What is rental income?

Rental income is any payment you receive for the use or occupancy of property, be it residential, commercial, or industrial. In addition to standard rent payments, other types of income that the IRS also considers rental income include:

  • advance rent or rent paid before the period that the payment covers,
  • fees for canceling a lease,
  • money paid by a tenant on your behalf to cover maintenance or improvement expenses, or
  • the fair market value (FMV) of property or services you receive in place of rent.

Interestingly, a security deposit does not count as rental income if you plan to give it back to the tenant at the end of the lease. If you end up keeping a portion of the deposit because the tenant did not live up to the terms of the lease, then that amount does count as rental income. The same is true if you apply the deposit as a final payment of rent, in which case the IRS considers it advance rent and requires you to income it as income for the year in which you received it.

Critically, rental income is subject to taxation — generally as ordinary income or a type of income taxed at ordinary rates. That means you must report all your rental income and expenses on your tax return for the year you actively or constructively received the payment.

Nevertheless, you can lighten your tax burden by deducting certain common expenses, such as mortgage interest, insurance, and utilities. We’ll dive deeper into potential deductions later in this post.

How does the IRS know if I have rental income?

The most common way the IRS learns about your rental income is simple: You report it! Correctly reporting your income and expenses is a vital part of your tax responsibilities as a landlord, and it’s a good idea to prioritize accuracy in your tax filings.

If you fail to do so, there are other ways the IRS can discover income you don’t report, including audits, real estate paperwork, and public records.

To avoid potentially costly or devastating problems down the line, you must report all rental income and keep detailed records of any rental activities.

The good news is by making an accurate report, you can take advantage of any deductions for which you are eligible, including those related to expenses.

What counts as expenses on rental income?

As mentioned above, if you receive rental income, you can deduct certain expenses on your tax return that are considered “ordinary and necessary.” This refers to expenses that are common and generally accepted as part of the business of being a landlord or property owner and necessary to conduct that business.

Examples of what the IRS considers expenses “ordinary and necessary” may include mortgage or other interest, property tax or other taxes, operating expenses, advertising, utilities, insurance, and depreciation.

You can also deduct the costs of certain materials, supplies, repairs, and maintenance that you make to keep your rental property in good operating condition. Furthermore, you can deduct the expenses paid by the tenant if they are deductible rental expenses. Lastly, when you include the fair market value (FMV) of the property or services in your rental income, you can deduct that same amount as a rental expense.

One important note: You may not deduct the cost of improvements. However, you can recover the cost of some of your improvements through depreciation by using Form 4562.

Can you deduct rental property expenses and take the standard deduction?

Suppose you’re accustomed to simply taking the standard deduction rather than itemizing your tax return. In that case, you may wonder if you can claim deductions for specific rental property expenses while refraining from itemizing the rest of your return.

The tax code can sometimes be a minefield for taxpayers who want to keep things simple…but in this case, there’s good news — many rental property tax deductions for landlords are, in fact, “above-the-line,” deducted directly from your gross income. That means that you can deduct those expenses in many cases while still taking the standard deduction!

Generally speaking, here are some of the categories of expense deductions that you may be able to claim above the line:

  • Mortgage interest and insurance
  • Property taxes
  • Property and segmented depreciation
  • Repairs, maintenance, cleaning
  • Property management fees
  • Insurance premiums
  • Closing costs
  • Professional services, such as bookkeeping, accounting, and legal
  • Advertising
  • Supplies
  • Utilities
  • Home office space
  • Real estate-related travel
  • Losses from theft or damage to rental properties (when deducted as business expenses)

As mentioned above, remember that you cannot deduct improvements or travel costs related to progress. Other costs you cannot deduct include lost rent during vacancies, unpaid rent, commuting expenses, and points or origination fees you paid for your mortgage.

How do you keep track of rental income and expenses?

This recent blog post discussed good record-keeping for taxpayers, and many of the same principles apply. However, record-keeping is essential for landlords, so it’s a good idea to go even further in tracking your income and expenses and maintaining supporting documents like receipts, credit cards, and bank statements.

Spreadsheets, created in programs such as Microsoft Excel, Apple Numbers, or Google Sheets, are an effective way to keep track of everything. You should also consider utilizing personal finance software like Microsoft Money or Quicken and accounting software like Quickbooks.

Some examples of types of records you should keep include:

  • Documents from when you purchased the property
  • Past and current tenant leases, applications, and screening reports
  • Tenant-related documents
  • Proof of rental payments received
  • Bank statements
  • Expense receipts
  • Invoices
  • Mortgage loan documents
  • Records of sales or rental tax paid
  • Copies of federal, state, and local tax returns

How do you categorize rental property expenses?

Rental property expenses can be categorized in several different ways. One way is to categorize them by type, such as repairs and maintenance, property taxes, tenant screening, etc. You may also categorize them by time period, such as one-time expenses (like licenses and permits) and recurring expenses (like utilities or regular maintenance). A third option is to categorize them by purpose, such as tenant-related expenses or landlord-related expenses.

Finally, rental property expenses can be categorized by their tax status (deductible and non-deductible expenses, for example).

If you use a spreadsheet program to track your income and expenses from multiple rental properties simultaneously, you may create separate spreadsheets for each property. Alternatively, you could create a single master spreadsheet document but track each property in a separate tab.

No matter how you decide to track and categorize your income and expenses, the most vital takeaway is that your ability to maximize your deductions (and thereby minimize your tax burden) depends on one thing: Organization!

Of course, if you want to be sure you are taking full advantage of all the deductions and credits available, there is no substitute for the expert advice of a tax professional.

Would you like some help?

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