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 that may be rental income.

This part discusses repairs and certain other 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 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.

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. Improvements include the following items.

• Putting a recreation room in an unfinished basement.

• Paneling a den.

• Adding a bathroom or bedroom.

• Putting decorative grillwork on a balcony.

• Putting up a fence.

• Putting in new plumbing or wiring.

• Putting in new cabinets.

• Putting on a new roof.

• Paving a driveway.

   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.

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 28.

  

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

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 2004, the standard mileage rate for all business miles is 37½ 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 Form 4562, Part V, and attach it to your tax return.

Tax return preparation.   You can deduct, as a rental expense, the part of the tax return preparation fees you paid to prepare of Schedule E (Form 1040), Part 1. You can also deduct, as a rental expense, any expense you paid to resolve a tax underpayment related to your rental activities. On your 2004 Schedule E, you can deduct fees paid in 2004 to prepare your 2003 Schedule E, Part I.

If you do not rent your property to make a profit, you can deduct your rental expenses only up to the amount of your rental income. You cannot carry forward to the next year any rental expenses that are more than your rental income for the year. For more information about the rules for an activity not engaged in for profit, see chapter 1 of Publication 535.

If you change your home or other property, (or a part of it), to rental use at any time other than at the beginning of your tax year, you must divide yearly expenses, such as taxes and insurance, between rental use and personal use.

You can deduct as rental expenses only the part of the expense that is for the part of the year the property was used or held for rental purposes.

For depreciation purposes, treat the property as being placed in service on the conversion date.

You cannot deduct depreciation or insurance for the part of the year the property was held for personal use. However, you can include the home mortgage interest and real estate tax expenses for the part of the year the property was held for personal use as an itemized deduction on Schedule A (Form 1040).

If you rent part of your property, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes, as though you actually had two separate pieces of property.

You can deduct the expenses related to the part of the property used for rental purposes, such as home mortgage interest and real estate taxes, as rental expenses on Schedule E (Form 1040). You can also deduct as a rental expense a part of other expenses that normally are nondeductible personal expenses, such as expenses for electricity or painting the outside of your house.

You can deduct the expenses for the part of the property used for personal purposes, subject to certain limitations, only if you itemize your deductions on Schedule A (Form 1040).

You cannot deduct any part of the cost of the first phone line even if your tenants have unlimited use of it.

You do not have to divide the expenses that belong only to the rental part of your property. For example, if you paint a room that you rent, or if you pay premiums for liability insurance in connection with renting a room in your home, your entire cost is a rental expense. If you install a second phone line strictly for your tenants' use, all of the cost of the second line is deductible as a rental expense. You can deduct depreciation, discussed later, on the part of the property used for rental purposes as well as on the furniture and equipment you use for rental purposes.

If you have any personal use of a dwelling unit (including a vacation home) that you rent, you must divide your expenses between rental use and personal use. See Figuring Days of Personal Use and How To Divide Expenses, later.

If you used your dwelling unit for personal purposes, it may be considered a “dwelling unit used as a home.” If it is, you cannot deduct rental expenses that are more than your rental income for the unit. See Dwelling Unit Used as Home and How To Figure Rental Income and Deductions, later. If your dwelling unit is not considered a dwelling unit used as a home, you can deduct rental expenses that are more than rental income for the unit subject to certain limits. See Limits on Rental Losses, later.

You recover your cost in income producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of your cost on your tax return each year.

Three basic factors determine how much depreciation you can deduct. They are: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures and equipment, as an expense.

You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

You may have to use Form 4562 to figure and report your depreciation. See How To Report Rental Income and Expenses, later.

Depreciation Methods

There are three ways to figure depreciation. The depreciation method you use depends on the type of property and when it was placed in service. For property used in rental activities you use one of the following.

• MACRS (Modified Accelerated Cost Recovery System) for property placed in service after 1986.

• ACRS (Accelerated Cost Recovery System) for property placed in service after 1980 but before 1987.

