PART I: Rental Income and Rental Expense

Rental Income

There are two basic types of residential rental activity. The first type involves situations in which a taxpayer rents out his or her property for a profit, and does not use the property personally. The second type of residential rental activity relates to situations in which a taxpayer rents out property that he or she also uses personally.

When we think of residential rental income, we typically think of monthly rent payments made by tenants. However, several other types of payments are also considered rental income. Rental income may include all of the following: Regular rent payments; rent that is paid in advance; payments related to canceling a lease; certain expenses paid by tenants; the value of property given instead of rent payments; the value of services performed by tenants in lieu of normal rental payments; and even payments made by tenants who are leasing with an option to buy. Payments made under this type of agreement are generally considered rental income, and must be reported as rental income for the year by the landlord. However, if the tenant exercises the right to buy the property, any payments received for the period after the date of the sale are considered part of the selling price, and not rental income.

Some monies received by a landlord are not considered rental income. For example, security deposits paid by tenants are not considered rental income if the landlord plans to return the security deposit to a tenant at the end of the lease. However, in certain circumstances, a security deposit can become rental income for a landlord; even if the landlord originally intended to return the deposit to the tenant. As a general rule, any amount retained by the landlord must be included in rental income. Some landlords charge a ‘nonrefundable security deposit’ to tenants with pets. Other landlords charge a ‘security deposit’ that will be used as the tenant’s final rent payment. These types of charges are considered advanced rent payments; and must be included in rental income in the year they were received.

Rental Expenses

Generally, rental expenses may be deducted from the landlord’s rental income for tax purposes.

The amount of expenses that will be deductible will vary, depending on the specific circumstances of a taxpayer. In cases where a taxpayer owns property that he or she sometimes rents to tenants and sometimes uses for personal purposes, the taxpayer must divide expenses between personal use of the property and rental use. Only expenses related to renting out the property will be deductible as rental expense. The expenses paid to maintain the property for tenants are rental expenses.

According to the IRS, the most common rental expenses are: Advertising; auto and travel expenses, cleaning and maintenance of a rental property; commissions,  depreciation, insurance premiums,  interest payments, legal and professional fees, local transportation expenses, management fees, mortgage interest, points, rental payments,  repairs to property, taxes,  and utility costs.

A taxpayer may also deduct mortgage interest paid on rental property. However, in cases where a taxpayer refinances a rental property for more that the outstanding balance that had owed before the refinance occurred, the portion of interest that is allocable to loan proceeds not related to rental use will generally not be deductible as a rental expense. Certain professional fees paid by a taxpayer for a rental property are deductible as rental expenses. For example, legal fees and fees paid to prepare a tax return may be deductible, proving that they are paid so that the taxpayer is able to engage in residential rental activities. A taxpayer may even be able to deduct certain expenses paid to resolve a tax underpayment related to his or her rental activities.

Certain local benefits taxes paid by a landlord may be deductible as rental expenses. If a landlord paid local benefit taxes of maintaining, repairing, or paying interest charges for benefits, those payments will be deductible as rental expenses. However, if a landlord pays fees for local benefits that increase the value of his or her property, those expenses will be considered non-depreciable capital expenditures that must be added to the basis of the taxpayer’s property.

Some landlords are able to deduct local transportation expenses as rental expenses. In order for travel expenses to be deductible, the must have been incurred so that the landlord could collect rental income, manage his/her property, or execute maintenance or conservation on the rental property. If transportation expenses are deductible, a taxpayer may use one of two methods to calculate the deduction: Either actual expenses incurred, or the standard mileage rate for deductible travel.

Repairs and Improvements.

In a broad sense, any expense incurred by a taxpayer to either repair or maintain a rental property may be deducted; unless the taxpayer is required to capitalize the expense. Capital expenses must be written off over a period of years. However, repairs may generally be deducted in the year the repair cost is incurred.  It should also be noted that any repairs done during the course of an improvement will be considered part of the improvement.