This guide is designed for the average homeowner who is converting his personal residence into rental property, either because they are unable to sell it, intend to reside in it later, or simply hope to use it as an investment. It does not cover all the specifics of how to file a Rental Property tax return, rather it covers record keeping and tax issues that an owner of Residential Rental Real Estate should be aware of. This document does not discuss Alternative Minimum Tax implications of Rental Property.
When is it Rental Property?
It’s rental property the day it is available for rent. This is when you can start deducting expenses. Generally, when you put the sign out front, put the ad in the paper, or tell your co-workers to find you a tenant, you have made it available for rent.
What is Rent?
Rent is the full amount of rent received. If you have a property manager who deducts a commission, the rent is the full rent paid (including the commission) and the commission is a deduction. Similarly, if your tenant performs a repair and deducts the cost from the rent, the rent is the full amount of the rent and the deducted amount is a repair expense. If someone pays advance rent, include it in the year received. If a security deposit is paid, it becomes rent when you keep it to cover an expense (and the expense is deductible.) If the deposit is agreed as non-refundable (such as a pet cleaning deposit) it is rent when received. If the tenant is supposed to pay rent and doesn’t, do not include the amount not paid as rent. This means there is no “bad debt” deduction for rental – if you don’t get it, it’s not rent.
You can deduct all reasonable and necessary expenses for the rental of your home. Some items must be depreciated (see the Depreciation section.) These must be expenses you pay for – your labor is not an expense. A fairly comprehensive list of expenses:
Mortgage Interest (pro-rate by day for the first year of rental)
Taxes (pro-rate by day for the first year of rental)
Insurance (pro-rate by day for the first year of rental)
Mortgage Insurance Premiums (pro-rate by day for the first year of rental)
Utilities you pay (including those paid when unoccupied but available for rent)
Legal expenses for collecting rent, preparing leases
Tax prep fees for rental related forms
Travel and Mileage to manage the rental property (the primary purpose of the trip must be to manage the rental property – don’t try to deduct a vacation during which you “check on” the rental.
Save receipts for all of these and report the amounts to your tax preparer.
Depreciation is how you deduct the cost of major items with a life longer than 1 year. You will deduct a portion of the cost a little at a time over a specified number of years. Don’t let someone tell you not to depreciate so you can avoid recapture – you have to recapture any depreciation allowed (whether deducted or not.)
You will depreciate the building, appliances and any improvements to the property, as well as certain landscaping items (fences, trees etc.) It’s important to understand that if you have a major expense that increases the value, or prolongs the life of your property, it will be depreciated vice deducted. Repairs that do not increase the value or extend the life may be deducted. Examples of improvements are: A/C replacement, roof replacement, additions. Examples of repairs are painting, replacing garbage disposal, repairing hole in roof, repairing A/C unit.
When converting your home to rental you need to know the Basis. This is generally the price you paid for the home, plus any improvements you made to it (see Pub 551, below, for other things that might affect it.) If the Fair Market Value (FMV) the day you convert it to rental property is less than this value, then this is your basis. The FMV is what your house would sell for to a willing buyer. You also need to know what the land is worth. You subtract this from the basis before depreciating the basis. You can determine the land value from your property tax card or by comparing to other similar properties sold in the area. You will depreciate the house by taking an even portion of the basis every month for the next 27.5 years (this means the first year’s deduction will be smaller, and the deduction for the rest of the years will be about the same.) Your tax preparer will need the basis, land price, FMV, date purchased and date available for rent for your house.
Improvements are depreciated for 27.5 years just like the house. Appliances are depreciated for 5 years and Landscaping improvements are depreciated for 15 years. See Pub 527, below, for how to depreciate 5 and 15 year property. Your tax preparer will need to know the date you bought these items and the price you paid for them (including installation if you paid for it.)
Do I need a Property Manager?
I like property managers. They will keep about 10% of your rent, but if they can save you 1 month of vacancy, they’ve paid for 10 months of commissions. If you try to rent without one, and can generally keep the place occupied, you probably are okay without one. If you try to rent it and it goes more than a month empty, get referrals and hire a property manager. Similarly, if you have a property manager and your house goes vacant more than a month, find a new property manager.
It generally behooves you to be an active participant in the renting of your property. You can be an active participant even if you have a property manager. If you make the decisions about what rent to charge, what repairs to make, and whether to allow pets, you are actively participating. Even if the manager says: “I think we should raise the rent to $1200.” and you have to give the OK, you are actively participating. By being an active participant, you can generally deduct up to $25000 of rental loss from the rest of your income (subject to income and filing status limitations.) If you are totally passive in the rental than you cannot deduct any losses. If you are passive, or you have losses in excess of the limit, you will have to carry them over until you have a gain or dispose of the property.
At Risk Issues:
You may be asked if you are “At Risk” for the full amount of your rental. This means that you are not protected from losses on the property should everything go south on you. Generally speaking, unless you have some sort of a loan that you would not have to pay back (such as from a family member) you are At Risk for the full amount.
Tax Implications When Selling:
When selling a house that has been used as rental property it is generally treated as a sale of a business asset. Thus, it is a fully taxable transaction. It will be reported on Form 4797 (Sale of Business Assets.) The form will ask for the date purchased, date sold, the sale price (minus expenses of sale) and the Basis. Other than basis, these entries are fairly self explanatory. The basis is that which you are using to depreciate the home. It is the price paid (or FMV when converted to rental if this was lower than the basis) + the cost of any improvements – any depreciation taken or allowed. There are other things that might affect the basis but they are unusual and won’t normally be seen. The gain or loss is the difference between the basis and the sales price.
It is possible to use the exclusion for the Sale of Main Home if you meet the requirements. This will normally only occur if you lived in the home for at least two years before you rented it out and sold it within three years of renting it. If this is the case you may be able to exclude up to $250000 of the gain ($500000 if Married Filing Jointly.) You may use this exclusion for all gain except that attributable to depreciation.
Personal Use or Part Year Rentals:
If you rent your property for only part of the year, or you rent only a portion of your property (such as a room or a duplex) you need to pro-rate your expenses. Your tax preparer will need to know the status of the property for each day of the year (rented, occupied by you, occupied by family, vacant, vacant but available for rent.) He will also need to know the square footage of the property that is rental use, personal use and communal use, as well as which expenses cover the whole property (mortgage, taxes, etc.) and which are exclusive to the rental portion (repairs to that portion, utilities billed separately etc.) There are more intricacies of this – contact your tax preparer for more details.
If you rent out a property in a state that is not your state of residency, make sure you make this clear to your tax preparer and make sure you understand how each state handles it. South Carolina, for example, requires you to add an out of state rental loss back as income to SC.