Generally, cash or the fair market value of property you receive for the use of real estate or personal property is taxable to you as rental income. Income and expenses related to real estate rentals are usually reported on Schedule E (Form 1040). Income and expenses related to personal property rentals are reported on Schedule C or C-EZ (Form 1040) if you are in the business of renting personal property.

Most individuals operate on a cash basis, which means that they count their rental income as income when it is actually received and deduct their expenses as they are paid. If you are a cash basis taxpayer you cannot deduct uncollected rents as a loss because you have not included those rents in income. If a tenant pays you to cancel a lease, this money is also rental income and is reported in the year you receive it. Do not include a security deposit in your income if you plan to return it to the tenant at the end of the lease. If you keep part or all of the security deposit because the tenant damaged the property or did not live up to the terms of the lease, this money is taxable income in the year this determination is made. If the security deposit is to be used as the tenant's final month's rent, then it is included in income when you receive it.

Some examples of expenses that may be deducted from your total rental income are depreciation, repairs, and operating expenses. You recover both your original investment in the rental property and the cost of later improvements through depreciation. The year your rental property is first placed in service and any year you make an improvement, you must use Form 4562, Depreciation and Amatorization, to report depreciation.

The cost of repairs may be deducted in full in the year you paid. If you repair something on your rental property yourself, you may not deduct the value of your own labor. Only out-of-pocket costs, such as materials, are deductible. For a discussion of the difference between repairs and improvements, see Publication 527, Residential Rental Property. Other expenses you may deduct include advertising, fire and liability insurance, taxes, interest, and commissions for the collection of rent.

If you rent only a part of your property, you must divide the expenses between the part used for rental purposes and the part used for personal purposes. You may use any reasonable method for dividing the expenses, but a method based on square footage is usually the most accurate.

There are special rules relating to rental income from vacation property and property rented at less than fair market value. For information on income from vacation property rentals, refer to Topic 415.

Passive activity rules may limit the amount of a loss you can deduct each year on rental property. For information on these limitations, refer to Topic 425, Passive Activities - Losses and Credits.

For more information on rental income and expenses, including passive activity loss limits, see Publication 527.

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