Every Landlord's Tax Deduction Guide
Every Landlord's Tax Deduction Guide
Stephen Fishman, J.D.
December 2016, 13th Edition
Maximize your Tax Deductions
Named a "Top 10 Real Estate Book" by Robert Bruss, syndicated real estate columnist
Rental real estate provides more tax benefits than almost any other investment. Whether you own a ten-unit rental apartment building or rent a room in your home through Airbnb, you need to know about all the valuable deductions you are entitled to take as a landlord. Every Landlord’s Tax Deduction Guide is the only book that focuses exclusively on IRS rules and deductions for landlords.
With this book, you will learn about:
- depreciation, casualty and theft losses, start-up expenses, and other common landlord deductions
- IRS rules on deducting repairs and improvements
- vacation home tax rules
- proper record keeping and accounting - and much more.
The book also covers landlord tax classifications, reporting rental income, hiring workers, and deducting rental losses.
“This unusual book makes tax tactics actually interesting, whether you are a novice or a serious full-time investor.”-The Washington Post
“The best of the best...heavily emphasizes maximizing depreciation deductions.”-Chicago Tribune
Your Tax Deduction Companion for Landlords
1. Tax Deduction Basics for Landlords
- How Landlords Are Taxed
- What is Rental Income?
- How Income Tax Deductions Work
- How Property Ownership Affects Taxes
- The Airbnb Landlord: Short-Term and Partial Rentals
2. Landlord Tax Classifications
- The Landlord Tax Categories
- Business Owner Versus Investors
- Are You Profit Motivated?
3. Deducting Your Operating Expenses
- Requirements for Deducting Operating Expenses
- Operating Expenses That Are Not Deductible
- The New IRS Rules: Repair Versus Improvement
- How to Deduct Repairs
- Tips for Maximizing Your Repair Deductions
5. Depreciation Basics
- Depreciation: The Landlord’s Best Tax Break
- Understanding the Basics
- How to Depreciate Buildings
- Depreciating Land Improvements
- Depreciating Personal Property
- When You Sell Your Property
- Tax Reporting and Record Keeping for Depreciation
6. Maximizing Your Depreciation Deductions
- Determining the Value of Your Land and Buildings
- Segmented Depreciation
- Interest Landlords Can (and Can’t) Deduct
- Mortgage Interest
- Other Interest Expenses
- Points and Prepaid Interest
- Interest on Construction Loans
- Loans With Low or No Interest
- Loans on Rental Property Used for Nonrental Purposes
- Keeping Track of Borrowed Money
8. Start-Up Expenses
- What Are Start-Up Expenses?
- Determining Your Business Start Date
- Avoiding the Start-Up Rule’s Bite
- How to Deduct Start-Up Expenses
- If Your Business Doesn’t Last 15 Years
- If Your Business Never Begins
9. The Home Office Deduction
- Qualifying for the Home Office Deduction
- Calculating the Home Office Deduction
- Simplified Home Office Deduction Method
- IRS Reporting Requirements
- Deducting an Outside Office
10. Car and Local Transportation Expenses
- Deductible Local Transportation Expenses
- The Standard Mileage Rate
- The Actual Expense Method
- Other Local Transportation Expenses
- Reporting Transportation Expenses on Your Tax Return
11. Travel Expenses
- What Are Travel Expenses?
- Deductible Travel Expenses
- How Much You Can Deduct
12. Hiring Help
- Deducting Payments to Workers
- Employees Versus Independent Contractors
- Tax Rules When Hiring Independent Contractors
- Tax Rules for Employees
- Hiring Your Family
- Hiring a Resident Manager
13. Casualty and Theft Losses
- What Is a Casualty?
- Calculating a Casualty Loss Deduction
- Disaster Area Losses
- Repair and Replacement Costs of Casualty Losses
- Casualty Gains
- Tax Reporting and Record Keeping for Casualty Losses
14. Additional Deductions
- Dues and Subscriptions
- Education Expenses
- Insurance for Your Rental Activity
- Legal and Professional Services
- Meals and Entertainment
- Unpaid Rent
15. Tax Deductions for Part-Time or Partial Rentals
- Calculating Personal and Rental Use
- Calculating Your Tax Deductions
16. Deducting Rental Losses
- What Are Rental Losses?
