Most Real Estate Investors find themselves as landlords at one time or another and it is vital to an investor’s financial success to understand the tax implications of the decision to rent a property before you rent. How you report and document your rental income can impact your taxes and affect you on an audit. As such, the following is a list of tax issues that (I believe as a tax preparer and tax attorney) investors who are thinking of renting a property should understand.

Rental Property Income. Generally, when you receive money from tenants this money should be included as rental income on your tax return. But remember you are allowed to lower your income from rental properties by subtracting the costs you incur getting your property ready to rent and the costs of maintaining it as a rental property.

Reporting Rental Property Income. Under the IRS Rules all rental income must be reported the year you receive the money.

First example: If a tenant gives you a deposit of $1,000 in December of 2010 for a lease that begins January 1, 2011, you must still report the 1,000 on the 2010 tax return.

Second example: If a tenant pre-pays 12 months rent in December of 2010, all of that pre-payment must be reported on the tax return in 2010.

Third example: If tenant gives you a pickup truck on January 1, 2010 worth $12,000 in exchange for 12 months rent with a lease term beginning on January 1, 2010. Under IRS rules, if you receive goods and/or services in exchange for rent from your tenant, you must value the goods and/or services at their fair market value / present worth and report that as income in the year received.

Fourth example: If a tenant mails a check to you for 12 months rent (lease term beginning January 1, 2010) and the check is dated November 1, 2009. You receive the check in the mail in November of 2009 and you decide to hold the check and only deposit it on January 2, 2010. The IRS rules state that you have to report the $12,000 in rent as income on your 2009 tax return. This is because you have “constructive receipt” of the funds.

TIP: Understanding the law and following the law from the beginning of your business activities is the key to saving money on taxes and keeping yourself out of hot water with the IRS. It has been my experience that most real estate investors act first and ask questions later. Properly managing your real estate investments requires good legal and tax advice in advance of starting your business activities!

Security Deposits Under the IRS rules, security deposits are not taxable in income, if your lease agreement shows that the security deposits are to be returned back to the tenant at the end of the lease term. If you end up keeping some of the security deposit at the end of the lease term then you must report it in income in the year the lease terminates. Unlike security deposits, last months rent is fully taxable when received as they are merely rents received in advance.

TIP: Understanding the difference between a security deposit and first and last months rent can save you money on annual rental properties. Moreover, at an IRS audit the written lease agreement can be good evidence to support your intent in advance so that there is no confusion as to your intent and the tax status of the funds. As a tax attorney, I can’t stress enough the importance of having good documentation in the form of lease agreements, dated, signed and legally executed to support the intent of landlord and tenant.

Rental Property Deductions All expenses associated with renting, managing and maintaining your property are fully deductible. Even if the property is vacant, as long as it is held out for rent, the expenses are still fully deductible on the tax return. Under the IRS rules the expenses must be “ordinary and necessary”, which means they must not be extravagant.

The following is a checklist of expenses:

  • Legal fees for drafting leases and Entity Formation
  • Accounting fees for preparing tax returns for investment properties
  • Depreciation on properties
  • Interest expenses
  • Commissions for real estate agents
  • Home owners association and condo fees
  • Property management firms
  • Cleaning and maintenance fees
  • Pest control
  • Yard and pool maintenance
  • Local property taxes
  • Rental equipment
  • Repairs
  • Supplies
  • Trash removal
  • Utilities
  • Insurance premiums
  • Postage
  • Travel expenses to rental property if the purpose of the trip is business. Mixing personal with business can place the entire deduction at risk. It is important to document the trip in advance, keeping letters to tenants and anticipating in writing the scope of the trip, dates and activities. Keep this documentation in an audit file as travel expenses are perhaps the most subject to scrutiny on audit.
  • Repairs

Part 2 in the October issue of The AZREIA Advantage.