The deductions you’re allowed to claim for having Schedule E as part of your tax return depend upon the type of income reported. The most commonly-used sections of Schedule E are Part I -- where income from rental real estate is reported – and Part II, which lists income from partnerships and S-corporations you own. Less common uses of Schedule E pertain to income and losses from estates and trusts, and from royalties. Tax rules place restrictions on the deductions you’re entitled to take in Part I as well as the deduction of losses in either section against other income sources.
Rental Property Expenses
You’re entitled to deduct all ordinary and necessary expenses related to generating income from your rental real estate. Typical deductions for rental properties are local real estate taxes, mortgage interest, repairs, insurance, commissions, and property manager fees. Don’t claim deductions for the value of your own labor. You also cannot deduct capital costs, which are expenditures that extend the property’s life or add significant value to it. These are different than repair expenses needed to keep the property in good condition.
Depreciation is different from other deductions because it includes amounts you paid in years other than the one when this deduction is claimed. For example, a small roof repair is an ordinary deduction. Alternatively, replacement of the roof adds value to the property. The new roof is a capital cost that’s depreciated by deducting it over a number of years. The cost for land is never depreciated. Separate the cost for land when calculating the depreciation for a rental building you acquire. Special tables established by tax laws assign the number of years and the annual percentages for deducting capital costs.
If you’re an owner of a partnership or S-corporation, your share of income or loss already includes deductions taken by the entity. Therefore, Schedule E shows your part of net income or loss after expenses. As a partner, however, you may have been required to pay other expenses on behalf of the partnership. You’re entitled to claim these amounts as unreimbursed partner expenses on Schedule E, thus deducting them from your partnership net income. This step is not allowed for shareholders of S-corporations.
Special rules limit the amount of loss on Schedule E that you can deduct against other sources of income. For example, the shareholder of an S-- corporation isn’t allowed to deduct a loss that exceeds his basis, which is essentially his invested capital plus his share of undistributed prior-year profits. Similarly, at-risk rules limit your deduction of loss on a partnership business to the amount of money you contributed to the entity plus funds borrowed by the partnership that you’re personally obligated to repay. Your deduction of losses from so-called “passive activities” is also limited.
Passive activities include any business in which you are not a material participant. For instance, a limited partner in a partnership is normally considered passive. Rental activity is passive except for individuals classified as real estate professionals or meeting the conditions for active participation. To actively participate in your rental property you must be regularly, continuously and substantially involved. This usually entails having responsibility for such acts as approving tenants, deciding lease terms and directing repairs. Active participants in rental activities generally can deduct an annual loss of up to $25,000 as long as the gross income on their tax returns is $100,000 or less.