Residential rental property
Residential rental property generally includes rentals from single family homes, duplexes, condominiums, and mobile homes. This post primarily addresses tax rules for investors who have very little to no personal use of the property being rented. I will briefly touch on personal use of the property at the end of this post.
Rental income received on the property may be described in different terms under the lease agreement; however, the tax reporting rules for the various types of payments received are clearly defined. We will focus on cash basis tax reporting as this will most likely be the method of accounting adopted for your rental real estate investments.
For an individual taxpayer, rental income and expenses are reported Schedule E filed with the Form 1040. For partnerships and S-Corporations, the income is reported on Form 8825 filed with Form 1065 (partnerships) and Form 1120-S (S-Corporations).
Types of Rental Income
Monthly Rental Payments - A cash basis investor reports monthly rental payments in the tax year received. The tax year for most rental property investors will be a calendar year.
Advance Rent – Advance rent is a rental payment received before the period it covers. For example, if you receive a rental payment on December 28 for the next month January rent from your tenant, the receipt of the advance rent is reported for the calendar year received regardless of your tax accounting method.
Expenses Paid by the Tenant – If your tenant pays for an expense on the property that is not required by the terms of the lease agreement and deducts the amount from the next rent payment, then you will include the payment in rental income and deduct the offsetting cost. For example, if your tenant pays for a $125 repair while you are out of town, then the tenant reduces the next rental payment by $125, then you will include this payment in the rental income for the year, and then deduct the $125 as a repair expense.
Security Deposits – Amounts received as a security deposit which you intend to return to the tenant at the time received are not currently included in rental income. Such amount is reported as income if you later retain part of the security deposit at the end of the lease or during the lease. If you receive any amount referred to as last month’s rent, then this amount will fall under the advance rent rules referenced above.
Rental expenses and deductions
Rental Operating Expenses
Ordinary and necessary rental expenses are deductible from the rent you receive. An ordinary expense is one that is common in the trade or business (in this case a rental trade or business) while a necessary expense is one that is helpful or beneficial to the trade or business.
Common expenses for a rental include advertising, cleaning, insurance, professional fees, management fees, interest, repairs, supplies, and property taxes. Rental expenses are deducted in the year paid by cash basis taxpayers (see discussion of improvements later).
Expenses are deductible once the property is available for rent. Expenses paid prior to opening may be for capital improvements or start up costs. Capital Improvements are generally subject to capitalization and depreciation.
Startup costs are eligible for an election to deduct the costs once the property is available for rent for amounts up to $5,000. Amounts in excess of $5,000 are amortized over 15 years. If you spend more than $50,000 on start up costs, then additional rules will apply. To make the election, you simply deduct the start up costs up to $5,000. The costs deducted generally should be described as “start-up costs.”
If you own a part-interest in a rental property, you will deduct the expenses you paid in the same percentage as your ownership of the property. If you split expenses with the other owner(s) based on ownership, then you are entitled to deduct your share. However, if you pay an expense for the property in full, you are only entitled to deduct your share even though you may not have been reimbursed by the owner(s).
Certain prepayments may have to be prorated. For example, if you prepay insurance for more than a year in advance, then you must prorate the premium to the years the policy applies. Premiums paid for 12 month or less are deductible in the year paid.
Improvements are costs incurred to improve the property and are generally capitalized and subject to an annual depreciation deduction. Improvements can be defined as expenditures that result in a betterment to the property, a restoration of the property, or adapts the property to a new or different use. There are really no bright line tests to determine when a cost results in an improvement to the property or a cost that is incurred to repair the property.
Example 1 – Your tenant terminates his lease at the end of July. You inspect the property and notice there are some holes in the walls, a section of the carpet needs replaced, and the roof has a small leak. Repairs should be thought of as placing property back to its normal working condition. So, each of these items will generally be considered a repair.
Example 2 – Your tenant terminates her lease in August. You inspect the property and notice the carpet is getting old, the dishwasher needs replaced, and the bathroom could use a re-tiling. You decide to refresh the place before the next tenant in hopes of increasing the rental value of the property and take care of each of these items. In this situation, you are not placing the property back to its normal working condition. You have improved the property. These items would be capitalized and depreciated.
De Minimis Safe Harbor
To minimize the inherent confusion over costs that may either be repairs or improvements, the de minimis safe harbor election allows you to deduct up to $2,500 of costs paid to acquire or produce tangible property (e.g., a dishwasher or carpet) providing you meet the following requirements:
1. The costs must also be deducted by you for financial accounting purposes or in your books and records. This is referred to as book-tax conformity.
2. You must have implemented an accounting procedure at the beginning of the year accounting for these costs (amounts under $2,500) as de minimis costs for the entire year. A written policy is not required; however, consistency is required.
3. The $2,500 amount is substantiated per item or per invoice.
4. This election does not apply to inventory or land.
5. You must attach a written election to the timely filed (including extensions) tax return for each year you claim the election.
