Real Estate rental income is earned when a real estate is leased for rental income generation. Rental income generally is treated as unearned or passive income for income tax purposes. Rental income is reported on Schedule E for individual and Form 8832 for partnerships and S-Corps. For rent to be treated as earned income, service must be part of the rent lease use of the property. For example, boarding house or motel leasing by a property owner is treated as a business income reported on Schedule C. Real estate income reported on schedule E cannot be treated as earned income for IRA contribution and is also not subject to self-employment tax. Whereas the rental income reportable on schedule C can be.
Gross Rent
Gross rent is reported on a cash basis which includes scheduled lease amounts, advances, late payments, lease cancellation income and security deposit forfeiture. Payments made by tenants for taxes, mortgage interest, insurance or repairs are all reported as rental income.
Rental Expenses
Regular repair and maintenance that do not add to the value or the life of the property are treated as current expense. Other examples of the repair and maintenance are:
- Painting
- Common cleaning
- wall papering
- roof repair
- electricity repair
- plumbing
- heating
- air-conditioning
- ground care etc.
The rule of thumb is that repair and maintenance is necessary expense for the safe keeping and maintaining rentable condition of the property.
Other examples of deductible expenses from rental income are:
- Real estate taxes
- mortgage interest
- electricity
- water
- gas
- telephone
- cate-taker wages
- travel exp
- legal expenses
- advertising
- commissions
- pest controls
- trash-removal
- Consultant fees etc.
Cash Vs Accrual
Most of the income items for tax purposes are accounted for on a cash basis. However, prepaid rent expense, interest and insurance are deducted only for the tax year they pertain to.
Depreciation
Depreciable basis of a property is undepreciated basis minus land value:
Purchase price + major remodeling + improvements – land value – accumulated depreciation = Current basis
For this paper we will assume all properties placed in service before 1987 are fully depreciated. Residential rental properties place into service after 1986 are depreciated under MACRS using straight line over 27.5 years. Commercial properties placed in service after May 12, 1993, are depreciated over 39 years or 31.5 years.
Furniture and appliances provide along with the rent are also depreciated over shorter using lives in accordance with the IRS codes.
Passive Activity Losses (PAL)
PAL is defined by IRS code as any trade or business activity where the taxpayer does not materially participate. Real estate income by default is generally considered as passive. Thus, a taxpayer gets to group all passive activities together and net all passive income and losses. However, if there is still a net loss such loss cannot be netted against non-passive or earned income.
However, IRS has special allowance provision for active passive participation (Form 8582) in a real estate rental activity. Under the special allowance if a taxpayer is an active participant in a real estate rental activity, he may be able to deduct up to $25,000 (for married filing jointly) of loss from the activity against active or portfolio income (i.e., wages, interest, dividend, etc.) even if there are no other passive income. However, the credit is phased out if the taxpayer’s modified adjusted gross income (MAGI) is more than $100,000 and is completely lost for MAGI’s $150,000 and above.
Real Estate investing and rental activity is quite common among the taxpayers as a secondary activity. Its applicable tax rules can be tricky. Consul with your tax advisor if you have rental income activity.