- Overview of the Passive Loss Rules
- The $25,000 Offset
- The Real Estate Professional Exemption
- Deducting Losses for Airbnb and Other Short-Term Rentals
- Deducting Suspended Passive Losses
- Tax Reporting for Passive Rental Losses
- Strategies for Dealing With the Passive Loss Rules
- At-Risk Rules
- How to Deduct Rental Losses
17. Record Keeping and Accounting
- What Records Do You Need?
- A Simple Record-Keeping System
- Accounting Methods
- Tax Years
18. All About Schedule E
- Who Must File Schedule E?
- Filling Out Schedule E
19. The Net Investment Income Tax
- How the NII Tax Works
- Real Estate Professional Exemption From the NII Tax
- Planning to Avoid the NII Tax
Tax Deduction Basics for Landlords
How Landlords Are Taxed
Income Taxes on Rental Income
Income Taxes When You Sell Your Property
Social Security and Medicare Taxes
Net Investment Income Tax
What Is Rental Income?
Other Rental Income
IRS Reporting of Rental Income
How Income Tax Deductions Work
What Can You Deduct?
How Your Tax Status Affects Your Deductions
How Property Ownership Affects Taxes
Ownership Through a Business Entity
The Airbnb Landlord: Short-Term and Partial Rentals
Prorating Deductions for Short-Term or Partial Rentals
Landlords Who Provide Substantial Services
If You Rent Your Home for 14 Days or Less
If You Incur Rental Losses
The tax code is full of deductions for landlords. Before you can start taking advantage of these deductions, however, you need a basic understanding of how landlords pay taxes and how tax deductions work. This chapter gives you all the information you need to get started, including:
how the IRS taxes landlords
how tax deductions work, and
how forms of property ownership affect landlord taxes.
How Landlords Are Taxed
When you own residential rental property, you are required to pay the following taxes:
income taxes on rental income and property sales
Social Security and Medicare taxes (for some landlords)
net investment income taxes (for some landlords), and
Let’s look at each type of tax.
Income Taxes on Rental Income
You must pay federal income taxes on the net income (rent and other money minus expenses) you receive from your rental property each year. When you file your yearly tax return, you add your net rental income to your other income for the year, such as salary income from a job, interest on savings, and investment income.
This book covers rental property deductions for federal income taxes. However, 43 states also have income taxes. State income tax laws generally track federal tax law, but there are some exceptions. The states without income taxes are Alaska, Florida, Nevada, South Dakota, Texas, Washington, and Wyoming. For details on your state’s income tax law, visit your state tax agency’s website, or contact your local state tax office. You can find links to all 50 state tax agency websites at www.taxsites.com/state.html.
Income Taxes When You Sell Your Property
When you sell your property, any profit you earn is added to your income for the year and is subject to taxation. Profits from the sale of rental property owned for more than one year are taxed at capital gains rates. These rates are lower than income tax rates, except for taxpayers in the lowest tax brackets. (See Chapter 5 for an example of the tax effects of a rental property sale.)
However, you may be able to defer tax on your profits—perhaps indefinitely—by selling your property through a like-kind exchange (also called a Section 1031 exchange or tax-free exchange). This kind of exchange involves swapping your property for similar property owned by someone else. These property swaps are subject to complex tax rules that are beyond the scope of this book, since they have nothing to do with income tax deductions. For more information, see IRS Publication 544, Sales and Other Dispositions of Assets.
Social Security and Medicare Taxes
Everyone who works as an employee or who owns his or her own business must pay Social Security and Medicare payroll taxes (known as FICA. or Federal Insurance Contributions Act, taxes). Employees pay half of these taxes themselves and their employers pay the other half. Self-employed people must pay them all themselves. These are two separate taxes:
Social Security tax. The Social Security tax is a flat 12.4% tax on net self-employment income or employee wages up to an annual ceiling, which is adjusted for inflation each year. In 2016, the ceiling was $118,500.
Medicare payroll tax. There are two Medicare tax rates: a 2.9% tax up to an annual ceiling—$200,000 for single taxpayers and $250,000 for married couples filing jointly. All income above the ceiling is taxed at a 3.8% rate.
For both the self-employed and employees, the combined Social Security and Medicare tax is 15.3%, up to the Social Security tax ceiling.
