What are the basic rules for rental properties?
Deciding to invest in a rental property is a big commitment, and one that will also be a big change to your tax forms. Here are some of the basics you should know if you are the owner of a rental property:
- Make sure you are not considered a resident of your rental property. This is determined by a series of tests that would determine if your property is for personal use:
- Make sure the taxpayer did not use the residence for more than 14 days or 10% of the total days rented to others
- The property must be rented out at fair market value (FMV)
- Any person who owns an interest in the property would also be considered for personal use
- Anyone who has an arrangement that lets the owner use some other dwelling
- Keep track of all expenses related to the property and have evidence in case of an audit. These expenses include, but are not limited to, mortgage expenses, utilities, and any cleaning expenses.
- When you have a rental property your Federal 1040 will also have a Schedule E attached. This schedule will include an overview of income received and expenses.
Improvements & Depreciation
Some expenses will either need to be capitalized or expensed as they are incurred. A capitalized expense is “an expense added to the cost basis of a fixed asset.” Capitalized expenses will generally be depreciated or amortized over a period of time rather than expensed in the year in which they occurred. Any expense that increases the value of your property, such as improvements, must be capitalized. Some common expenses that must be capitalized include:
- Lawn & Grounds Improvements
- Heating & Air Conditioning
- Interior Improvements
When an expense is capitalized, it is added to your cost basis. Cost basis is the total of the original price you paid for an asset, in this case your rental property, plus any additions or improvements. This may influence when you decide to dispose of your property as you now have a greater financial interest in the asset.
When considering expenses, you should also remember to include depreciation. Most residential properties are depreciated using the 27.5-year MACRS method. This means that a portion of the cost of the residential property will be expensed over the course of its useful life each year, rather than in one lump sum. Choosing the right depreciation system is also important. The two options taxpayers have are the General Depreciation System or the Alternative Depreciation System. Most taxpayers will use the General Depreciation System, but there are exceptions. If the following list describes your property, you must use the Alternative Depreciation System:
- Has a qualified business use 50% of the time or less
- Has a tax-exempt use
- Is financed by tax-exempt bonds
- Is used primarily in farming
When using the Alternative Depreciation System, the recovery period is 30 years for property placed in service after 12/31/2017, or 40 years if the property is placed in use before that. Remember to keep track of your basis as it is needed to calculate depreciation correctly. Certain property you provide to the rental could also be depreciated; some common examples include:
- Office furniture
The depreciation method for the assets listed above will vary depending on the asset. Be sure to check with your accountant for the appropriate depreciation method to optimize tax savings.
Reducing your tax liability as a taxpayer is always a goal. As discussed above there are many deductions one can take when owning a rental property. Understanding your rental property’s expenses will also help determine what your income will be from the property. Some of the more common expenses are:
- Legal & Professional Fees
Additionally, there are some expenses that many taxpayers think are deductible but are not. These include:
- Escrow fees
- Improvements (need to be depreciated)
We highly encourage you to discuss any tax considerations regarding your rental property with your accountant before implementation. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. You should consult with your own tax, legal, or accounting advisor before engaging in any transaction.