Rental Income and Expenses

Tips for Schedule E

House for rent in the middle of winter.
© David Joel / Photographer's Choice RF / Getty Images

The key to mastering the Schedule E is to organize your income and expenses using a spreadsheet or personal finance software program. In my experience, clients who keep detailed summaries of their rental property expenses are the ones who benefit most at tax time from the generous tax rules regarding rental income.

Schedule E Tax Tips

Landlords need to keep excellent records regarding cost basis, income, and expenses.

And the number one best way to keep track of all this? Set up a spreadsheet. Your tax accountant may even have a template you can use.

As a landlord, here are the things you need to keep track of:

  • Purchase price of the house, condo, or apartment building you are renting out,
  • Accumulated depreciation, and current annual depreciation on your property,
  • Rental income,
  • Security deposits you received.

In addition, you will need to keep track of various expenses associated with your rental property, including:

  • Commissions or property management fees,
  • Advertising costs,
  • Cleaning, maintenance, and repair costs,
  • Homeowners insurance and HOA dues,
  • Real estate taxes and mortgage interest expenses,
  • Security deposits reimbursed to the tenant.
  • and various other expenses, such as utilities, landscaping, garbage, and so forth.

As you can see, it will be particularly helpful if you track these various expenses using personal finance software or a computer spreadsheet, so that monthly and year-end reports can be quickly printed out.

Passive Activity Losses

If a rental property has a net loss for the year, that loss is netted against the losses and profits of all other rental properties for the year. If the grand total for all rental properties is negative (at a net loss), that rental net loss might be fully, partially, or not at all deductible against the rest of your income for the year as a result of the passive activity loss limitations.

Renting out real estate property is generally considered a passive activity, even if you devote a substantial amount of time to selecting the right tenants, repairing the rental unit, and inspecting the property for routine maintenance. Losses from passive activities are limited to offsetting passive profits.

In the case where the owner actively participates in the rental activities, any rental losses can potentially be deducted up to $25,000 per year in aggregate across all rental property. (Married persons who file separately have a rental loss limit of up to $12,500 provided the person lived apart from his or her spouse at all times during the tax year.) The amount of the rental loss allowed for active participants in a rental property varies based on modified adjusted gross income (MAGI):

  • For MAGI of $100,000 or less ($50,000 or less if married filing separately), rental losses can be deducted in full, up to the $25,000 ($12,500) limit.
  • For MAGI between $100,000 and $150,000 (between $50,000 and $75,000 if married filing separately), rental losses can be deducted up to a limit of 50% of the difference between $150,000 ($75,000 if married filing separately) and MAGI.
  • For MAGI over $150,000 ($75,000 if married filing separately), none of the rental losses can be deducted against other income.

Any rental losses that are limited by the passive activity loss limitations, those losses are carried forward to the subsequent tax year. In the subsequent tax year, those rental losses can offset rental profits. Be aware that the passive activity loss limitations are applied each year. Rental losses continue to carry forward year after year until the losses are either used up by offsetting rental profits or by being deducted against other income. Rental losses for a particular property are allowed in full in the year in which a rental property is sold in a complete disposition to an unrelated buyer.

Form 8582 is used to calculate passive activity loss limitations and to keep track of rental losses that accumulate each year for each property.

The rules concerning limits on passive activity losses are discussed in more detail in chapter 3 of Publication 527, Residential Rental Property, and in Publication 925, Passive Activity and At-Risk Rules.

Tax Planning for Landlords

Landlords sometimes make a small profit on their rental income. This is the case because rental income is usually sufficient to pay the mortgage, and plus a little extra for property taxes, insurance, and repairs. However, landlords get to depreciate the purchase price of the rental property, which is usually sufficient to turn a small economic profit into a small tax loss. That means expenses exceed income after depreciation is taken into consideration.

Every so often, however, landlords face major expenses, such as replacing a roof, or gutting an apartment after a long-term tenant vacates. In these circumstances, it is possible that the landlord has a loss greater than $25,000. But the Passive Activity Loss rules will limit the loss to exactly $25,000. The remainder will be carried over to next year, when hopefully the landlord will have more of a profit and will be able to absorb the excess tax losses.

Selling Rental Properties

Selling a house, apartment building or other rental property is different than selling your main home. Different rules apply for calculating your taxes. Just like calculating capital gains, the formula for calculating the gain or loss of rental property involves subtracting your cost basis from your selling price.

Adjusted Cost Basis for Rental Property

The formula for calculating your cost basis on rental property is as follows:

  • Purchase price
  • + Purchase costs (title & escrow fees, real estate agent commissions, etc.)
  • + Improvements (replacing the roof, new furnace, etc.)
  • + Selling costs (title & escrow fees, real estate agent commissions, etc.)
  • - Accumulated depreciation (as reported on your tax forms)
  • = Cost Basis

And then calculating your profit or loss would be:

  • Selling price
  • - Cost Basis
  • = Gain or Loss

If the resulting number is positive, you made a profit when you sold your rental property. If the resulting number is negative, you incurred a loss when you sold your rental property. Gains on rental property can be taxed partly as depreciation recapture at a maximum 25% tax rate and partly as capital gains. This is due to rules for rental property contained in the Internal Revenue Code Section 1250, which is discussed in IRS Publication 544. Rental property sales are reported on Form 4797, and any capital gain calculations are reported on Schedule D.

Real Property and Limited Liability

Many people have asked me about forming corporations, limited liability companies and partnerships to own their rental properties. A real estate attorney is really the best person to ask such questions. But here's the tax perspective. A corporation might be disadvantageous since corporations do not have a preferred tax rate on long-term capital gains. A limited liability company would be able to pass through long-term gains to its members, and so gains will still be eligible for the preferred 15% rate on long-term gains. Landlords should discuss this and other legal aspects of forming a company for rental properties with an attorney to get a grasp of all the legal and financial implications of such a strategy.