• Useful lives and either straight line or an accelerated method of depreciation, such as the declining balance method, for property placed in service before 1981.

This chapter discusses MACRS only. If you need more information about depreciating property placed in service before 1987, see Publication 534.

If you placed property in service before 2004, continue to use the same method of figuring depreciation that you used in the past.

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

No deduction greater than basis.   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.

Cooperative apartments.   If you are a tenant-stockholder in a cooperative housing corporation and rent your cooperative apartment to others, you can deduct depreciation for your stock in 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.

MACRS

Most business and investment property placed in service after 1986 is depreciated using MACRS.

MACRS consists of two systems that determine how you depreciate your property—the General Depreciation System (GDS) and the Alternative Depreciation System (ADS). GDS is used to figure your depreciation deduction for property used in most rental activities, unless you elect ADS.

To figure your MACRS deduction, you need to know the following information about your property:

• Its recovery period,

• Its placed-in-service date, and

• Its depreciable basis.

Personal home changed to rental use.   You must use MACRS to figure the depreciation on property you used as your home and changed to rental property in 2004.

Excluded property.   You cannot use MACRS for certain personal property placed in service in your rental property in 2004 if it had been previously placed in service before MACRS became effective.

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

Recovery Periods Under GDS

Each item of property that can be depreciated is assigned to a property class. The recovery period of the property depends on the class the property is in. Under GDS, the recovery period of an asset is generally the same as its property class. The property classes under GDS are:

• 3-year property,

• 5-year property,

• 7-year property,

• 10-year property,

• 15-year property,

• 20-year property,

• Nonresidential real property, and

• Residential rental property.

Recovery periods for property used in rental activities are shown in Table 10-1.

The class to which property is assigned is determined by its class life. Class lives and recovery periods for most assets are listed in Appendix B in Publication 946.

Additions or improvements to property.   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 date the addition or improvement is placed in service, or

• The date the property to which the addition or improvement was made is placed in service.

  The property 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.

Example.

You own a residential rental house that you have been renting since 1986 and that you are depreciating under ACRS. You put an addition onto the house and you placed it in service in 2004. You must use MACRS for the addition. Under GDS, the addition is depreciated as residential rental property over 27.5 years.

Placed-in-Service Date

You can begin to depreciate property when you place it in service in your trade or business or for the production of income. Property is considered placed in service in a rental activity when it is ready and available for a specific use in that activity.

Depreciable Basis

To deduct the proper amount of depreciation each year, you must first determine your basis in the property you intend to depreciate. The basis used for figuring depreciation is your original basis in the property increased by any additions or improvements made to the property. Your original basis is usually your cost. However, if you acquire the property in some other way, such as by inheriting it, getting it as a gift, or building it yourself, you may have to figure your original basis in another way. Other adjustments could also affect your basis. See chapter 14.

Conventions

Under MACRS, conventions establish when the recovery period begins and ends. The convention you use determines the number of months for which you can claim depreciation in the year you place property in service and in the year you dispose of the property.

Mid-month convention.    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.

Mid-quarter convention.   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.

Half-year convention.   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

	MACRS Recovery Period
Type of Property	General Depreciation System	Alternative Depreciation System
Computers and their peripheral equipment	5 years	5 years
Office machinery, such as: Typewriters Calculators Copiers	5 years	6 years
Automobiles	5 years	5 years
Light trucks	5 years	5 years
Appliances, such as: Stoves Refrigerators	5 years	9 years
Carpets	5 years	9 years
Furniture used in rental property	5 years	9 years
Office furniture and equipment, such as: Desks Files	7 years	10 years
Any property that does not have a class life and that has not been designated by law as being in any other class	7 years	12 years
Roads	15 years	20 years
Shrubbery	15 years	20 years
Fences	15 years	20 years
Residential rental property (buildings or structures) and structural components such as furnaces, water pipes, venting, etc.,	27.5 years	40 years
Additions and improvements, such as a new roof	The same recovery period as that of the property to which the addition or improvement is made, determined as if the property were placed in service at the same time as the addition or improvement.