You may have to pay (and withhold) Social Security and Medicare taxes if you hire employees to work in your rental activity—for example, if you hire a resident manager. The employer’s share of such taxes is a deductible expense. (See Chapter 12.)
The income you earn from your rental property is not subject to Social Security and Medicare taxes. (I.R.C. § 1402(a)(1).) This is true even if your rental activities constitute a business for tax purposes. (See Chapter 2.) This is one of the great tax benefits of owning rental property. A person who owns a hot dog stand must pay the 15.3% self-employment tax on his or her annual profits, whereas a person who owns a rental house or other real estate pays no self-employment taxes on his or her rental income.
There is an important exception to the rule that landlords don’t have to pay Social Security or Medicare taxes on their rental income. Namely, this tax must be paid by landlords who provide “substantial services” to their tenants. These are services provided for tenants’ convenience that are typically provided by hotels or bed and breakfasts, such as maid service, food, or concierge services. The value of such services must be equal to at least 10% or 15% of the rent charged to be substantial. If you provide substantial services to your tenants, your activity is classified as a regular business, not a rental activity. If you’re an individual owner, you report your income or losses on IRS Schedule C, Profit or Loss From Business (Sole Proprietorship). Substantial services are rarely provided by traditional landlords who rent to long-term tenants. However, landlords who rent to short-term guests through Airbnb and similar online platforms sometimes provide substantial services. (For more details, see “The Airbnb Landlord: Short-Term and Partial Rentals,” below.)
Net Investment Income Tax
A new net investment income tax went into effect in 2013. This 3.8% tax affects many higher-income landlords. (For details, see Chapter 19.)
Estimated Taxes for Landlords
Whether you are a traditional landlord who rents to long-term tenants or you rent to short-term guests through Airbnb, no taxes will be withheld from the rental payments you receive. If your rentals earn a profit and you expect to owe at least $1,000 in income tax on the profit, you may need to pay estimated taxes to the IRS to prepay your tax liability. However, if you work and have income tax withheld from your pay, you’ll need to pay estimated tax only if your total withholding (and any tax credits) amounts to less than 90% of the total tax you expect to pay for the year. Thus, you can avoid paying any estimated tax at all by having your withholding increased. But, you’ll be able to hold on to your money a bit longer if you pay estimated tax instead of having the money taken out of your paychecks every pay period.
If you pay estimated tax, the payments are due four times per year: April 15, June 15, September 15, and January 15. To avoid having to pay an underpayment penalty, your total withholding and estimated tax payments must equal the lesser of either (1) 90% of your tax liability for the current year, or (2) 100% of what you paid the previous year (or 110% if you’re a high-income taxpayer—those with adjusted gross incomes of more than $150,000, or $75,000 for married couples filing separate returns).
The easiest way to calculate your quarterly estimated tax payments is to subtract your total expected income tax withholding for the current year from the total income tax you paid last year. The balance is the total amount of estimated tax you must pay this year. But, if you’re a high-income taxpayer, add 10% to the total. Note, however, that if your income is higher this year than last, you’ll owe extra tax to the IRS on April 15. To avoid this, you can increase your estimated tax payments or simply save the money you’ll need to pay the taxes when you file your annual return.
You pay the money directly to the IRS in four equal installments, so divide the total by four. You can pay by mail, electronic withdrawal from your bank account, or by credit or debit card. For details, see the IRS estimated tax Web page at www.irs.gov/Businesses/Small-Businesses-Self-Employed/Estimated-Taxes.
Property owners in all states pay property taxes imposed by cities, counties, and other local governments. They are a tax on the value of your rental property. Property taxes are not covered in this book.
Local Lodging Taxes on Short-Term Rentals
If you rent your property on a short-term basis through Airbnb or other online rental platforms, your rental activity may be subject to local lodging taxes levied by your city, county, or local government and state. These taxes go by different names—for example:
These local taxes are completely separate from income tax and are collected by your state and local government, not the IRS. Typically, the taxes apply to rentals of 30 days or less. The amount of the taxes varies, as does how they are calculated and how often they must be paid.
