words, when it’s ready and available for potential tenants. It does not start the day you purchase the property, nor does it start the day your tenant moves in.
• Report depreciation on Form 4562, Depreciation and Amortization: Calculate and report depreciation on Form 4562 the first year you claim the asset or improvement.
• You will generally owe tax on the depreciation amount when you sell: When you depreciate your rental property, you lower its value on paper, which is called an adjusted tax basis. If you sell the property down the line for more than the adjusted tax basis, the IRS taxes that portion of the profit.

If you rent out your property, depreciation can be an incredibly valuable tax benefit, allowing you to deduct a portion of the costs year after year, even if you actually spent the money a previous year.

What expenses are not immediately deductible? 

As previously mentioned, the IRS allows you to depreciate improvements over time, rather than deducting the full value at once. Here’s the depreciation schedule for the many types of improvements you could make to your rental property:

Repairs vs. improvements: What is the difference? 

The IRS differentiates between repairs and improvements based on what the work does to your rental property, not how much it costs, or how big the project feels. Here’s a quick guide to tell the two apart:

Repairs…

• Keep your property operating in ordinary condition
• Don’t add value to your property
• Don’t extend the life of your property
• Don’t adapt the property for any additional uses

Improvements…

• Add value to the property
• Restore the property to a like-new condition, like rebuilding or replacing a major component after damage
• Adapt the property for a new use, like converting a basement to an apartment

It can help to think of it like this: if you’re keeping something working, it’s a repair, but if you’re making something better, it’s an improvement.

Where it becomes tricky is when a project has elements of both, like if, for example, your full kitchen remodel involves also fixing a leaky pipe or a broken dishwasher. In most cases like these, the IRS requires you to treat the whole project as an improvement.

Can a rental property loss reduce your taxes? 

Yes, a rental property loss, which is when your deductible expenses exceed your rental income, can reduce your tax.

The IRS sees renting out property as a “passive activity,” even if you actively manage the property yourself. In general, it only allows you to deduct passive losses from passive income, not from your ordinary income, like your salary or self-employment income. There are two main exceptions to this rule.

The $25,000 special allowance

If you take an active role in managing the property, and own at least 10% of it, you may be able to deduct up to $25,000 against non-passive income. The IRS imposes income limits to qualify and starts phasing out the total amount you can deduct at a modified adjusted gross income (MAGI) of $100,000. At a MAGI of $150,000, you no longer qualify.

Real estate professional status (REPS)

If you qualify as a real estate professional under the IRS’s rules, you can avoid the passive activity income rules altogether, because the IRS now sees your passive losses as active losses. To qualify, you must pass one of two tests:

1. The time test: You must spend at least 750 hours per year in a real estate trade, and this work must represent at least 50% of your overall working hours for the year. This rule can make it difficult to qualify for REPS if you manage property in addition to being a regular W-2 employee.
2. The material participation test: You must prove that you took an active role in management operations for the property. To qualify, you must either: 1) participate in rental activities for more than 500 hours, 2) participate in rental activities for more than 100 hours, with no other individual (tenant or other property manager) participating more than you, or 3) be the sole participant, which means you do all the work and do not have a property manager to help.

If you are unable to use a loss for a year, because you do not qualify for one of the above exceptions, or because your loss exceeded the $25,000 special allowance rules, don’t fret. Your loss is not lost forever. You can generally carry over any unused loss into future years to offset future rental income.

How do you report rental income and expenses? 

Report rental income and expenses on Schedule E (Form 1040), Supplemental Income and Loss. Here are a few tips to help:

• List each rental property you own separately. Schedule E gives you space to list 3 properties. If you have more rentals, you must attach an additional form(s).
• Report all types of rental income you received, including regular monthly rent, deposits, fees, etc.
• Schedule E has predefined expense categories. List your rental property expenses by category, so you can sort your costs to match them.
• Report depreciation on Schedule E, but only after the first year you claim the asset. For the first year, report depreciation on Form 4562.

If you own your rental property through a trust, partnership, or S corporation, you’ll report income or losses from the rental property on Schedule E, Part II. You can find this information on Schedule K-1, which the trust, partnership, or S corporation you work with will compile and send you and the IRS.

What records should rental property owners keep?

Proof of income: Monthly rent receipts, bank deposit records, lease agreements, and receipts or other records of any advance rent, security deposits, or tenant fees you collected

• Proof of expenses: Receipts, invoices, and canceled checks or bank/credit card statements for all deductible expenses
• Purchase and closing documents: Your original purchase price and closing statement show how you split the value between land and building, which you'll need to calculate depreciation accurately
• Improvement records: Receipts and other documentation for improvements
• Mileage logs: A running log of the date, miles, and purpose of each trip
• Depreciation schedules: Keep a record of what you’ve depreciated each year and its depreciation rate

Diligent record keeping, as well as good bookkeeping, will make it easy to find the documentation you need when it’s time to file. Plus, it gives you peace of mind in knowing you have what you need in case the IRS asks for proof of a claim.

What if you rent out part of your home?

The IRS’s rules change a bit when you rent out only a part of the property you’re living in. Here’s what you need to know:

• You can only deduct a portion of expenses, including depreciation, that are tied to the whole house, like utilities or a new roof, based on the percentage of the rental space in your home. For example, if your basement apartment is 600 sq. ft. of your 2,000 sq. ft. home, you can deduct 30% of your expenses.
• You can fully deduct expenses that are exclusively and directly for the rental space, like professional cleaning, painting, etc.
• You still report your rental income and expenses the same way, on Schedule E.
• If you rent out the space for fewer than 15 days per year, the IRS does not require you to report any rental income, but you can’t deduct rental expenses either.
• If you use the rental space yourself for more than 14 days of the year, the IRS will treat your property as a personal residence with limited rental use, which caps how much of a rental loss you can deduct.

Suffice it to say, taxes can be complicated for rental property owners. The good news? You don’t have to tax alone. Your local Jackson Hewitt Tax Pro is here all year and ready to help. Find tax services near you today, then walk in or book now.