KEY TAKEAWAYS
- Rental income includes monthly rent, security deposits that are kept as payment for damages, property or services received in lieu of rent, advanced rent payments, and lease cancellation payments.
- Expenses paid by the renter are also considered rental income but can be deducted as rental expenses if eligible.
- Expenses that may be eligible for deduction include mortgage interest, property taxes, repairs and maintenance, utilities, insurance premiums, advertising costs, depreciation, and property management fees.
- Schedule E (Form 1040) is typically used to report rental income and expenses.
- Accurate record-keeping is crucial for tax reporting, financial and operational purposes, and documentation in case of an audit or legal dispute.
Owning a rental property and earning rental income comes with tax responsibilities. Failing to report rental income to the IRS can lead to penalties and fines. However, the process of reporting rental income can be complicated. In this blog, we provide a step-by-step guide on how to report rental income, including what needs to be reported, how to fill out tax forms, and how to keep track of your records.
What to report as rental income
Aside from the monthly rent that property owners need to report, there are other items that must be reported as rental income as stipulated in IRS Topic No. 414.
Security deposit
Most property owners require renters to provide a security deposit at the start of a lease as protection against any damage or unpaid rent. If the renter abides by the lease terms, the security deposit is typically returned at the end of the lease and does not need to be reported as rental income.
However, if you deduct all or part of the security deposit as payment for damages caused by a renter, the amount you keep is considered rental income and must be reported on your tax return. Moreover, if you plan to use the security deposit as the final month’s rent, it should be reported at the time it was received rather than the time it was used.
Property or services received in lieu of rent
If the renter provides property or services in exchange for rent, the fair market value of the property or services, or the agreed-upon amount, must be reported as rental income.
For example, if your renter is a carpenter and offers to fix your ceiling in exchange for two months’ rent, you should include the equivalent of that amount in your rental income. You can also include that amount as repair and maintenance expenses.
Advance rent payments
If a renter pays rent in advance for a future period, the rent must be reported in the year it was received, even if it’s for a future period. Similarly, if the security deposit is used to pay for the renter’s final month, it is considered an advance payment and should be reported at the time it was received rather than the month it will be used as a rent payment.
Lease cancellation payments
The Internal Revenue Service (IRS) considers any payment received by a property owner in connection with the rental of a property to be rental income. Thus, lease cancellation and other fees should also be reported as income.
Expenses paid by the renter
Any expenses paid by your renter are considered rental income and should be included in your total income. However, you can claim a deduction for those expenses if they are eligible for deduction as rental expenses.
For example, if your renter paid for a plumbing repair and deducted the payment from next month’s rent, you should include the net payment you received from your renter and the repair cost paid by the renter. However, you can also deduct the cost of the repair as a rental expense.
Expenses that are eligible for deduction
Some other expenses that may be eligible for deduction include:
- mortgage interest,
- property taxes,
- repairs and maintenance,
- utilities,
- insurance premiums,
- advertising costs,
- depreciation,
- and property management fees
For instance, you can deduct the interest paid on a mortgage for your rental property, as well as any secondary mortgages or home equity loans. Similarly, you can claim deductions for property taxes, repairs and maintenance, utilities, and insurance premiums paid for your rental property.
In addition, you can deduct advertising costs incurred to attract new tenants, and you can claim depreciation as a tax deduction to recover the cost of your rental property over its useful life. Finally, if you engage a property management company to manage your rental property, you can deduct their fees as an expense.
Recommended: Cost segregation on a rental property: What it is and how it works
How to Report Rental Income
Typically, property owners report their rental income and expenses using Schedule E (Form 1040). This form requires you to provide information about your property, including its income and expenses, as well as depreciation expenses.
It’s important to note that the Schedule E forms only cover up to three properties. If you own more than three properties, you’ll need to use additional Schedule E forms. However, it’s important to ensure that the “Totals” column on one of the Schedule E forms reflects the combined income and expenses for all your properties. This column should only be filled in on one Schedule E form.
Here are the steps to fill out Schedule E:
- Report all rental income: Enter the total amount of rental income received during the year on line 3.
- Report expenses and deductions: Enter all rental expenses and deductions on lines 5-19. This includes expenses such as mortgage interest, property taxes, insurance, repairs, and depreciation.
- Calculate your net rental income or loss: Subtract your total expenses from your total rental income to arrive at your net rental income or loss. This amount is reported on line 26.
- Transfer the net rental income or loss to your tax return: If you have a net rental income, you’ll need to report it on your tax return as additional income. If you have a net rental loss, you can deduct it from your other income to reduce your overall tax liability.
Record Keeping for Rental Income
Keeping accurate records of rental income and expenses is crucial for several reasons. Good recordkeeping can help you accurately report the rental income and expenses on your tax return, minimize your tax liability, track your rental income and expenses for financial and operational purposes, and provide documentation in case of an audit or legal dispute.
Here are some records you should keep for your rental income:
- Rental Agreements: Keep a copy of all rental agreements, including the lease or rental agreement, security deposit receipts, and any addendums.
- Income Records: Keep a record of all rental income received, including the date received, the amount, and the source of income.
- Expense Records: Keep a record of all rental expenses, including receipts, invoices, and canceled checks.
- Depreciation Records: Keep a record of the cost of the property, any improvements made, and the depreciation taken each year.
To make it easier to keep track of your rental income records, consider using a separate bank account for your rental income and expenses. Use software to track rental income and expenses and store electronic copies of receipts and invoices.
Some property management companies, like Poplar Homes, have robust financial reporting accessible through your Owner Dashboard. This allows you to track your income and expenses accurately and will make reporting your rental income much easier.
Conclusion
Reporting rental income to the IRS is a crucial step for any property owner. It’s essential to understand what constitutes rental income and the different types of expenses that can be deducted to reduce your taxable rental income. Using Schedule E (Form 1040) is the most common way to report rental income, and it’s important to keep accurate records of all income and expenses related to your rental property.
Failure to report rental income accurately may result in penalties and fines, so it’s essential to follow the guidelines provided by the IRS. By understanding the process of reporting rental income and following the necessary steps, you can ensure that you stay compliant and avoid any unwanted penalties.
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