If you lost money on one or more of your rental properties this year, you aren’t alone. In fact, the IRS says that more than half of all Schedule E forms relating to rental income show a loss. You will report your property losses, along with your rental income, on Form 1040 Schedule E, then transfer the information to Line 17 Form 1040 Schedule 1. You’ll only be able to claim rental property losses against other passive income, like rental property income.
Rental property losses are considered passive losses, which means they can only be deducted from passive income. If you don’t have enough in rental income for the tax year to offset your losses, you should be able to carry the excess over to a future year.
Rental Income on Taxes
Those who rent property are responsible each year for reporting income earned during the tax year. Whether it’s a vacation rental or house you rent on a yearly lease, you’ll have to claim all the income you make on your rental properties, including:
- Rent payments
- Advance rent payments
- Lease cancellation fees
- Tenant-paid expenses
One source of income you don’t have to report is the security deposit you require at move-in. As long as you return it when your tenants move out, it’s considered a deposit, not income. Depending on state law, though, you may be required to put the money in an interest-bearing account and possibly even notify tenants of the financial institution where that account is located.
Rental Property Income on Taxes
Each year that you own one or more rental properties, you’ll claim the income you made from those properties on your taxes. You’ll do this on Schedule E, Part 1. On Line 3, you’ll be asked to list the rent payments you received in the column that correlates to the rental property you’ve listed in the numbered columns above.
You’re only given space to list three rental properties, and you’ll have to list the location and property type of each one. If you own more than three, you simply use as many Schedule E forms as necessary to include them all, then include all Schedule E forms with your tax return. On the additional Schedule E forms, you’ll only need to complete Lines 23a to 26, then combine them with your totals from the first Schedule E to get your full rental income for the year.
Rental Property Losses on Taxes
Since you’re claiming rental income, it stands to reason you can also claim your losses to offset your tax burden, as you would with any business. Your income will go on Line 17 of 1040 Schedule 1, which pulls over the calculations you made on Schedule E. All of your expenses relating to your rental properties will go on Schedule E, which breaks out your losses by category.
Once you’ve totaled your income for Line 17 1040 on Line 3 and your expenses on Line 20, you’ll subtract Line 20 from Line 3. If the result is that you operated at a loss for the tax year, you’ll need to carry the amount over to a future year using Form 8582.
Offsetting Rental Income
One thing you’ll need to know if you have more losses than income during the tax year is that you can’t claim rental losses against non-rental income. Rental income and losses are considered “passive.” Whereas active income comes from working a minimum number of hours at a job each year, passive income, and therefore losses, come to you without your having to “materially participate” in making it happen.
The good news is that you won’t lose those extra deductions. If you had $50,000 in rental income losses this year but made only $25,000, for instance, you can hold that excess over until a future year, when your income increases. The losses you can’t use are “suspended losses,” which means you can’t claim them until you have sufficient income to claim them against or you sell the property.
Passive Loss Rule Exceptions
For some real estate professionals, rental property counts as active income since they actively participate in the business of managing their properties. A landlord who handles rentals by profession, for example, might qualify for this exception. To meet this qualification, though, either you or your spouse has to participate in real property business-related activities for more than half of your total working hours during the tax year.
If you own more than one property, though, things get a little more complicated. Under IRS requirements, you must materially participate in each rental property every year. As an alternative, you can file an election with the IRS to let you treat all of your rental properties as one for the purposes of measuring your active participation.
Even if you aren’t a real estate professional, though, you still may qualify for an exception. Those who make $100,000 or less may be able to use the $25,000 annual rental loss allowance, which allows you to take that amount in losses each year. That allowance begins to phase out once your adjusted gross income exceeds $100,000, going away completely when your income tops $150,000.
Property Sale Losses and Gains
Eventually, the day will come when you sell your rental property. When that happens, hopefully, you’ll earn money on the sale. Those earnings will be taxable as capital gains, which is a good thing because capital gains are taxed at a lower rate than ordinary income.
Losses, on the other hand, serve as deductions. Unlike rental losses, this type of deduction can be claimed against your ordinary income. This type of deduction is only available on rental property you own and sell, not your primary residence. You can convert your primary residence to a rental property, but the IRS won’t let you do that if you convert it just before you sell.
Deducting Property Sale Losses
To get started deducting the loss from your rental property sale, you first need to calculate its tax basis. To do this, jot down your original purchase amount. If you’ve renovated it or added to it without previously deducting that cost on your taxes, add those expenses to your purchase amount. This is your tax basis.
