Report rental income on your return for the year you actually or constructively receive it, if you are a cash basis taxpayer. You are a cash basis taxpayer if you report income in the year you receive it, regardless of when it was earned. You constructively receive income when it is made available to you, for example, by being credited to your bank account.

For more information about when you constructively receive income, see Accounting Methods in chapter 1.

Advance rent is any amount you receive before the period that it covers. Include advance rent in your rental income in the year you receive it regardless of the period covered or the method of accounting you use.

Do not include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease. But if you keep part or all of the security deposit during any year because your tenant does not live up to the terms of the lease, include the amount you keep in your income for that year.

If an amount called a security deposit is to be used as a final payment of rent, it is advance rent. Include it in your income when you receive it.

If your tenant pays you to cancel a lease, the amount you receive is rent. Include the payment in your income in the year you receive it regardless of your method of accounting.

If your tenant pays any of your expenses, the payments are rental income. You must include them in your income. You can deduct the expenses if they are deductible rental expenses. See Rental Expenses, later, for more information.

If you receive property or services, instead of money, as rent, include the fair market value of the property or services in your rental income.

If the services are provided at an agreed upon or specified price, that price is the fair market value unless there is evidence to the contrary.

If you rent property that you also use as your home and you rent it fewer than 15 days during the tax year, do not include the rent you receive in your income and do not deduct rental expenses. However, you can deduct on Schedule A (Form 1040) the interest, taxes, and casualty and theft losses that are allowed for nonrental property. See Personal Use of Dwelling Unit (Including Vacation Home), later.

If you own a part interest in rental property, you must report your part of the rental income from the property.

You generally deduct your rental expenses in the year you pay them.

If you hold property for rental purposes, you may be able to deduct your ordinary and necessary expenses (including depreciation) for managing, conserving, or maintaining the property while the property is vacant. However, you cannot deduct any loss of rental income for the period the property is vacant.

You can deduct your ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent.

You can begin to depreciate rental property when it is ready and available for rent. See Placed-in-Service Date under Depreciation, later.

If you sell property you held for rental purposes, you can deduct the ordinary and necessary expenses for managing, conserving, or maintaining the property until it is sold.

If you sometimes use your rental property for personal purposes, you must divide your expenses between rental and personal use. Also, your rental expense deductions may be limited. See Personal Use of Dwelling Unit (Including Vacation Home), later.

If you own a part interest in rental property, you can deduct your part of the expenses that you paid.

A repair keeps your property in good operating condition. It does not materially add to the value of your property or substantially prolong its life. Repainting your property inside or out, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows are examples of repairs.

If you make repairs as part of an extensive remodeling or restoration of your property, the whole job is an improvement.

An improvement adds to the value of your property, prolongs its useful life, or adapts it to new uses. Improvements include the following items.

If you make an improvement to property, the cost of the improvement must be capitalized. The capitalized cost can generally be depreciated as if the improvement were separate property.

You can deduct the rent you pay for property that you use for rental purposes. If you buy a leasehold for rental purposes, you can deduct an equal part of the cost each year over the term of the lease.

You can deduct the rent you pay for equipment that you use for rental purposes. However, in some cases, lease contracts are actually purchase contracts. If so, you cannot deduct these payments. You can recover the cost of purchased equipment through depreciation.

If you pay an insurance premium for more than one year in advance, each year you can deduct the part of the premium payment that will apply to that year. You cannot deduct the total premium in the year you pay it.

Generally, you cannot deduct charges for local benefits that increase the value of your property, such as charges for putting in streets, sidewalks, or water and sewer systems. These charges are nondepreciable capital expenditures. You must add them to the basis of your property. You can deduct local benefit taxes if they are for maintaining, repairing, or paying interest charges for the benefits.

You can deduct the ordinary and necessary expenses of traveling away from home if the primary purpose of the trip was to collect rental income or to manage, conserve, or maintain your rental property. You must properly allocate your expenses between rental and nonrental activities. For information on travel expenses, see chapter 28.

To deduct travel expenses, you must keep records that follow the rules in chapter 28.

You can deduct your ordinary and necessary local transportation expenses if you incur them to collect rental income or to manage, conserve, or maintain your rental property.

Generally, if you use your personal car, pickup truck, or light van for rental activities, you can deduct the expenses using one of two methods: actual expenses or the standard mileage rate. For 2003, the standard mileage rate for all business miles is 36 cents a mile. For more information, see chapter 28.

To deduct car expenses under either method, you must keep records that follow the rules in chapter 28. In addition, you must complete Part V of Form 4562 and attach it to your tax return.