Local lodging taxes are ordinarily paid by the guests who pay for the short-term rentals, not the landlord-hosts who provide them. This is the same as hotel occupancy taxes that are paid by a hotel’s guests. The hosts’ role is ordinarily limited to collecting the taxes from their guests and remitting them to the appropriate state and local agency. In some locations, Airbnb has entered into agreements with the local governments involved to collect and remit the applicable local taxes on behalf of hosts. You can find a list of these locations at airbnb.com. However, if Airbnb or other rental platforms you use won’t collect local taxes for you, it is your responsibility to do it yourself. If you fail to do so, you could be fined by your local tax authority. If this seems like too much work, there are private companies you can hire to collect and remit local taxes for you.
You can find a list of the local short-term rental taxes charged in many areas on the Airbnb website, along with helpful links. This list is helpful whether or not you use Airbnb to rent your property. You should also check your local government’s website for information about local taxes.
What Is Rental Income?
You only pay tax on your net rental income each year—your total income minus your deductible expenses. Your rental income consists primarily of the rent your tenants (or short-term guests in the case of Airbnb-type rentals) pay you for the use of your property. However, rental income can include other types of payments as well. As a rule, the rent and other payments landlords receive are not reported by tenants or anyone else to the IRS; but there can be exceptions in the case of short-term Airbnb-type rentals.
Other Rental Income
Tenants typically make various kinds of payments to their landlords in addition to rent, or provide things of value other than money. Many of these must be included in landlord income.
Security deposits. When you receive a security deposit that you plan to use for the tenant’s final rent payment, you should include that amount in your income for the year when you receive it. However, do not include security deposit money in your income when you receive it if you plan to return the money to your tenant at the end of the rental term. If you keep part or all of the security deposit at any time because your tenant does not live up to the terms of the rental agreement, include the amount you keep in your income for that year.
Interest earned on security deposits is also rental income that should be included in your income in the year it is earned, unless your state or local law requires landlords to credit that interest to tenants.
Property or services in lieu of rent. Property or services you receive from a tenant as rent (instead of money) must be included in your rental income. For example, if your tenant is a painter and offers to paint your rental property instead of paying rent for two months, you must include in your rental income the amount the tenant would have paid for two months’ worth of rent.
Rental expenses paid for by tenant. Any rental expenses paid for by a tenant are rental income; for example, payments a tenant makes to you for repairs, utilities, or other rental costs. These costs are then deductible by you as rental expenses.
Lease cancellation payments. If a tenant pays you to agree to cancel a lease, the amount you receive is rent that must be included in your rental income in the year you receive it.
Reservation cancellation fees. If you rent your property to short-term guests through Airbnb or another online rental platform, any fees you retain when a guest cancels a reservation are rental income.
Leases with option to buy. A lease with an option to buy occurs if the rental agreement gives your tenant the right to buy your rental property. The payments you receive under such an agreement are generally rental income.
Advance rent payments. 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. For example, to get you to agree to a one-year lease, a tenant with poor credit pays you six months’ rent in advance in December. You must include the entire amount as rental income in the year it was received.
Fees. Fees or other charges tenants pay are also rental income. These include:
fees you charge tenants for paying rent late
garage or other parking fees
fees you charge tenants for use of storage facilities, and
laundry income from washers and dryers you provide for
IRS Reporting of Rental Income
Residential tenants have no legal duty to report to the IRS how much rent they pay to their landlords. As a result, the income received by traditional landlords who rent their property to long-term tenants is ordinarily not reported by tenants to the IRS (unless a property management company manages the rentals). However, things can be different for landlords who engage in short-term rentals through online platforms like Airbnb. Short-term guests typically pay by credit card or PayPal (something long-term residential tenants rarely do). The IRS requires that all United States companies processing credit card payments report to it the gross earnings of United States customers that earn over $20,000 and have 200+ transactions in the calendar year. This reporting is done by filing IRS Form 1099-K, Payment Card and Third Party Network Transactions. Copies of the form are sent by the processing company to the host, the IRS, and the host’s state tax department. The deadline for filing is January 31 of the year following the year the payments were made.
Currently, Airbnb issues a 1099-K to hosts located in the United States who have earned over $20,000 and had 200+ reservations. The average Airbnb host only earns about $7,500 per year so 1099-K forms are not filed for most hosts. Moreover, online platforms like Craigslist or HomeAway that don’t process payments for users don’t issue any 1099s to anyone. It’s important to understand, however, that whether or not you receive a 1099-K or any other form reporting your rental income to the IRS, you’re supposed to report all of your rental income in your annual tax return. The only exception is if your rental activity is tax-free.
