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If you own rental real estate, you'll probably need to report the income and expenses associated with your properties to the IRS. You'll do this on Schedule E, which is the part of the IRS's Form 1040 that deals with supplemental income and losses.
This includes income from rental real estate, as well as royalties, partnerships, S-corporations, estates, trusts, and more. We're going to take a closer look at Schedule E from a real estate investor's perspective, so here's everything you need to know about this important piece of your tax return.
Figuring out your rental income or loss
Part I of Schedule E is where you'll figure out your taxable profit or loss from your rental real estate activities.
First, you'll give the IRS some basic information about the property or properties you own. For each one, you'll give the physical address of the property, the type of property it is, and how many days of the year each was rented at fair market value and how many days each was used personally. There's also a checkbox next to each property labeled "QJV" -- qualified joint venture. This is a special status for rental properties you own jointly with your spouse (and no other partners).
After the basic information, you'll list the total rent you received during the calendar year in line 3. Lines 5 through 20 have to do with your expenses, which we'll get into in the next section.
Deducting your expenses -- what is allowed?
There are a variety of expenses you can use to reduce your taxable rental income. Some are pretty self-explanatory, while others require a little more detail to make sure you're using them correctly. Going through the list from Schedule E:
Advertising -- If you take out a classified ad in a newspaper or purchase signs at your local home improvement store for the purpose of advertising your property to tenants, you'd list it as an advertising expense.
Auto and travel -- You can deduct expenses incurred when traveling to and from your rental properties. The current IRS mileage rate is $0.58 per mile, so be sure to log the trips you take to your properties. (Note: You have the choice between deducting your actual automobile expenses or using this standard rate, but in the majority of cases the standard rate is easier as well as more financially beneficial.) You can also deduct 50% of your meal expenses incurred during these trips.
Cleaning and maintenance -- If you pay for lawn service or pest control at your rental properties, these are examples of expenses you would report on this line.
Commissions -- If you pay commissions to anybody, these can be expensed here. This does not include commissions you pay to a real estate agent when buying a property.
Insurance -- This includes your insurance expenses for your rental properties.
Legal and other professional fees -- Aside from the obvious, this also includes any fees for tax advice or any tax preparation fees incurred in connection to your rental properties.
Management fees -- If you hire a property manager to oversee the day-to-day operations of your rental properties, their management fees can be deducted from your taxable rental income.
Mortgage interest paid to banks, etc. -- Unlike with your residence, you can deduct mortgage interest paid on rental properties no matter how large your loan balance is. You should receive an annual mortgage interest statement from your lender that tells your deductible amount.
Other interest -- This includes interest paid on any non-mortgage debt, as well as any mortgage debt owed to non-bank lenders. A good rule of thumb is that if you don't receive a Form 1098 mortgage interest statement, report this interest on the "other interest" line.
Repairs -- If you say, repair a broken window or patch a hole in the roof, you can report the expense here. However, you cannot list the cost of any improvements, such as buying new energy-efficiency windows for the entire home or putting a new roof on the building. These must be capitalized (added to your cost basis) and depreciated over time, which we'll discuss later.
Supplies -- This is a broad category and can refer to office equipment you purchase to help manage your rental properties or any other supplies you use exclusively for your rental real estate activities. For example, if you self-manage your properties and buy a toolset to keep in your car for the purpose of making repairs to your properties, it can be a deductible supplies expense.
Taxes -- When you pay your local property taxes on your rentals, you can use that expense to help offset your taxable rental income.
Utilities -- If you pay any of the utilities (such as water or sewer) at any of your rental properties, you can deduct those expenses here. This category can also include the cost of "ordinary and necessary" telephone calls related to your rental properties.
Depreciation expense or depletion -- We won't get too deep into depreciation here (check out our thorough guide to rental property depreciation), but the short version is that rental property owners can deduct the acquisition cost of the building itself as well as any capital improvements over a period of time -- 27.5 years for residential properties. When you calculate your annual depreciation deduction, you list it on this line on Schedule E.
Other -- If you have any other expenses related to owning, maintaining, and/or managing your rental property, list them on this line. However, if you aren't 100% sure something is deductible, it's wise to seek help from a qualified tax professional.
Once you've listed all of these expenses, the next step is to add them together and subtract them from the rent you received during the tax year on line 21.
What if you show a tax loss on your rental properties?
Because of the long list of deductible rental property expenses, particularly depreciation, it's quite common for rental properties to show a loss for tax purposes, even if they were quite profitable. There are a few different rules that govern the amount of loss (if any) you're allowed to claim on your rental properties. They are:
- The at-risk rules
- Passive activity loss rules
- Excess business loss rules
Let's look at these one at a time (Note: These are simplified explanations and you should consult a tax professional if you have any grey area.):
In simple terms, the at-risk rules limit your deductible losses on an investment to the amount you could potentially lose. For example, if you only invested $20,000 of your own money to acquire a rental property, you couldn't claim a $25,000 loss, no matter what your tax return or the other loss rules say. This rule more commonly comes into play when you sell a property, but it applies to particularly bad years for rental income as well.
The passive activity loss rules may also limit your ability to take a loss. For rental property investors, if you are a real estate professional, your rental properties are not a passive activity and your ability to claim a loss is not limited by this rule. If you're not, the IRS generally classifies rental property investing as passive which typically means that you can only deduct expenses to the extent of your rental income (no losses allowed).
However, you may be classified as an "active participant" in your rental properties, which gives you a limited ability to claim some loss. If you actively participated (finding and approving tenants, approving repairs and capital expenditures, etc.) and you have modified adjusted gross income of $100,000 or less, you may be able to claim as much as $25,000 of rental property losses on your taxes.
Finally, the IRS has rules that disallow any excess business losses. After you've applied the previous rules, this can further limit your ability to take rental losses, but it only applies to taxpayers with big business losses. Specifically, an excess business loss is defined as the amount that the total business deductions of the taxpayer exceed their gross business income plus $255,000 ($520,000 for a joint return).
Your tax software will likely do the hard work for you
As a final point, it's worth mentioning that unless you're one of the few Americans who still fills out tax forms by hand, whatever software program you (or your tax preparer) use will likely do all of this for you. You'll be asked a series of questions, and the program will put your data in the appropriate spots on the form.
However, by understanding how Schedule E works, rental property investors can get a better idea of what to expect when tax time rolls around and will also be in a better position to maximize their allowable deductions.
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