  Under this convention, you treat all property placed in service, or disposed of, during any quarter of a tax year as placed in service, or disposed of, at the midpoint of the quarter.

Example.

During the tax year, Jordan Gregory purchased the following items to use in his rental property. He elects not to claim the special depreciation allowance, discussed earlier.

• A dishwasher for $400, that he placed in service in January.

• Used furniture for $100, that he placed in service in September.

• A refrigerator for $500, that he placed in service in October.

Jordan uses the calendar year as his tax year. The total basis of all property placed in service in that year is $1,000. The $500 basis of the refrigerator placed in service during the last 3 months of his tax year exceeds $400 (40% × $1,000). Jordan must use the mid-quarter convention instead of the half-year convention for all three items.

MACRS Depreciation Under GDS

You can figure your MACRS depreciation deduction under GDS in one of two ways. The deduction is substantially the same both ways. (The difference, if any, is slight.) You can either:

• Use the percentage from the optional MACRS tables, see Table 10-2, or

• Actually figure the deduction using the depreciation method and convention that apply over the recovery period of the property.

Publication 946 discusses computing depreciation using the proper method and convention.

Table 10-2. Optional MACRS Tables Table 10-2-A. MACRS 5-Year property

	Half-year convention	Mid-quarter convention
Year		First quarter	Second quarter	Third quarter	Fourth quarter
1 2 3 4 5 6	20.00% 32.00 19.20 11.52 11.52 5.76	35.00% 26.00 15.60 11.01 11.01 1.38	25.00% 30.00 18.00 11.37 11.37 4.26	15.00% 34.00 20.40 12.24 11.30 7.06	5.00% 38.00 22.80 13.68 10.94 9.58

Table 10-2-B. MACRS 7-Year property

	Half-year convention	Mid-quarter convention
Year		First quarter	Second quarter	Third quarter	Fourth quarter
1 2 3 4 5 6	14.29% 24.49 17.49 12.49 8.93 8.92	25.00% 21.43 15.31 10.93 8.75 8.74	17.85% 23.47 16.76 11.97 8.87 8.87	10.71% 25.51 18.22 13.02 9.30 8.85	3.57% 27.55 19.68 14.06 10.04 8.73

Table 10-2-C. MACRS 15-Year property

		Half-year convention		Mid-quarter convention
Year				First quarter		Second quarter		Third quarter		Forth quarter
1 2 3 4 5 6			5.00% 9.50 8.55 7.70 6.93 6.23		8.75% 9.13 8.21 7.39 6.65 5.99		6.25% 9.38 8.44 7.59 6.83 6.15		3.75% 9.63 8.66 7.80 7.02 6.31		1.25% 9.88 8.89 8.00 7.20 6.48

Table 10-2-D. Residential Rental Property (27.5-year)

		Use the row for the month of the taxable year placed in service.
		Year 1		Year 2		Year 3		Year 4		Year 5		Year 6
	Jan. Feb. Mar. Apr. May Jun. Jul. Aug. Sept. Oct. Nov. Dec.		3.485% 3.182 2.879 2.576 2.273 1.970 1.667 1.364 1.061 0.758 0.456 0.152		3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636		3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636		3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636		3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636		3.636% 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636 3.636

Using the Optional Tables

You can use the tables in Table 10-2 to compute annual depreciation under MACRS. The tables show the percentages for the first 6 years. The percentages in Tables 10-2-A, 10-2-B, and 10-2-C make the change from declining balance to straight line in the year that straight line will yield a larger deduction. See Appendix A of Publication 946 for complete tables.

If you elect to use the straight line method for 5-, 7-, or 15-year property, or the 150% declining balance method for 5- or 7-year property, use the tables in Appendix A of Publication 946.