You can deduct, as a rental expense, the part of the tax return preparation fees you paid to prepare Part I of Schedule E (Form 1040). You can also deduct, as a rental expense, any portion of the total expense you paid to resolve a tax underpayment related to your rental activities. On your 2003 Schedule E, you can deduct fees paid in 2003 to prepare Part I of your 2002 Schedule E.

Report your not-for-profit rental income on line 21, Form 1040. You can include your mortgage interest (if you use the property as your main home or second home), real estate taxes, and casualty losses on the appropriate lines of Schedule A (Form 1040), Itemized Deductions, if you itemize your deductions.

Claim your other rental expenses, subject to the rules explained in chapter 1 of Publication 535, as miscellaneous itemized deductions on line 22 of Schedule A (Form 1040). You can deduct these expenses only if they, together with certain other miscellaneous itemized deductions, total more than 2% of your adjusted gross income.

If an expense is for both rental use and personal use, such as mortgage interest or heat for the entire house, you must divide the expense between the rental use and the personal use. You can use any reasonable method for dividing the expense. It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them. However, the two most common methods for dividing an expense are one based on the number of rooms in your home and one based on the square footage of your home.

If you use the dwelling unit as a home and you rent it fewer than 15 days during the year, do not include any of the rent in your income and do not deduct any of the rental expenses. See Dwelling Unit Used as Home, later.

A dwelling unit includes a house, apartment, condominium, mobile home, boat, vacation home, or similar property. A dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities. A dwelling unit does not include property used solely as a hotel, motel, inn, or similar establishment.

Property is used solely as a hotel, motel, inn, or similar establishment if it is regularly available for occupancy by paying customers and is not used by an owner as a home during the year.

A fair rental price for your property generally is an amount that a person who is not related to you would be willing to pay. The rent you charge is not a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property.

If the other person or member of the family in (1) or (2) above has more than one home, his or her main home is ordinarily the one lived in most of the time.

This is an agreement under which two or more persons acquire undivided interests for more than 50 years in an entire dwelling unit, including the land, and one or more of the co-owners is entitled to occupy the unit as his or her main home upon payment of rent to the other co-owner or owners.

You use a dwelling unit for personal purposes if:

If you use a dwelling unit as a home and you rent it fewer than 15 days during the year, do not include any rental income in your income. Also, you cannot deduct any expenses as rental expenses.

If you use a dwelling unit as a home and rent it 15 days or more during the year, you include all your rental income in your income. See How To Report Rental Income and Expenses, later. If you had a net profit from the rental property for the year (that is, if your rental income is more than the total of your rental expenses, including depreciation), deduct all of your rental expenses. However, if you had a net loss, you may not be able to deduct all of your rental expenses.

Use Worksheet 10–1 to figure your deductible expenses.

You should claim the correct amount of depreciation each tax year. Even if you did not claim depreciation that you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted. If you did not deduct the correct amount of depreciation for property in any year, you may be able to make a correction for that year by filing Form 1040X Amended U.S Individual Income Tax Return. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Claiming the correct amount of depreciation in Publication 527 for more information.

If you claimed less depreciation than allowable in an earlier year, you can change your accounting method to take a deduction in the current year for the unclaimed depreciation. To change your accounting method, you must have the consent of the IRS. In some instances, you can receive automatic consent. For more information, see chapter 1 of Publication 946.

You can never depreciate the cost of land because land does not wear out, become obsolete, or get used up. The costs of clearing, grading, planting, and landscaping are usually all part of the cost of land and are not depreciable.

You cannot claim the section 179 deduction for property held to produce rental income. See chapter 2 of Publication 946.

The total of all your yearly depreciation deductions cannot be more than the cost or other basis of the property. For this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim, even if you did not claim it.

If you are a tenant-stockholder in a cooperative housing corporation and rent your cooperative apartment to others, you can deduct depreciation for the apartment even though it is owned by the corporation. Your depreciation deduction is your share of the corporation's depreciation. See Cooperative apartments in Publication 527 for information on how to figure your depreciation deduction.

To qualify for the special depreciation allowance, your property must meet the following requirements.

Generally, you must have acquired the property after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance).

Generally, the property must be placed in service for use in your trade or business or for the production of income after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance), and before January 1, 2005.

The original use of the property must have begun with you after September 10, 2001 (after May 5, 2003, to be eligible for the 50% special depreciation allowance). “Original use” means the first use to which the property is put, whether or not by you.

You must use MACRS to figure the depreciation on property you used as your home and changed to rental property in 2003.

You cannot use MACRS for certain personal property placed in service in your rental property in 2003 if it had been previously placed in service before MACRS became effective in 1987 (before August 1, 1986, if election made).

In addition, you may elect to exclude certain property from the application of MACRS. See Publication 946 for more information.

