Deciding to rent out a part of your home is an exciting step toward achieving financial freedom, but it'll also require that you properly report and explain your tax positions to Uncle Sam. The IRS taxes gross income from every source -- even that spare room you're renting out for a little extra cash. Whether you're already doing so, thinking about it, or partnering with a short-term rental platform, you'll need to plan ahead to avoid the IRS's wrath. Here's how.
Image source: Getty Images.
1. Report your income on the right line
First, beware of misreporting your rental income. Some newer landlords may be less familiar with Schedule E, where you're supposed to disclose rental income to the IRS. Instead, they may include rental payments as "other income" on line 8 of IRS Form 1040 -- a serious tax faux pas. To ensure that your income is listed in the correct place -- remember, that's Schedule E -- before you file your return, most tax software will allow you to review the PDF version of your return.
Typically, the IRS will tax rental income as ordinary income exposed to marginal income tax rates and state and local taxes. Here's a look at the federal income tax bracket rates for single filers in 2021 (taxes paid in 2022):
|
Tax Rate |
Taxable Income Bracket |
|---|---|
|
10% |
$0 to $9,950 |
|
12% |
$9,951 to $40,525 |
|
22% |
$40,526 to $86,375 |
|
24% |
$86,376 to $164,925 |
|
32% |
$164,926 to $209,425 |
|
35% |
$209,426 to 523,600 |
|
37% |
over $523, 600 |
Data source: IRS. Chart by author.
2. Accurately apportion your rental expenses
When you rent out a portion of your home, you need to make sure you're properly dividing any expenses you pay to maintain the home between personal and rental uses. Some landlords may forget that when filing taxes and wind up facing an audit and tax penalties. The IRS imposes a 20% penalty for inaccuracy when a taxpayer significantly overstates expenses. To help avoid that hassle, let's take a look at which expenses you can fully deduct and which you'll have to split up between personal and rental use.
You can fully deduct any expenses incurred to rent out a room in your home. So, if you were to remodel the room or install a new bathroom to make it more attractive for your tenants, those expenses would be fully deductible.
Other expenses must be divided between rental use and personal use. Typically, you can divide the expenses for rental and personal use based on either:
- The square footage of the rental space versus that of your entire house (e.g., 250 square foot room rented / 2,500 square foot house = 10% of expenses are deductible).
- The number of rooms rented out versus the total number of rooms in your house (e.g., two rooms rented / 10 rooms in the house = 20% of expenses are deductible).
Some expenses that may be divided between rental and personal use include but are not limited to:
- Mortgage interest
- Repairs
- Improvements
- Homeowners insurance
- House cleaning or gardening services
- Trash removal
- Snow removal
- Security system costs
- Depreciation
Some other expenses, such as the water, gas, and electricity bills, could be more difficult to divide. If the utilities aren't included in the tenant's rental payments, you can simply divide the total cost by the number of people in the home. If the tenant pays utilities in addition to the rent, make sure you include those payments in your gross rental income.
3. See whether you're eligible for a qualified business income deduction
Some tax software allows you to manually enter an adjustment for the Qualified Business Income Deduction (QBID) on your return. But if you don't meet the qualifications for the QBID, you could face a 20% penalty for improperly claiming tax benefits. If you rent out a portion of your home, the water could be quite murky as to whether you qualify or not.
In general, your rental activity qualifies as a trade or business if it falls under the section 199A safe harbor. To qualify, you must:
- Have separately maintained books and records to reflect the expenses incurred on that property.
- Perform a minimum of 250 hours of real estate-related work annually.
- Attach a statement to your return indicating the safe harbor is being elected.
4. Keep good records
Sloppy rental record-keeping could slap you with yet another IRS penalty. The IRS requires taxpayers to keep records for three years from the date you filed your original return or two years from the date you paid the taxes, whichever is later. If you happen to omit some of your income -- 25% or more of the gross income stated on your return -- then when the IRS inevitably comes knocking, it will demand six years' worth of records.
Knowledge is power
Renting out a portion of your home and becoming a landlord is an exciting new journey, but make sure you don't embark on that venture without knowing the rules. Failing to characterize or report your income accurately could leave you entangled in an IRS nightmare.