If you are issued a 1099-K, it will list the total amount of money processed by Airbnb or another rental platform for you during the year, not the net amount you actually received. For example, there will be no deductions for host fees, refunds, or disputed credit card charges. You must list the total amount shown on the 1099-K as rental income on the appropriate tax form (Schedule E or C) and then deduct hosting fees and other expenses to arrive at your net taxable rental income.
How Income Tax Deductions Work
The tax law recognizes that you must spend money on your rental properties for such things as mortgage interest, repairs, maintenance, and many other expenses. The law allows you to subtract these expenses, plus an amount for the depreciation of your property, from your effective gross rental income (all the money actually earned from the property) to determine your taxable income. You pay income tax only on your taxable income, if any. Expenses you can deduct from your income are called tax deductions or tax write-offs. These deductions are what this book is about.
Although some tax deduction calculations can get a bit complicated, the basic math is simple: The entire tax regimen for rental real estate can be reduced to the following simple equation:
Effective Gross Rental Income
Operating Expenses (including mortgage interest)
Depreciation and Amortization Expenses
(People who analyze real estate investments don’t include mortgage interest as a real estate operating expense, but it is an operating expense for tax purposes.)
Example: Karen owns a rental house. This year, her effective gross rental income (all the income she actually earned from the property) was $10,000. She doesn’t pay tax on the entire $10,000 because she had the following expenses—$5,000 in mortgage interest, $1,000 for other operating expenses, and $2,000 for depreciation. She gets to deduct these as outlined in the above equation:
Effective Gross Rental Income
Depreciation and Amortization
Karen only pays income tax on her $2,000 taxable income.
Many landlords have so many deductions that they end up with a net loss when they subtract all their deductions from their effective gross rental income. In that situation, they owe no tax at all on their rental income. This is especially common in the early years of owning rental property, when you haven’t had time to raise the rents much. Indeed, it is common for landlords to have a loss for tax purposes even if they take in more in rental income than they pay in expenses each month.
Having a tax loss on your rental property is not necessarily a bad thing. You may be able to deduct it from other income you earn during the year, such as salary income from a job or income from other investments. However, there are significant restrictions on a landlord’s ability to deduct rental losses from nonrental income. Many small landlords can avoid them, but not all. These restrictions—known as the passive loss rules and at-risk rules—are covered in detail in Chapter 16.
What Can You Deduct?
All tax deductions are a matter of legislative grace, which means that you can take a deduction only if it is specifically allowed by one or more provisions of the tax law. You usually do not have to indicate on your tax return which tax law provision gives you the right to take a particular deduction. If you are audited by the IRS, however, you’ll have to provide a legal basis for every deduction you take. If the IRS concludes that your deduction wasn’t justified, it will deny the deduction and charge you back taxes and penalties.
Landlords can deduct three broad categories of rental expenses:
operating expenses, and
This section provides an introduction to each of these categories (they are covered in greater detail in later chapters).
Keep track of your rental expenses. You can deduct only those expenses that you actually incur. You need to keep records of these expenses to know for sure how much you actually spent and prove to the IRS that you really spent the money you deducted on your tax return, in case you are audited. Accounting and bookkeeping are discussed in detail in Chapter 17.
The first money you will have to shell out will be for your rental activity’s start-up expenses. These include most of the costs of getting your rental business up and running, like license fees, advertising costs, attorney and accounting fees, travel expenses, market research, and office supplies expenses. Start-up expenses do not include the cost of buying rental property. If your rental activity qualifies as a business, up to $5,000 of start-up expenses may be deducted for the year in which they’re incurred. The remainder, if any, must be deducted in equal installments over the first 180 months you’re in business—a process called amortization. (See Chapter 8 for a detailed discussion of deducting start-up expenses.)
Operating expenses are the ongoing, day-to-day costs a landlord incurs to operate a rental property. They include such things as mortgage interest, utilities, salaries, supplies, travel expenses, car expenses, and repairs and maintenance. These expenses (unlike start-up expenses) are currently deductible—that is, you can deduct them all in the same year when you pay them. (See Chapter 3.)
Capital assets are things you buy for your rental activity that have a useful life of more than one year. A landlord’s main capital asset is the building or buildings he or she rents out. However, capital assets also include such things as equipment, vehicles, furniture, and appliances. These costs, called capital expenses, are considered to be part of your investment in your rental activity, not day-to-day operating expenses.
