Rental Expenses

This part discusses expenses of renting property that you ordinarily can deduct from your rental income. It includes information on the expenses you can deduct if you rent a condominium or cooperative apartment, if you rent part of your property, or if you change your property to rental use. Depreciation, which you can also deduct from your rental income, is discussed later.

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

Vacant rental property. 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.

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

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

Expenses for rental property sold. 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.

Personal use of rental property. 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.

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

Repairs and Improvements

You can deduct the cost of repairs to your rental property. You cannot deduct the cost of improvements. You recover the cost of improvements by taking depreciation (explained later).

Separate the costs of repairs and improvements, and keep accurate records. You will need to know the cost of improvements when you sell or depreciate your property.

Repairs. 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.

Improvements. An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. Table 1 shows examples of many improvements.

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.

Other Expenses

Other expenses you can deduct from your rental income include advertising, cleaning and maintenance services, utilities, fire and liability insurance, taxes, interest, commissions for the collection of rent, ordinary and necessary travel and transportation, and other expenses discussed next.

Rental payments for 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.

Rental of equipment. 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.

Insurance premiums paid in advance. 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.

Local benefit taxes. 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.

Interest expense. You can deduct mortgage interest you pay on your rental property. Chapter 5 of Publication 535 explains mortgage interest in detail.

Expenses paid to obtain a mortgage. Certain expenses you pay to obtain a mortgage on your rental property cannot be deducted as interest. These expenses, which include mortgage commissions, abstract fees, and recording fees, are capital expenses. However, you can amortize them over the life of the mortgage.

Form 1098. 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, next to line 13, write "See attached."

Points. The term "points" is often used to describe some of the charges paid by a borrower when the borrower takes out a loan or a mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. If any of these charges (points) are solely for the use of money, they are interest.

Points paid when you take out a loan or mortgage result in original issue discount (OID). In general, the points (OID) are deductible as interest unless they must be capitalized. How you figure the amount of points (OID) you can deduct each year depends on whether or not your total OID, including the OID resulting from the points, is insignificant or de minimis. If the OID is not de minimis, you must use the constant-yield method to figure how much you can deduct.

De minimis OID. In general, the OID is de minimis if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity (generally, the principal amount of the loan) multiplied by the number of full years from the date of original issue to maturity (the term of the loan).

If the OID is de minimis, you can choose one of the following ways to figure the amount you can deduct each year.

1. On a constant-yield basis over the term of the loan.
2. On a straight line basis over the term of the loan.
3. In proportion to stated interest payments.
4. In full at maturity of the loan.

You make this choice by deducting the OID in a manner consistent with the method chosen on your timely filed tax return for the tax year in which the loan or mortgage is issued.

Example of de minimis amount. On January 1, 2001, you took out a loan for $100,000. The loan matures on January 1, 2011 (a 10-year term), and the stated principal amount of the loan ($100,000) is payable on that date. An interest payment of $10,000 is payable to the bank on January 2 of each year, beginning on January 2, 2002. When the loan was made, you paid $1,500 in points to the bank. The points reduced the issue price of the loan from $100,000 to $98,500, resulting in $1,500 of OID. You determine that the points (OID) you paid are de minimis based on the following computation.

The points (OID) you paid ($1,500) are less than the de minimis amount. Therefore, you have de minimis OID and you can choose one of the four ways discussed earlier to figure the amount you can deduct each year. Under the straight line method, you can deduct $150 each year for 10 years.

Constant-yield method. If the OID is not de minimis, you must use the constant-yield method to figure how much you can deduct each year.

You figure your deduction for the first year in the following manner.

1. Determine the issue price of the loan. For example, if you paid points on a loan, subtract the points you paid from the principal amount of the loan to get the issue price.
2. Multiply the issue price (the result in (1)) by the yield to maturity.
3. Subtract any qualified stated interest payments from the result in (2). This is the amount of OID you can deduct in the first year.