Figure any special depreciation allowance on qualified property before using Table 10-2-A, 10-2-B, or 10-2-C, or the 5-, 7-, or 15-year property tables in Appendix A of Publication 946.

How to use the tables.   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 MACRS 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:

1. Depreciation allowed or allowable, or

2. An addition or improvement that is depreciated as a separate item of property.

If there is an adjustment for a reason other than (1) or (2) (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.

Tables 10-2-A, 10-2-B, and 10-2-C.   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.

Example 1.

You purchased a stove and refrigerator and placed them in service in June. Your basis in the stove is $600 and your basis in the refrigerator is $1,000. After figuring the 50% special depreciation allowance your basis in the stove is $300 and your basis in the refrigerator is $500. Both are 5-year property. Using the half-year convention column in Table 10-2-A, you find the depreciation percentage for year 1 is 20%. For that year, your depreciation deduction is $60 ($300 × .20) for the stove and $100 ($500 × .20) for the refrigerator.

For year 2, you find your depreciation percentage is 32%. That year's depreciation deduction will be $96 ($300 × .32) for the stove and $160 ($500 × .32) for the refrigerator.

Example 2.

Assume the same facts as in Example 1, except you buy the refrigerator in October instead of June. You must use the mid-quarter convention to figure depreciation on the stove and refrigerator. The refrigerator was placed in service in the last 3 months of the tax year and its basis ($1,000) is more than 40% of the total basis of all property placed in service during the year ($1,600 × .40 = $640).

Because you placed the refrigerator in service in October, you use the fourth quarter column of Table 10-2-A and find that the depreciation percentage for year 1 is 5%. Your depreciation deduction for the refrigerator (after figuring the special depreciation allowance) is $25 ($500 × .05).

Because you placed the stove in service in June, you use the second quarter column of Table 10-2-A and find that the depreciation percentage for year 1 is 25%. For that year, your depreciation deduction for the stove (after figuring the special depreciation allowance) is $75 ($300 × .25).

Table 10-2-D.   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.

Example.

You purchased a single family rental house and placed it in service in February. Your basis in the house is $160,000. Using Table 10-2-D, you find that the percentage for property placed in service in February of year 1 is 3.182%. That year's depreciation deduction is $5,091 ($160,000 × .03182).

MACRS Depreciation Under ADS

If you choose, you can use the ADS method for most property. Under ADS, you use the straight line method of depreciation.

Table 10-1 shows the recovery periods for property used in rental activities that you depreciate under ADS. See Appendix B in Publication 946 for other property. If your property is not listed, it is considered to have no class life. Under ADS, personal property with no class life is depreciated using a recovery period of 12 years.

Use the mid-month convention for residential rental property and nonresidential real property. For all other property, use the half-year or mid-quarter convention.

Election.   For property placed in service during 2004, you choose to use ADS by entering the depreciation on Form 4562, Part III, line 20.

  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.

Other Rules About Depreciable Property

In addition to the rules about what methods you can use, there are other rules you should be aware of with respect to depreciable property.

Gain from disposition.   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.

Alternative minimum tax.   If you use accelerated depreciation, you may have to file Form 6251. Accelerated depreciation can be determined under MACRS, ACRS, and any other method that allows you to deduct more depreciation than you could deduct using a straight line method.

Limits on Rental Losses

Rental real estate activities are generally considered passive activities, and the amount of loss you can deduct is limited. Generally, you cannot deduct losses from rental real estate activities unless you have income from other passive activities. However, you may be able to deduct rental losses without regard to whether you have income from other passive activities if you “materially” or “actively” participated in your rental activity. See Passive Activity Limits, later.

Losses from passive activities are first subject to the at-risk rules. At-risk rules limit the amount of deductible losses from holding most real property placed in service after 1986.

Exception.   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.

Property used as a home.   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.)

At-Risk Rules

The at-risk rules place a limit on the amount you can deduct as losses from activities often described as tax shelters. Losses from holding real property (other than mineral property) placed in service before 1987 are not subject to the at-risk rules.