The cost of your capital assets must be deducted a little at a time over several years—a process called depreciation. Residential rental buildings are depreciated over 27.5 years. Capital assets other than real estate are depreciated over a much shorter period—for example, vehicles and furniture are depreciated over five years. The cost of land is not deductible—you must wait until land is sold to recover the cost. (See Chapter 5 for more on this topic.)
How Your Tax Status Affects Your Deductions
Owning rental property can be a business for tax purposes, an investment, or, in some cases, a not-for-profit activity. Landlords whose rental activities qualify as a business are entitled to all the tax deductions discussed in this book. However, those whose rentals are an investment lose certain useful deductions, such as the home office deduction. Tax deductions are extremely limited for landlords who, in the eyes of the IRS, are operating a not-for-profit activity.
Your tax status is determined by how much time and effort you put into your rental activity, and whether you earn profits each year or act like you want to. Most landlords who manage their property themselves qualify as for-profit businesses. (See Chapter 2 for more on determining your tax status.)
How Property Ownership Affects Taxes
How you own your residential rental property affects the tax returns you must file each year. The main ownership options for a small landlord are:
limited liability company (LLC)
tenancy in common, or
These can be sorted into two broad categories: individual ownership and ownership through a business entity. If you don’t know how you hold title to the rental property you already own, look at your property deed.
Most small landlords (owners of from one to ten residential rental units) own their property as individuals—either alone, or with one or more co-owners. Indeed, a government study found that individuals owned approximately 83% of the 15.7 million rental housing properties with fewer than 50 units. (Department of Housing and Urban Development and Department of Commerce, U.S. Census Bureau, Residential Finance Survey: 2001 (Washington, DC: 2005).)
One Property Owner
The simplest way to own rental property is for a single individual to own it in his or her own name. When you do this you are a sole proprietor for tax purposes. Any rental income you earn is added to your other income, such as salary from a job, interest income, or investment income. Losses you incur can be deducted from your other income, subject to the restrictions discussed in Chapter 16. You report your rental income and losses on IRS Schedule E and attach it to your individual tax return. (See Chapter 18 for a detailed discussion of Schedule E.)
Things are a bit more complex if you acquired the property while married and you live in one of the nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin. Although the rental is held in your name alone, unless you and your spouse agree otherwise, it will be jointly owned community property under your state’s marital property laws. However, for tax purposes, you may still treat the rental activity as a sole proprietorship with only one spouse listed as owner on Schedule E. (See “Spouses who live in community property states,” below.)
Co-Owners Not Married to Each Other
It’s not uncommon for two or more relatives, friends, or colleagues to own rental property together. If you acquire the property with one or more co-owners, you don’t necessarily have to form a separate business entity like a partnership, limited liability company, or corporation to own and operate it. Instead, for tax purposes, each owner can in essence be treated like a sole proprietor. This can be accomplished where co-owners take title to the property together as tenants in common or, more rarely, joint tenants. (See “Co-Ownership by Spouses,” below, for the difference between the two.) Each co-owner owns an undivided interest in the entire property. In the case of a tenancy in common, the interests can be equal or divided in unequal amounts; whatever the owners agree upon. The ownership interest of each owner should be listed on the property deed.
EXAMPLE: Al and Alice, brother and sister, buy a rental house together, taking title as tenants in common. They decide that because Al put more money down on the property, he should own a 60% interest and Alice 40%. This means that Al is legally entitled to 60% of the income the property generates and is supposed to pay 60% of the expenses. Alice gets the remaining 40%.
Although they own rental property together, each cotenant is treated like a sole proprietor for tax purposes. Each cotenant reports their share of the income and deductions from the rental property on their own tax return, filing Schedule E. Each owner’s share is based on his or her ownership interest—for example, Alice in the example above lists her 40% share of the income and deductions from the co-owned rental house on her Schedule E and pays tax on that amount. Al lists the other 60% on his own Schedule E.
If one cotenant pays more than his or her proportionate share of the expenses, the overpayment is treated as a loan to the other cotenants and may not be deducted. The cotenant who overpays is legally entitled to be reimbursed by the other cotenants. (T.C. Memo 1995-562.)
