Schedule E Tax Tips for Landlords

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.

Here's some tips. First, just like filing out a Schedule D for stock investments, 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 (either on paper or on the computer). Your tax accountant may even have a spreadsheet 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

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. What this means is that the IRS limits your losses from your rental business to a maximum of $25,000 per year. The rules and criteria for Passive Activity Losses are found in IRS Instructions for Schedule E. Note: this is $25,000 in total losses from all your rental properties.

Tax Planning for Landlords

Landlords normally 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 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. The IRS provides a tax break for homeowners who rent out their property instead of using the property as a personal residence.

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. The actual amount of losses that can be deducted is a maximum of $25,000, but it could be less depending on the landlord's level of income. Any losses not currently deductible will be carried over to the following 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.

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. Profits on rental property can be taxed partly as ordinary gain and partly as capital gain. This is due to rules for rental property contained in the Internal Revenue Code Section 1231, which is discussed in IRS Publication 544. Gains are reported on Form 4797.

Real Property and Limited Liability

Many clients have asked me about forming corporations to own their rental properties. A real estate attorney is really the person to ask. But here's the tax perspective. If you form an S-Corporation or Partnership, you may be exposing yourself to unlimited liabilities that arise from lawsuits and other legal risks. If you form a regular C-Corporation, you have limited liability protection, but you lose the ability to pass-through your income and lossess to your personal 1040. If you form a Limited Liability Company, you have limited liability protection and you pass through all profits and losses to your 1040. From a tax perspective, forming an LLC to own your rental property sounds appealing. Nonetheless, setting up an LLC, transferring title, and getting the tenants to sign new leases with the LLC as the owner may prove a time-consuming project. Landlords should discuss other legal aspects of forming an LLC or other business around their rental properties with their attorney. Besides limited liability, landlords should ask about how they can transfer ownership of their company to their children and other heirs, how they can achieve legal protection through other means such as insurance, and just what legal protections they need.