Important Change
Special depreciation allowance. You can claim a special depreciation allowance for qualified property you placed in service in 2002. The allowance is a depreciation deduction equal to 30% of the property's depreciable basis.
Qualified property includes property depreciated under the modified accelerated cost recovery system (MACRS) with a recovery period of 20 years or less. See Special Depreciation Allowance under Depreciation later, for more information.
Important Reminder
Photographs of missing children. The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843- 5678) if you recognize a child.
Introduction
This publication discusses rental income and expenses, including depreciation, and explains how to report them on your return. It also covers casualty losses on rental property and the passive activity and at-risk rules.
Sale of rental property. For information on how to figure and report any gain or loss from the sale or other disposition of your rental property, get Publication 544, Sales and Other Dispositions of Assets.
Sale of main home used as rental property. For information on how to figure and report any gain or loss from the sale or other disposition of your main home that you also used as rental property, get Publication 523, Selling Your Home.
Comments and suggestions. We welcome your comments about this publication and your suggestions for future editions.
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Useful Items You may want to see:
Publication
- 463 Travel, Entertainment, Gift, and Car Expenses
- 534 Depreciating Property Placed in Service Before 1987
- 535 Business Expenses
- 547 Casualties, Disasters, and Thefts
- 551 Basis of Assets
- 925 Passive Activity and At-Risk Rules
- 946 How To Depreciate Property
Form (and Instructions)
- 4562 Depreciation and Amortization
- 5213 Election To Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for Profit
- 8582 Passive Activity Loss Limitations
- Schedule E (Form 1040) Supplemental Income and Loss
See How To Get Tax Help at the end of this publication for information about getting these publications and forms.
Rental Income
You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. In addition to amounts you receive as normal rent payments, there are other amounts, discussed later, that may be rental income.
When to report. 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 Publication 538, Accounting Periods and Methods.
Advance rent. 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.
Example. You sign a 10-year lease to rent your property. In the first year, you receive $5,000 for the first year's rent and $5,000 as rent for the last year of the lease. You must include $10,000 in your income in the first year.
Security deposits. 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 in 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.
Payment for canceling a lease. 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.
Expenses paid by tenant. 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.
Example 1. Your tenant pays the water and sewage bill for your rental property and deducts it from the normal rent payment. Under the terms of the lease, your tenant does not have to pay this bill.
Example 2. While you are out of town, the furnace in your rental property stops working. Your tenant pays for the necessary repairs and deducts the repair bill from the rent payment.
Based on the facts in each example, include in your rental income both the rent payment received from the tenant and the amount the tenant paid for the utility bills and the repairs. You can deduct the cost of the utility bills and repairs as rental expenses.
Property or services. 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.
Example. Your tenant is a painter. He offers to paint your rental property instead of paying 2 months' rent. You accept his offer.
Include in your rental income the amount the tenant would have paid for 2 months' rent. You can deduct that same amount as a rental expense for painting your property.
Lease with option to buy. If the rental agreement gives the tenant the right to buy your rental property, the payments you receive under the agreement are generally rental income. If your tenant exercises the right to buy the property, the payments you receive for the period after the date of sale are considered part of the selling price.
Rental of property also used as a home. 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.
Part interest. If you own a part interest in rental property, you must report your part of the rental income from the property.
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.
Table 1. Examples of Improvements
| |
Caution: Work you do (or have done) on your home that does not add much to either the value or the life of the property, but rather keeps the property in good condition, is considered a repair, not an improvement. |
| Additions Bedroom Bathroom Deck Garage Porch Patio Lawn & Grounds Landscaping Driveway Walkway Fence Retaining wall Sprinkler system Swimming pool Miscellaneous Storm windows, doors New roof Central vacuum Wiring upgrades Satellite dish Security system |
Heating & Air Conditioning Heating system Central air conditioning Furnace Duct work Central humidifier Filtration system Plumbing Septic system Water heater Soft water system Filtration system Interior Improvements Built-in appliances Kitchen modernization Flooring Wall-to-wall carpeting Insulation Attic Walls, floor Pipes, duct work |
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. The OID is de minimis if it is less than one-fourth of 1% (.0025) of the stated redemption price at maturity 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.
- On a constant-yield basis over the term of the loan.
- On a straight line basis over the term of the loan.
- In proportion to stated interest payments.
- In its entirety 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 is issued.
Example of de minimis amount. On January 1, 2002, you took out a loan for $100,000. The loan matures on January 1, 2012 (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, 2003. 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.
| Redemption price at maturity (principal amount of the loan) |
$100,000 |
| Multiplied by: The term of the loan in complete years |
× 10 |
| Multiplied by |
× .0025 |
| De minimis amount |
$ 2,500 |
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.
- Determine the issue price of the loan. Generally, this equals the proceeds of the loan. If you paid points on the loan, the issue price generally is the difference between the proceeds and the points.
- Multiply the result in (1) by the yield to maturity.
- Subtract any qualified stated interest payments from the result in (2). This is the 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) is stated interest that is unconditionally payable in cash or property (other than another loan of the issuer) at least annually over the term of the loan 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 2002 as follows.
| Principal amount of the loan |
$100,000 |
| Minus: Points |
1,500 |
| Issue price of the loan |
$ 98,500 |
| Multiplied by: YTM |
× .102467 |
| Total |
10,093 |
| Minus: QSI |
10,000 |
| Points (OID) deductible in 2002 |
$ 93 |
You figure the deduction for 2003 as follows.
| Issue price |
$98,500 |
| Plus: Points (OID) deducted in 2002 |
93 |
| Adjusted issue price |
$98,593 |
| Multiplied by: YTM |
× .102467 |
| Total |
10,103 |
| Minus: QSI |
10,000 |
| Points (OID) deductible in 2003 |
$ 103 |
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 2002 the standard mileage rate for all business miles is 36½ 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 2002 Schedule E you can deduct fees paid in 2002 to prepare Part I of your 2001 Schedule E. You can also deduct, as a rental expense, any expense you paid to resolve a tax underpayment related to your rental activities.
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