EXAMPLE: Alice from the example above pays 80% of the annual expenses for the rental house this year, instead of the 40% she should pay based on her ownership interest. She may not deduct her overpayment, which amounts to $10,000. Instead, it is treated as a loan to her cotenant Al. Alice is entitled to be repaid the $10,000 by Al. If he doesn’t pay, she can sue him to collect. If he does pay, he can deduct the amount as a rental expense.
Are cotenants partners? The type of cotenancy described above may seem like a partnership, but it’s really not. Unlike in a partnership, a cotenant cannot act or contract on behalf of the other cotenants without their authorization. Moreover, one cotenant is not liable for any debts incurred by another cotenant without his or her consent. Each tenant in common may lease, mortgage, sell, or otherwise transfer all or part of his or her interest without obtaining consent from the other cotenants, or even telling them about it. This power to transfer property also applies upon the death of a tenant in common. It’s often desirable, but not required, that the co-owners enter into a written cotenancy agreement.
Not being in a partnership can save time and expense. Filing a partnership tax return and dealing with complex partnership tax laws is not easy. If you are a partnership, here is what you’re supposed to do:
complete and file Form 1065, U.S. Return of Partnership Income, reporting all the partnership’s income, deductions, gains, and losses
complete a Schedule K-1 for each partner showing his or her share of the partnership’s income or loss
transfer the Schedule K-1 information onto a Schedule E, Supplemental Income and Loss, for each partner
complete a Schedule SE for each partner, listing his or her share of partnership income as self-employment income, and
transfer the data from the individual schedules onto the joint Form 1040.
Obviously, this requires a lot of time and money—tax pros can charge $1,000 or more to prepare partnership returns.
Co-owners who provide services to tenants. IRS regulations provide that tenants in common or joint tenants do not become partners in a partnership as long as all they do is own rental property together and merely maintain, repair, and rent it. (IRS Reg. § 1.761-1(a), IRS Reg. § 301.7701(a)(2).) (See also IRS Publication 541, Partnerships: “co-ownership of property maintained and rented or leased is not a partnership unless the co-owners provide services to the tenants.”)
However, the tax situation changes if co-owners of a rental property provide significant services to their tenants. In this event, the IRS will consider them partners in a partnership for tax purposes.
Significant services do not include furnishing heat and light, cleaning of public areas, normal repairs, trash collection, or similar services. Instead, they are services that primarily benefit the tenants personally, such as maid service, linen changing, food service, or concierge services. (IRS Reg. § 301.7701-1(b); Rev. Rul. 75-374.) Providing occasional cleaning or concierge services would probably not constitute significant services. Would providing tenants with an Internet connection or cable TV constitute significant services? It’s unclear.
If co-owners are deemed to be partners in a partnership, the partnership must file a partnership tax return (unless they are married and elect qualified joint venture status—see “Co-Ownership by Spouses,” below). The individual or partnership members are each given a Schedule K-1 by their partnership reporting their individual shares of annual income or loss from the rental activity. The individuals then list this amount in Part II of Schedule E, on page 2. This doesn’t increase or decrease the owners’ deductions but it does result in a more complex tax return.
Co-Ownership by Spouses
Spouses who own rental property together typically take title as joint tenants—rather than tenants in common. Joint tenants are treated exactly the same as tenants in common for tax purposes, but there are significant nontax differences. Joint tenants must own the property 50- 50. In addition, joint tenancy always includes “the right of survivorship.” When one joint tenant dies, his or her share automatically goes to the survivor. This is not the case with tenants in common, who can leave their share of the co-owned property to anyone they want. Unmarried people can also be joint tenants, but this isn’t commonly done.
If a married couple that jointly owes rental property files a joint income tax return, as most do, they are treated as a single taxpayer by the IRS. The spouses’ shares of the income and deductions from the rental property are combined on their single joint tax return. The couple reports their income and deductions from the jointly owned property on a single Schedule E they file with their joint return.
Are co-owner spouses partners in a partnership? Like other co-owners of rental property, spouses who are landlords of property they own together are ordinarily not considered partners in a partnership as long as all they do is maintain, repair, and rent their property. However, spouses who provide significant services to their tenants will be viewed as partners in a partnership by the IRS. (See “Co-owners who provide services to tenants,” above.) This means they would have to file a partnership tax return—unless they can elect joint venture status.