Generally, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year. You are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity. See Publication 925 for more information.

Passive Activity Limits

In general, all rental activities (except those meeting the exception for real estate professionals, below) are passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services.

Limits on passive activity deductions and credits.    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.

Exception for real estate professionals.   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.

Losses From Rental Real Estate Activities

If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

If you are married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance cannot be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you cannot use the special allowance to reduce your nonpassive income or tax on nonpassive income.

The maximum amount of the special allowance is reduced if your modified adjusted gross income is more than $100,000 ($50,000 if married filing separately).

Active participation.   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.

More information.   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.

How To Report Rental Income and Expenses

If you rent buildings, rooms, or apartments, and provide only heat and light, trash collection, etc., you normally report your rental income and expenses on Form 1040, Schedule E, Part I. However, do not use that schedule to report a not-for-profit activity. See Not Rented for Profit, earlier.

If you provide significant services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C (Form 1040), Profit or Loss From Business or Schedule C-EZ, Net Profit From Business (Sole Proprietorship). Significant services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc. For information, see Publication 334, Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ). You also may have to pay self-employment tax on your rental income. See Publication 533, Self-Employment Tax.

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 Form 1040, Schedule E, line 13. 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, enter “See attached.”

Schedule E (Form 1040)

Use Form 1040, Schedule E, Part I, to report your rental income and expenses. List your total income, expenses, and depreciation for each rental property. Be sure to answer the question on line 2.

If you have more than three rental or royalty properties, complete and attach as many Schedules E as are needed to list the properties. Complete lines 1 and 2 for each property. However, fill in the “Totals” column on only one Schedule E. The figures in the “Totals” column on that Schedule E should be the combined totals of all Schedules E.

Schedule E, page 2, is used to report income or loss from partnerships, S corporations, estates, trusts, and real estate mortgage investment conduits. If you need to use Schedule E, page 2, use page 2 of the same Schedule E you used to enter the combined totals in Part I.

On Schedule E, page 1, line 20, enter the depreciation you are claiming. You must complete and attach Form 4562 for rental activities only if you are claiming:

• Depreciation on property placed in service during 2004,

• Depreciation on listed property (such as a car), regardless of when it was placed in service, or

• Any car expenses reported on a form other than Schedule C or C-EZ (Form 1040) or Form 2106 or Form 2106-EZ.

Otherwise, figure your depreciation on your own worksheet. You do not have to attach these computations to your return.

Example.

On January 1, Justin Cole bought a townhouse and placed it in service as residential rental property. He receives $1,100 a month rental income. His rental expenses for the year are as follows:

Fire insurance (1-year policy)	$ 200
Mortgage interest	5,000
Fee paid to real estate company for collecting monthly rent	572
General repairs	175
Real estate taxes imposed and paid	800

Justin's basis for depreciation of the townhouse is $150,000. He is using MACRS with a 27.5-year recovery period. On April 1, Justin bought a new refrigerator for the rental property at a cost of $725. He uses the MACRS method with a 5-year recovery period. The refrigerator qualifies for the special depreciation allowance which he figures first.

Justin uses the percentage for January in Table 10-2-D to figure his depreciation deduction for the townhouse. He uses the percentage under “Half-year convention” in Table 10-2-A to figure his depreciation deduction for the refrigerator. He must report the depreciation on Form 4562.

Justin figures his net rental income or loss for the townhouse as follows:

Total rental income received
($1,100 × 12)		$13,200
Minus Expenses:
Fire insurance (1-year policy)	200
Mortgage interest	5,000
Rent collection fee	572
General repairs	175
Real estate taxes	800
Total expenses		6,747
Balance		$6,453
Minus Depreciation:
Townhouse ($150,000 × 3.485%)	5,228
Refrigerator–special allowance ($725 × 50%)	363
Refrigerator ($725 – $363 (special allowance) × 20%)	72
Total depreciation		5,663
Net rental income for townhouse		$ 790

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