To get your total loss amount, you’ll subtract the amount your property sold for from that tax basis. So, if you bought your rental at $300,000 and made $10,000 in upgrades, you’ll have a tax basis of $310,000. But if you could only sell it for $200,000, you took a $110,000 loss on the property, which could be tax deductible.
Qualifying Deductions on Rental Property
In order to claim rental property losses on taxes, though, you need to know exactly what you’re allowed to claim. The expenses that can be the hardest to track are the ones that really add up over the course of the year: ordinary and necessary expenses. They include:
- Property taxes
- Advertising and marketing costs
- Property maintenance
- Homeowners association fees
In addition to those costs, you can also deduct costs associated with maintaining your property, including all materials and supplies. If the tenant does these repairs and you pay for them, you can still deduct them as long as they qualify. You can also deduct them from rent, as long as you calculate the fair market value of those repairs first.
There is a restriction on repairs if they are considered improvements, though. There can be a fine line, but the IRS considers improvements something that adapts a space to a new or different use. You can recover those costs, as well, but you do this through depreciation.
Depreciation on Rental Property
When you purchase a rental home or make improvements to it, the IRS lets you depreciate the expense over the entire useful life of that property. This is an alternative to taking the entire loss at once, in a tax year when you likely wouldn’t have the income to cover that loss. You cannot depreciate land, and you can’t use depreciation if you purchase and sell a property in the same tax year.
Depreciation does not begin when you make the purchase or improvements. Its official start time is when you first put it in service as a rental. Even if you can’t get a renter for a couple of months, depreciation begins when you first officially listed it for sale. If you make improvements between renters, you can continue to enjoy previous depreciation, even if nobody is staying there at the time.
Ending Depreciation With a Rental
Once you’ve depreciated an expense, it will continue to show up on your tax return each year until you’ve deducted the entire cost. If you sell the property to someone else, you’ll also lose your depreciation. Worse, you may find that you’re taxed on some of the depreciation you took previously in the property through something called rental property depreciation recapture.
To determine your depreciation recapture amount, you’ll start by determining your adjusted cost basis, which is the cost of the property after the depreciation has been subtracted from its value. If the amount you sell it for exceeds the adjusted cost basis, you may owe capital gains tax on the difference.
Personal Use of Rental Property
If you own a lovely cabin in the mountains or a quaint cottage on the beach, you probably occasionally want to stay there. You may even want to spend part of the year there. By renting it during the months you aren’t there, you can make a little money while treating it as a home away from home.
This type of use can hurt the deductibility of the money you spend on that property, though. You’ll be considered to be using your rental property as a residence if you use it for the greater of the following:
- 14 days during the tax year
- 10 percent of the total days you rented it to others at a fair rate during the tax year
It’s also important to note that you aren’t the only one who can trigger that “personal use” definition. If you allow relatives to stay there or you swap rentals with someone else in trade, the days the rental is used for those purposes are also considered personal days. If they exceed the maximum allowed, you won’t be able to take deductions on it.
Vacant Rental Units
If you occasionally rent out a home you use as a residence during the tax year, you’ll need to rent it for at least 15 days of the year. If you don’t, you simply won’t claim the rent you make or any expenses you have associated with it.
Rental property owners who live in the home part of the year and rent it the other part, though, will need to do some careful calculating. In this case, you’ll simply divide your expenses between the number of days you rented versus the number of days it fell under the “personal use” classification. This will give you the itemized deductions you need for your taxes.
- IRS.gov: Know the Tax Facts About Renting out Residential Property
- LegalNature: Are Landlords Required to Keep Security Deposits in Interest-Bearing Accounts?
- IRS.gov: 2018 Instructions for Schedule E (Form 1040) (2018)
- NOLO: Can You Deduct Your Rental Losses?
- NOLO: Tax Deduction If Selling Rental Property at a Loss
- IRS.gov: Supplemental Income and Loss
- FitSmallBusiness: Rental Property Depreciation: Rules, Schedule & Recapture
- IRS.gov: Topic Number 415 - Renting Residential and Vacation Property
Stephanie Faris has written about finance for entrepreneurs and marketing firms since 2013. She spent nearly a year as a ghostwriter for a credit card processing service and has ghostwritten about finance for numerous marketing firms and entrepreneurs. Her work has appeared on The Motley Fool, MoneyGeek, Ecommerce Insiders, GoBankingRates, and ThriveBy30.