Guide to Tax Reporting: IRS Schedule E

Whether you're a brand-new investor managing properties on your own or you have a million-dollar portfolio with a team of professionals, it's always beneficial to have foundational knowledge of every aspect of your business. 

This comprehensive guide to IRS Schedule E is designed to help real estate investors at every level better understand real estate tax deductions and the passive income tax forms involved.

While real estate tax can be complex, this guide is written for investors of all skill levels to make the topic accessible and understandable.

What Is IRS Schedule E Used For?

Schedule E is the form where you report "supplemental income and loss" related to rental real estate, royalties, estates, trusts, partnerships, and S-Corporations. The emphasis here is on "supplemental income and loss," not "earned income."

In short, IRS Schedule E is the IRS form for reporting rental income.

Understanding Earned vs. Supplemental Income

Earned Income: Generated from active trade or business activities. You pay self-employment tax on earned income. For example, income from flipping houses or developing properties, which would be reported on IRS Schedule C.

Supplemental Income: Typically passive income, such as rental income, which is reported on IRS Schedule E.

Why Report Rental Property on IRS Schedule E?

Rental income is generally considered passive income, and IRS Schedule E is designed to capture this type of income and the associated expenses. Reporting on Schedule E allows you to claim deductions related to your rental activities, which can reduce your taxable income.

How IRS Schedule E Interacts with Your Tax Return

When you report income or loss on Schedule E, that amount is integrated into various parts of your tax return.

Line 26 of Schedule E: Shows your total taxable income or loss from rental properties.

Form 1040: The net income or loss from Schedule E is carried over to line 8 of your Form 1040.

Passive Activity Loss Limitations

If your rental activities result in a loss, you may be limited in how much of that loss you can deduct due to the Passive Activity Loss (PAL) rules. Here's a high-level overview:

Adjusted Gross Income (AGI) under $100,000: You can deduct up to $25,000 of passive losses annually.

AGI between $100,000 and $150,000: The $25,000 deduction limit phases out.

AGI over $150,000: You cannot deduct passive losses against your other income unless you qualify as a real estate professional or utilize the Short-Term Rental (STR) loophole.

Unallowed Losses and Form 8582

If you're unable to deduct your passive losses due to these limitations, the losses are not lost. Instead, they become "unallowed losses" and are reported on Form 8582. These losses are carried forward to future years and can offset passive income or gains from the sale of rental properties.

Determining Property Basis and Depreciation

One of the most crucial aspects of preparing IRS Schedule E is accurately calculating the cost basis of your rental property and determining depreciation.

Calculating the Property's Cost Basis

Your property's cost basis is generally:

• Purchase Price + Capital Improvements

However, you cannot depreciate the full cost basis because the value allocated to land is not depreciable. Here's how to calculate the depreciable basis:

Obtain the Property's Tax Card: Usually available on the county assessor's website.

Determine the Building-to-Land Ratio: For example, if the tax card shows $90,000 allocated to the building and $10,000 to land, the ratio is 90% building and 10% land.

Apply the Ratio to Your Purchase Price: Multiply the purchase price by the building percentage to find the depreciable basis.

Depreciate the Building's Value: Residential rental property is depreciated over 27.5 years using the Modified Accelerated Cost Recovery System (MACRS).

Including Closing Costs and Improvements

Closing costs are categorized into three groups:

Property Basis: Includes purchase price and certain closing costs like title insurance, transfer taxes, inspections, and appraisals. These costs are added to your property's basis and depreciated over time.

Loan Cost Basis: Includes costs associated with obtaining the loan, such as origination fees and lender-required appraisals. These costs are amortized over the life of the loan.

Currently Deductible Expenses: Includes expenses like hazard insurance and property taxes that can be deducted in the year they are paid.

A Walk-through of IRS Schedule E

Now let's go through IRS Schedule E step by step.

Download IRS Schedule E

Before proceeding, download a copy of IRS Schedule E from the IRS website to follow along.

Part I: Income or Loss From Rental Real Estate and Royalties

Section A: Indicate if you made any payments that would require you to file Form 1099. Generally, if you paid $600 or more to an independent contractor for services related to your rental, you need to issue a 1099.

Property Information: Enter the address and type of each property (e.g., single-family, multi-family).

Fair Rental Days and Personal Use Days: Specify the number of days the property was rented at fair market value and the days it was used for personal purposes.

Qualified Joint Venture

Suppose you and your spouse jointly own and operate a rental property and file a joint tax return. In that case, you can elect to be treated as a qualified joint venture instead of a partnership, simplifying your tax reporting.

Income and Expenses to Report on IRS Schedule E

Income

Rental Income: Include all rental income received, including rent payments, tenant reimbursements for utilities, and any prorated rents received during the purchase year.

Expenses

Report expenses related to your rental property in the following categories:

Advertising: Costs for marketing your rental property.

Auto and Travel: Deductible vehicle and travel expenses related to managing your rental.

Cleaning and Maintenance: Costs for preparing a unit for new tenants and general upkeep.

Commissions: Fees paid to agents or property managers for finding tenants.

Insurance: Premiums for hazard, flood, and liability insurance.

Legal and Professional Fees: Attorney fees, accounting fees, and other professional services.

Management Fees: Payments to property management companies.

Mortgage Interest Paid to Banks: Interest paid on loans used to acquire or improve the rental property, as reported on Form 1098.

Other Interest: Interest paid to private lenders or individuals.

Repairs: Costs for ordinary repairs that keep the property in good operating condition.

Supplies: Miscellaneous supplies necessary for the rental activity.

Taxes: Property taxes and other taxes related to the rental property (excluding income taxes).

Utilities: Expenses for utilities that you pay for the rental property.

Depreciation Expense: The annual depreciation deduction calculated for the property.

Other Expenses: Any other ordinary and necessary expenses not captured in the categories above.

Important Notes on Expenses

Escrow Payments: Only deduct property taxes and insurance when they are actually paid out of escrow, not when you pay into the escrow account.

Capital Improvements vs. Repairs: Capital improvements must be depreciated, while repairs can be deducted in the year they are made.

Adding It All Up

After reporting all income and expenses:

Line 21: Shows the income or loss for each property.

Line 22: Indicates how much of the loss you can deduct, considering any limitations.

Line 26: The total income or loss from all rental activities, which carries over to line 8 of Form 1040.

If you have losses that are limited by the Passive Activity Loss rules, these will be reported on Form 8582.

Reporting Auto Expenses

If you use a vehicle for your rental activities, you can deduct related expenses. You'll report these on Form 4562 and then carry the deduction over to Schedule E.

Methods for Calculating Auto Expenses

Standard Mileage Rate: Multiply the IRS standard mileage rate by the number of business miles driven.

Actual Expense Method: Deduct the actual costs of operating the vehicle, prorated for business use.

Documentation Is Key

Regardless of the method you choose, it's essential to keep detailed records, including mileage logs and receipts.

Having this foundational knowledge empowers you to make informed decisions and work more effectively with your tax professionals.

This should give you a basic and fundamental knowledge of how to review and understand the IRS' Schedule E form.

Regards,

Johan Garcia, CPA, MST.