Income that you receive for allowing another person to use your property is rental income. Rental income includes advance rental payments, late payments, and current payments. Payments received for lease cancellation and forfeited security deposits are rental income in the year that the leases are canceled or the security deposits are actually forfeited.
Rental income is considered passive income for purposes of the passive-loss rules limitation, except for qualified real estate professionals.
If your rental income is greater than your expenses (a net gain), you simply report the income on your tax return. However, if your rental income is less than the expenses that you incurred (a net loss), there are special rules that must be applied to see if the loss can be taken against other income.
Like any other business activity, rental activities are subject to the limitations of the at-risk rules. For most people, these rules don’t apply.
In addition, rental activities are subject to the limitations of the passive-loss rules. These rules come into play more often. This is because rental real estate often generates a loss because of large depreciation deductions, as well as cash expenses such as mortgage interest, insurance, and taxes. In general, you can deduct passive-activity losses only up to the amount of income that you receive from rent and other passive activities.
The passive-loss rules determine whether or not you can actually take the loss against other income. If you can’t, then you have to carry the loss into another year, offsetting that year’s income.
Also, you generally can’t deduct passive losses from nonpassive income, such as wages. If you have several sources of passive income, such as 5 rental houses, then you can deduct the loss from one of them as long as the income from the others covers it.
There is a special loss allowance for rental real estate activities that falls outside the general rule. It allows up to $25,000 in losses to be taken against nonpassive income. To qualify, you must be an active participant in the activity. The ability to take the special loss allowance disappears as your income rises over $100,000 ($50,000 if you are married filing separately and lived apart from your spouse all year).
If you own a home that you live in part of the year and rent out for part of the year, the expenses that you incur must be prorated between personal and rental use. To figure out the ratio of personal and rental use, you take the number of days someone rented the home and divide it by the total days of use (both personal days and rental days). Since vacation homes typically get this kind of treatment, the rules are known as the vacation-home rules. For details, see Vacation Home Income.
If you convert your residence to rental property instead of selling it, you don’t need to apply the vacation-home rules as long as you intend to keep the property exclusively for rental use. When taking expenses in the year of the conversion, taxes and mortgage interest need to be allocated between a rental portion and a personal portion.
If you rented or tried to rent the dwelling for:
At least 12 consecutive months, or
A period of less than 12 consecutive months and the period ended because the owner sold or exchanged the home,
Then these days don’t count as personal use for the purpose of allocating expenses between rental and personal use.
Example: You used your home as a principal residence from January 1 through June 30. On July 1, you began renting the home to an unrelated individual for two consecutive years. In determining whether the unit was used as a residence under the vacation-home rules, you don’t consider the period before July 1.
Depreciation of this converted rental property follows some special rules. When you convert property from personal to business use, the basis for depreciation is the lesser of:
The adjusted basis (most common)
The fair market value on the date of conversion (this comes up when property values are dropping)
To figure out how much depreciation you can take, you have to determine the basis of the property. The basis is usually how much you paid for the property; however, a part of the price must be allocated to the land based on local market forces in place at the time of purchase. This is because you can’t depreciate the land, only the building itself (your home).
To figure out how much the land is worth, you should get an appraisal of the property. The appraisal should separately state the fair market value of the land and the building. If necessary, the value of the land can be estimated based on the tax assessment statement for the year of conversion. Or a local real estate firm might provide guidance on land values at the time the house was purchased and on the conversion date.
When deducting expenses, make sure that you deduct them in the year that you pay them. You can deduct the following expenses on your tax return:
Advertising
Auto and travel
Cleaning and maintenance
Insurance
Legal and other professional fees
Mortgage interest paid to banks and other financial institutions
Other interest
Supplies
Taxes
Utilities
Depreciation expense or depletion
Other expenses specific to your rental, such as certain condominium fees or landscaping expenses.
If you don’t use the rental property personally, then you don’t have to worry about prorating your expenses between personal and rental use, which is required for vacation homes.
You report rental income on Schedule E, page 1, of Form 1040. You can also use the Rentals and Royalties topic in the Business, Rentals, Partnership, Farm, and Royalties section of the interview to report your rental income. You deduct rental expenses on lines 5–20 of Schedule E.
Rental income of property other than real estate is reported in the Other Income section of Form 1040.
For more information about rental property, see IRS Publication 527, Resident Rental Property (Including Rental of Vacation Homes).