Before you take the plunge and purchase a beach condo to use for rental property because your neighbor talks about the “great tax write-off,” a great deal of consideration should be given to the tax implications (as well as emotional implications) of owning real estate other than your personal residence.
Rental income (amounts you receive for the use or occupation of property you own) must be included in your gross income in the year you actually or constructively receive the income. You constructively receive income when it is made available to you. This would include advance rent or payment to cancel a lease. If you receive property or services instead of money as rent, include the fair market value of the property or services in your rental income. If a rental agreement gives the tenant the right to purchase your rental property, the payments you receive under the rental agreement are generally rental income. The payments you receive for the period after the sale are part of the selling price.
Rental expenses paid in conjunction with your rental income are generally deductible in the year you pay them. You may deduct costs that are ordinary and necessary in the operation of your property. These expenses may include, but are not limited to, management fees, maintenance, repairs, insurance, interest, taxes, utilities, pest control, travel and association fees.
Depreciation on your rental property is also an allowable deduction from rental income. You may begin to depreciate your rental property when the property becomes available and ready for rent. The cost of your residential real estate is depreciated (or recovered) over a period of 27.5 years. Factors to determine how much depreciation you can deduct are your cost or basis in the property and improvements that increase the value or prolong the life of the property. The land associated with the property is not depreciable. Other types of property considered depreciable may include furniture and fixtures, computer equipment, carpet, shrubbery, fences, roads, and structural improvements or additions. Each class of property has a different recovery basis.
Rental real estate activities are generally considered passive activities and, if you incur a loss, the loss may be limited to income from other passive activities. However, if your rental losses are less than $25,000 ($12,500 for married filing separately), the passive activity limits probably do not apply if you actively participated in the real estate activity unless your modified adjusted gross income is $150,000 or more. The good news is that if you are not allowed the losses on your current year tax return, the losses are carried forward (indefinitely, if need be) to offset future passive income. The passive loss carry forward can be completely captured in the year the real estate is disposed of or sold.
Rental income and expenses are reported on Schedule E (Part 1), Supplemental Income and Loss, of your 1040. On page 1 of the Schedule E, enter the depreciation that is allowed on line 20. You must also complete and attach Form 4562, Depreciation and Amortization (Including Information on Listed Property), to report the depreciation you are claiming.
IRS Publication 527, Residential Rental Property, may be printed from the IRS website (www.irs.gov) or Henssler Financial can assist you with further information on reporting your rental income and expenses. Please contact us at 770-429-9166 or [email protected].