To figure your deduction in any subsequent years, you start with the adjusted issue price. To get the adjusted issue price, add to the issue price any OID previously deducted. Then follow steps (2) and (3) above.

The yield to maturity (YTM) is generally shown in the literature you receive from your lender. If you do not have this information, consult your lender or tax advisor. In general, the YTM is the discount rate that, when used in computing the present value of all principal and interest payments, produces an amount equal to the principal amount of the loan.

Qualified stated interest (QSI) generally is stated interest that is unconditionally payable in cash or property (other than debt instruments of the issuer) at least annually at a single fixed rate.

Example of constant yield. The facts are the same as in the previous example. The yield to maturity on your loan is 10.2467%, compounded annually.

You figure the amount of points (OID) you can deduct in 2001 as follows.

You figure the deduction for 2002 as follows.

Loan or mortgage ends. If your loan or mortgage ends, you may be able to deduct any remaining points (OID) in the tax year in which the loan or mortgage ends. A loan or mortgage may end due to a refinancing, prepayment, foreclosure, or similar event. However, if the refinancing is with the same lender, the remaining points (OID) generally are not deductible in the year in which the refinancing occurs, but may be deductible over the term of the new mortgage or loan.

Travel expenses. 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 1 of Publication 463.

To deduct travel expenses, you must keep records that follow the rules in chapter 5 of Publication 463.

Local transportation expenses. 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 2001 the standard mileage rate for all business miles is 34 1/2 cents a mile. For more information, see chapter 4 of Publication 463.

To deduct car expenses under either method, you must keep records that follow the rules in chapter 5 of Publication 463. In addition, you must complete Part V of Form 4562, and attach it to your tax return.

Tax return preparation. You can deduct, as a rental expense, the part of tax return preparation fees you paid to prepare Part I of Schedule E (Form 1040). For example, on your 2001 Schedule E you can deduct fees paid in 2001 to prepare Part I of your 2000 Schedule E. You can also deduct, as a rental expense, any expense you paid to resolve a tax underpayment related to your rental activities.

Condominiums and Cooperatives

If you rent out a condominium or a cooperative apartment, special rules apply. Condominiums are treated differently from cooperatives.

Condominium

If you own a condominium, you own a dwelling unit in a multi-unit building. You also own a share of the common elements of the structure, such as land, lobbies, elevators, and service areas. You and the other condominium owners may pay dues or assessments to a special corporation that is organized to take care of the common elements.

If you rent your condominium to others, you can deduct depreciation, repairs, upkeep, dues, interest and taxes, and assessments for the care of the common parts of the structure. You cannot deduct special assessments you pay to a condominium management corporation for improvements. But you may be able to recover your share of the cost of any improvement by taking depreciation.

Cooperative

If you have a cooperative apartment that you rent to others, you can usually deduct, as a rental expense, all the maintenance fees you pay to the cooperative housing corporation. However, you cannot deduct a payment earmarked for a capital asset or improvement, or otherwise charged to the corporation's capital account. For example, you cannot deduct a payment used to pave a community parking lot, install a new roof, or pay the principal of the corporation's mortgage. You must add the payment to the basis of your stock in the corporation.

Treat as a capital cost the amount you were assessed for capital items. This cannot be more than the amount by which your payments to the corporation exceeded your share of the corporation's mortgage interest and real estate taxes.

Your share of interest and taxes is the amount the corporation elected to allocate to you, if it reasonably reflects those expenses for your apartment. Otherwise, figure your share in the following way.

1. Divide the number of your shares of stock by the total number of shares outstanding, including any shares held by the corporation.
2. Multiply the corporation's deductible interest by the number you figured in (1). This is your share of the interest.
3. Multiply the corporation's deductible taxes by the number you figured in (1). This is your share of the taxes.

In addition to the maintenance fees paid to the cooperative housing corporation, you can deduct your direct payments for repairs, upkeep, and other rental expenses, including interest paid on a loan used to buy your stock in the corporation. The depreciation deduction allowed for cooperative apartments is discussed later.

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