9.1 Reporting Rental Real Estate Income and Expenses

On the cash basis, you report rent income on your tax return for the year in which you receive payment or in which you “constructively” receive it, such as where payment is credited to your bank account.

On the accrual basis, you report income on your tax return for the year in which you are entitled to receive payment, even if it is not actually paid. However, you do not report accrued income if the financial condition of the tenant makes collection doubtful. If you sue for payment, you do not report income until you win a collectible judgment.

Caution

IRS to Increase Audits of Taxpayers With Rental Real Estate Losses

Following the recommendation of the Treasury Inspector General for Tax Administration (TIGTA), the IRS is setting up a plan to identify tax returns with questionable rental real estate losses and to increase the number of examinations of such returns. TIGTA and the IRS believe that the audits can bring in millions of dollars in additional revenue from taxpayers who have underpaid tax on their rental income.

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Schedule E reporting.

Use Schedule E to report rental real estate income and expenses unless you are providing substantial services for tenants that go beyond the provision of utilities, trash collection, and cleaning of public areas. For example, if you operate a hotel or motel, and provide cleaning services such as maid service and changing linens, you should use Schedule C rather than Schedule E.

Advance rentals.

Advance rentals or bonuses are reported in the year received, whether you are on the cash or accrual basis.

Filing Tip

Husband-Wife Owners Can File Schedule E for Qualified Joint Venture

If you and your spouse are sole owners of a rental real estate business that you both materially participate in, and you file jointly, you can elect to be treated as a qualified joint venture (QJV) on Schedule E; see 40.6). You do not each file a separate Schedule E to report your respective share of the income and expenses. Instead, on Line 1 of Schedule E, each of your and your spouse’s QJV interests is reported as a separate property, and on Line 2 you check the QJV box for each such property interest. For each separate property interest, enter on Lines 3-22 (income and expenses) the applicable share of the QJV income, deductions or loss.

The rule that exempts rental real estate income from self-employment tax (45.1) is not affected by the fact that the QJV election is made on Schedule E. The passive loss rules (10.1) also continue to apply..

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Tenant’s payment of landlord’s expenses.

The tenant’s payment of your taxes, interest, insurance, mortgage amortization (even if you are not personally liable on the mortgage), repairs, or other expenses is considered additional rental income to you. If your tenant pays your utility bills or your emergency repairs and deducts the amount from the rent payment, you must include as rental income the full rental amount, not the actual net payment. However, you can claim an offsetting deduction for expenses, such as repairs, that would have been deductible had you paid them.

Tenant’s payment to cancel lease.

A tenant’s payment for cancelling a lease or modifying its terms is considered rental income in the year you receive it regardless of your method of accounting. You may deduct expenses incurred because of the cancellation or modification and any unamortized balance of expenses paid in negotiating the lease.

Caution

Security Deposits

Distinguish advance rentals, which are income, from security deposits, which are not. Security deposits are amounts deposited with you solely as security for the tenant’s performance of the terms of the lease, and as such are usually not taxed, particularly where local law treats security deposits as trust funds. If the tenant breaches the lease, you are entitled to apply the sum as rent, at which time you report it as income. If both you and your tenant agree that a security deposit is to be used as a final rent payment, it is advance rent. Include it in your income when you receive it.

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Insurance.

Insurance proceeds for loss of rental income because of fire or other casualty are rental income.

Improvements by tenants.

You do not realize taxable income when your tenant improves the leased premises, provided the improvements are not substitute rent payments. Furthermore, when you take possession of the improvements at the time the lease ends, you do not realize income. However, you may not depreciate the value of the improvements as the basis to you is considered zero.

Property or services.

If you receive property or services instead of money, include the fair market value of such property or services as rental income.

If you agree upon a specified price for services rendered, that price is generally treated as the fair market value.

Rental losses.

Rental income may be offset by deductions claimed for depreciation, mortgage interest, and repair and maintenance costs. However, if these expenses exceed rental income, the resulting loss is subject to the passive activity loss restrictions. If you do not qualify as a real estate professional (10.3), you generally may not deduct rental losses from other income (such as salary, interest, and dividends) under the passive loss rules. Rental losses may offset only other rental and passive activity income. However, if you perform some management role, you may deduct from other income real estate rental losses of up to $25,000, provided your adjusted gross income does not exceed $100,000 (10.2). The passive activity restrictions have the positive effect of making rental income attractive. Consider purchasing rental property if you have passive tax losses that may be used to offset the rental income. See Chapter 10 for details on the passive loss restrictions.

Application of the passive activity loss rules and exceptions assumes that the property is not considered a residence under the personal-use rules (9.7). If it is, rental expenses are deductible from rental income (9.9) but a loss is not allowed for that property.