Referring to Example 2 above, each of the costs incurred would qualify for the de minimis safe harbor provided you meet the requirements noted above.
Rental Property Depreciation
For assets or property you acquire that are not eligible for the de minimis safe harbor or for those you choose to depreciate (rather than electing the de minimis safe harbor), you will need to calculate depreciation. Depreciation is a book entry to record the annual cost of a depleting asset over its MACRS (tax) life. The IRS publishes a table for various assets commonly acquired by residential property owners. I have noted below several common assets and their MACRS Class life.
Residential Structure – 27.5 years
Land – Not Depreciable
Appliances (stove, refrigerator) -5 years
Carpets – 5 years
Furniture used in the rental property – 5 years
Landscaping – 15 years
Fencing – 15 years
When you initially purchase your rental property, you will need to split the basis (cost) of the property between the land and the structure. This may be done by appraisal, by actual purchase price for a new property, or using other publicly available information such as a property tax appraisal. Remember, the cost allocable to the land is not deductible.
Qualified Business Income Deduction
Rental real estate may be eligible for the Qualified Business Income Deduction (QBID) created under the Tax Cuts and Jobs Act of 2017. The deduction is based on Qualifying Business Income (QBI). QBI is the net amount of qualified items of income, gain, deduction and loss from any qualified trade or business, including income from partnerships, S corporations, sole proprietorships, and certain trusts. Generally, the following deductions reduce QBI: deductible part of self-employment tax, self-employed health insurance, and deductions for contributions to qualified retirement plans, unreimbursed partnership expenses, and charitable contributions (this is not an exhaustive list).
The QBI component of the deduction equals 20% of Qualified Business Income. For rental real estate, the deduction is available if the rental real estate activity qualifies as a trade or business. The courts have consistently applied the following in determining whether a rental real estate activity is a trade or business:
1. You must carry on the activity with the intent to make a profit.
2. Your activity in operating the activity must be considerable, regular, and continuous.
There are limitations to the QBID depending on many factors including income, so the above is intended only as a brief summary.
Rental Real Estate Safe Harbor
The IRS provides a safe harbor for those who want some assurance the Service will respect the activity as a trade or business and thus qualify for the QBID. The safe harbor applies to a real estate enterprise which may include a single rental property or an interest in multiple properties. To include an activity in the enterprise, you must directly own the activity (individually) or own the activity through a disregarded entity (single member LLC). To meet the safe harbor requirements, you must meet the following requirements:
1. Separate books and records are maintained to reflect income and expenses for each rental real estate enterprise.
2. For rental real estate enterprises that have been in existence less than four years, 250 or more hours of rental services are performed per year. For other rental real estate enterprises, 250 or more hours of rental services are performed in at least three of the past five years.
3. The taxpayer maintains contemporaneous records, including time reports, logs, or similar documents, regarding the following: hours of all services performed; description of all services performed; dates on which such services were performed; and who performed the services.
4. The taxpayer or RPE attaches a statement to the return filed for the tax year(s) the safe harbor is relied upon. The statement is signed under penalties of perjury.
The IRS has stated that a taxpayer does not have to meet or even elect (when qualified) the safe harbor for any tax year if the facts and circumstances indicate the rental real estate activity is a trade or business.
Maintaining Rental Property Books and Records
It is recommended to maintain a separate checking account for your rental property activities. This is one of the requirements for those who want to elect the safe harbor for the Qualified Business Income Deduction and maintaining a separate checking account makes it easier to track the income and expenses for the year.
Receipts should be retained for all expenses incurred on the property. For simplicity in bookkeeping it is recommended to keep personal expenditures off the receipts for rental expenses (so, ask the cashier to ring up rental expenses on a separate ticket, if applicable).
Logs should be maintained to record the rental income by month. This is very helpful should your tenant get behind on rental payments, and the log also provides a record for tax reporting.
If you use your vehicle for a rental activity, then you may be entitled to claim automobile expenses as a deduction for your rental property. The easiest method is to use the standard mileage rate as the basis for the deduction. The standard mileage rate for 2020 is 57.5 cents per business mile. You must maintain a contemporaneous mileage log to take any vehicle expenses including the standard mileage rate. Please note that commuting is not eligible for deduction. Commuting is defined as driving from your home to a business location (your rental property). So, driving from your home that does not qualify as a home office to your rental property is generally not deductible. However, if you drive from your rental property to a home improvement store to pick up supplies for a repair, then you may count this mileage.
Personal Use of a rental property
While this post is not designed to discuss the details associated with the personal use of property held for rental, please note that there are detailed separate rules that must be addressed if you use your rental property personally during the tax year.
This short guide is not intended to address all the tax implication of ownership in residential rental property; however, it should serve as a broad overview of items for the rental property owner to consider when preparing for tax reporting. If we can help, please give us a call at (806) 470-9609.