Rental Income and Expenses

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

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 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. 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 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 clients 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.