The Internal Revenue Service (IRS) publishes several documents to help tax filers in preparing their income taxes. A critical publication for real estate investors is IRS Publication 527, which focuses on residential rental property (including the rental of vacation homes). The document lays out how real estate investors should report rental income and deduct expenses relating to a residential property for tax purposes. (Homeowners, on the other hand, should see IRS Publication 530, as that document outlines how to treat tax-related expenses on their primary home.)
IRS Publication 527 provides tax-related information to owners who engage in two common types of residential rental activities:
- The full-time rental of a second home.
- The part-time rental of a vacation home when the owner or a family member isn't using the property.
The document discusses rental-for-profit activity and how to report income as well as deductible rental expenses when there is no personal use of the property. It also covers depreciation and discusses special rental situations such as not-for-profit rental activity. Finally, it outlines the rules for rental income and expenses when there is personal use of the property, such as a vacation home.
Residential rental activities covered under IRS Publication 527
This tax document discusses the following types of residential rental activities:
- A second home that the owner rents out for profit full time.
- A vacation home that the owner rents out part-time for profit when they or their family aren't using the property.
- Special situations such as condominiums, cooperatives, changes in use during a tax year, renting part of a property, and renting without profit.
How to use IRS Publication 527 to properly report rental income and expenses
Tax filers should use IRS Publication 527 as a guide to answering questions related to how they should report rental income and expenses on secondary residential rental properties that they own on their federal income tax return.
For example, when it comes to reporting rental income, the document states that: "In most cases, you must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of the property." This includes:
- Rental payments, including any rent paid in advance.
- Lease cancellation payments.
- Tenant-paid expenses (such as when a tenant pays for maintenance and then deducts the cost from their rent.)
- Property or services received as rent. (For example, the tenant paints the property in exchange for reduced rent).
- Any security deposit retained.
Likewise, the guide provides tax filers with a list of expenses related to their residential rental property that they can deduct on their federal taxes. Common ones include advertising, cleaning and maintenance, taxes, insurance, utilities, and mortgage interest.
The document also breaks down how owners of a vacation home rented out part of the time should treat expenses on their taxes. It states that: "In general, your rental expenses will be no more than your total expenses multiplied by a fraction, the denominator of which is the total number of days the dwelling unit is used and the numerator of which is the total number of days actually rented at a fair rental price."
For example, say you own a beach house that's available to rent year-round, except for the roughly three months (100 total days) you used it during the winter. Of the 265 available rental days, it rented out at fair market value for 200 days during the year. As a result, the denominator (total number of days used) would be 300 and the numerator (total number of days actually rented) would be 200, meaning you can deduct 67% of the total rental expenses for the vacation home on your income taxes.
What property owners need to know about IRS Publication 527 and the depreciation of rental property
IRS Publication 527 devotes an entire chapter to the depreciation of a residential rental property, which enables investors to recover the cost of an income-producing property. The document outlines three factors to determine how much the owner of a residential rental property can deduct each year:
- Your cost basis for the property.
- The recovery period of the property.
- The depreciation method used.
It also outlines what rental properties an owner can depreciate (ones they own, use for an income-producing activity, and that have a determinable useful life of more than one year). Further, it highlights what property an owner can't depreciate, including:
- Land (since it generally doesn't wear out).
- Certain excepted property. For example, an owner can't depreciate a property placed in service and disposed of in the same year. They also can't depreciate equipment used to build capital improvements. Instead, they must add this otherwise allowable depreciation on the equipment in the construction period to the cost basis of their improvements.
An important tax document for residential rental property owners
IRS Publication 527 is a vital guide for tax filers who own residential rental property. It helps them determine what income they must record as well as allowable expenses so that they don't unwittingly make a costly mistake when preparing their federal income taxes.
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