Treat depreciable additions or improvements you make to any property as separate property items for depreciation purposes. The recovery period for an addition or improvement to property begins on the later of:

The class and recovery period of the addition or improvement is the one that would apply to the original property if it were placed in service at the same time as the addition or improvement.

A mid-month convention is used for all residential rental property and nonresidential real property. Under this convention, you treat all property placed in service, or disposed of, during any month as placed in service, or disposed of, at the midpoint of that month.

A mid-quarter convention must be used if the mid-month convention does not apply and the total depreciable basis of MACRS property you placed in service in the last 3 months of a tax year (excluding nonresidential real property, residential rental property, and property placed in service and disposed of in the same year) is more than 40% of the total basis of all such property you place in service during the tax year.

The half-year convention is used if neither the mid-quarter convention nor the mid-month convention applies. Under this convention, you treat all property placed in service, or disposed of, during a tax year as placed in service, or disposed of, at the midpoint of that tax year.

If this convention applies, you deduct a half-year of depreciation for the first year and the last year that you depreciate the property. You deduct a full year of depreciation for any other year during the recovery period.

Table 10–1. MACRS Recovery Periods for Property Used in Rental Activities

The following section explains how to use the optional tables.

Figure the depreciation deduction by multiplying your unadjusted basis in the property by the percentage shown in the appropriate table. Your unadjusted basis is your depreciable basis without reduction for depreciation previously claimed.

Once you begin using an optional table to figure depreciation, you must continue to use it for the entire recovery period unless there is an adjustment to the basis of your property for a reason other than:

If there is an adjustment for any other reason (for example, because of a deductible casualty loss), you can no longer use the table. For the year of the adjustment and for the remaining recovery period, figure depreciation using the property's adjusted basis at the end of the year and the appropriate depreciation method, as explained in MACRS Depreciation Under GDS in Publication 527.

The percentages in these tables take into account the half-year and mid-quarter conventions. Use Table 10–2–A for 5-year property, Table 10–2–B for 7-year property, and Table 10–2–C for 15-year property. Use the percentage in the second column (half-year convention) unless you must use the mid-quarter convention (explained earlier). If you must use the mid-quarter convention, use the column that corresponds to the calendar year quarter in which you placed the property in service.

Use this table for residential rental property. Find the row for the month that you placed the property in service. Use the percentages listed for that month to figure your depreciation deduction. The mid-month convention is taken into account in the percentages shown in the table.

For property placed in service during 2003, you choose to use ADS by entering the depreciation on line 20, Part III of Form 4562.

The election of ADS for one item in a class of property generally applies to all property in that class that is placed in service during the tax year of the election. However, the election applies on a property-by-property basis for residential rental property and nonresidential real property.

Once you choose to use ADS, you cannot change your election.

If you dispose of depreciable property at a gain, you may have to report, as ordinary income, all or part of the gain. See Publication 544, Sales and Other Dispositions of Assets.

If you use accelerated depreciation, you may have to file Form 6251. Accelerated depreciation includes MACRS, ACRS, and any other method that allows you to deduct more depreciation than you could deduct using a straight line method.

If your rental losses are less than $25,000 and you actively participated in the rental activity, the passive activity limits probably do not apply to you. See Losses From Rental Real Estate Activities, later.

If you used the rental property as a home during the year, the passive activity rules do not apply to that home. Instead, you must follow the rules explained earlier under Personal Use of Dwelling Unit (Including Vacation Home.)

Deductions for losses from passive activities are limited. You generally cannot offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities. Any excess loss or credit is carried forward to the next tax year.

For a detailed discussion of these rules, see Publication 925.

You may have to complete Form 8582 to figure the amount of any passive activity loss for the current tax year for all activities and the amount of the passive activity loss allowed on your tax return.

Rental activities in which you materially participated during the year are not passive activities if, for that year, you were a real estate professional because you met the requirements. For a detailed discussion of the requirements, see Publication 527. For a detailed discussion of material participation, see Publication 925.

You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions in a significant and bona fide sense. Management decisions include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

See Publication 925 for more information on the passive loss limits, including information on the treatment of unused disallowed passive losses and credits and the treatment of gains and losses realized on the disposition of a passive activity.

If you paid $600 or more of mortgage interest on your rental property to any one person, you should receive a Form 1098, Mortgage Interest Statement, or similar statement showing the interest you paid for the year. If you and at least one other person (other than your spouse if you file a joint return) were liable for, and paid interest on the mortgage, and the other person received the Form 1098, report your share of the interest on line 13 of Schedule E (Form 1040). Attach a statement to your return showing the name and address of the other person. In the left margin of Schedule E (Form 1040), next to line 13, write “See attached.”