Published September 14, 2012
So you’ve just joined the world of being an “accidental landlord.” Maybe you had to relocate, or perhaps you had to downsize. Now you’re renting out your personal residence or second home instead of selling it.
This makes you a landlord in the eyes of the IRS, which means you’ll have to report the rental property on your federal income taxes.
So what’s a landlord to do?
Fortunately, most rental property ownership will initially generate taxable losses for you, which may, that’s may, save you some money on your taxes. These savings come from shielding, or deducting, losses against part of your regular taxable income. But keep in mind, taxable losses are different from positive or negative cash flows (and that’s a story for another day).
For our purposes, we’re just going to discuss what you need to do as a newbie landlord to get your taxes heading in the right direction.
Next April you’ll add an IRS 1040 Form Schedule E (Supplemental Income and Loss From Real Estate) when you file your taxes.
On the Schedule E, you’ll record all the rental income your received for the prior year. Then you will record all the cash expenses related to the property: mortgage interest, property taxes, HOA fees — which are now deductible because it is a rental property instead of a personal residence — maintenance and repairs, gardening costs and any other expenses, such as depreciation (described below) that are related to the operation of your “business.”
The net rental income, less all those expenses, will provide an income or loss figure that will be calculated on Schedule E and flow to your IRS 1040 Form, Line 17. So if rental income is $15,000 and expenses are $17,000, you have a $2,000 loss for tax purposes.
One favorable expense deduction that you can take against rental income is called depreciation. It is usually a large amount and can help you greatly decrease the taxes you pay. To figure out this amount, first you need to determine the tax basis and depreciable basis of your rental property. The tax basis will generally be what you originally paid for the property, plus any capital improvements you’ve made over the years. So if you paid $200,000 and put in a $25,000 addition, your taxable basis is $225,000.
You’ll then split that basis into land value and building value, which is your depreciable basis. Divide that building value by 27.5 years to get your depreciation deduction, which goes on your Schedule E just like any other expense. Make sure to have a tax preparer help you with this calculation.
Now let’s look at how the Schedule E income or loss flows to your main 1040 form. You would take your net income or loss on the Schedule E form and transfer it to your 1040. If it’s a loss, you save money on taxes. If it’s positive income, you pay additional taxes.
Note: On losses there are some “Passive Activity Loss” limitations on using losses to shield income. The net maximum loss you can use to shield income is $25,000, and the ability to use any losses phases out starting at $100,000 adjusted gross income. Real estate professionals, however, may be able to use unlimited losses. Talk to a tax professional on all these issues.
Even though your new landlording career may be an accident, being smart about the relevant income tax deductions shouldn’t be. Do some Internet research, talk to your tax professional, look at the Schedule E form, save all those receipts and make sure you maximize your deductions, especially depreciation, so you get the largest possible tax savings the IRS code allows.
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Leonard Baron, America’s Real Estate Professor, is a San Diego State University Lecturer, blogs at Zillow.com, authored several books including “Real Estate Ownership, Investment and Due Diligence 101”, and loves kicking the tires of a good piece of dirt! See more at ProfessorBaron.com.