Electing qualified joint venture status to file Schedule C. To avoid having to file a partnership tax return, spouses who provide significant services to their tenants can elect to be taxed as a “qualified joint venture.” When this is done, both spouses are treated as sole proprietors of a Schedule C business for tax purposes. They each file an IRS Schedule C, Profit or Loss From Business (Sole Proprietorship), with their joint return.
This election is available only where the spouses own the rental property as individuals in their own names. It may not be made when the activity is held in the name of a state law business entity such as a partnership or LLC.
To qualify for qualified joint venture status, the spouses must share all their rental income, losses, deductions, and credits according to their ownership interest in the property. If, as is usually the case, each spouse owns 50% of the property, they equally split their rental income or loss on their Schedules C.
In addition, the spouses must:
be the only owners of the activity
file a joint return
both elect not to be treated as a partnership, and
both materially participate in the business.
Material participation is determined by the same rules as those used to determine whether real estate owners qualify as real estate professionals for purposes of the passive activity loss (PAL) rules. This means that each spouse must be involved with their business’s day-to-day operations on a regular, continuous, and substantial basis. Working more than 500 hours in the business during the year meets this requirement. So does working over 100 hours if no one else worked more, or doing substantially all the work for the activity. (See “Material Participation Test” in Chapter 16 for a detailed discussion.)
In addition, the IRS says that married couples cannot make a qualified joint venture election if the business is owned and operated through a state law entity—this includes a partnership, limited liability company, limited liability partnership, or corporation. Thus, you cannot make this election if you’ve formed an LLC or corporation to own and run the business.
If you qualify, you and your spouse elect this status simply by filing a joint IRS Form 1040 with the required Schedule C. Once you elect this status, it cannot be revoked without IRS approval.
Electing qualified joint venture status to file Schedule E. The instructions to Schedule E provide that spouses whose rental activity constitutes a business for reasons other than providing their tenants with services may also elect qualified joint venture status. The same requirements discussed above must be satisfied. In this event, the co-owner spouses file one Schedule E to report their income and expenses from the rental property. However, each spouse must report his or her interest as separate properties on Schedule E. There is a special box to check on Schedule E to elect qualified joint venture status. (See Chapter 18 for a detailed discussion of Schedule E.)
It’s not entirely clear when this election is necessary. The IRS regulations discussed above make clear that it is not necessary if the spouses merely maintain, repair, and rent out their property—this activity is not a partnership for tax purposes. There must be something more that makes the activity a partnership business—something other than providing services. What this is remains unclear. But, spouses who want to ensure that their rental activity is viewed as a business by the IRS may wish to make this election if they meet the requirements. It costs nothing. The spouses will have to split their rental income and expenses between them for each rental property when they file their sole Schedule E.
Spouses who live in community property states. There are some special rules for co-owner spouses who live in community property states. There are nine such states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.
If you live in one of these states, you and your spouse will automatically be co-owners of any rental property you acquire while you’re married, unless you agree otherwise. Like married people in noncommunity property states, spouses in community property states ordinarily take title to their real property as joint tenants. However, they may take title as tenants in common instead, if they wish; or just one spouse may be named on the deed as owner.
The IRS says that spouses in community property states may treat their rental activity either as a sole proprietorship (technically, a “disregarded entity”) or a partnership. Either one is fine. If sole proprietorship status is selected, they would file one Schedule E and would not have to allocate their rental income and expenses between themselves. All they need do to elect this status is file their one Schedule E. They do not need to elect qualified joint venture status to avoid having to file a partnership return. (Rev. Proc. 2002-69 (10/9/2002).)
What Happens If a Husband and Wife File the Wrong Type of Return?
What happens if a husband and wife who co-own a rental should file a partnership return but fail to do so? Basically, nothing. In theory, the IRS can impose a penalty. But this never happens. Over 30 years ago, the IRS decided it was impossible to actively enforce the partnership filing rules for husband-and-wife businesses. Instead, it issued a revenue procedure waiving penalties for small businesses that “historically had not filed partnership returns.” The waiver did not “eliminate the filing requirement for partnerships … ; it merely provide[d] that a penalty for failure to file will not be assessed.” (Rev. Proc. 81-11.)
Ownership Through a Business Entity
Instead of owning your rental property in your own name, you can form a business entity to own it, and own all or part of the entity.
Example: Vicki and Victor, a married couple, own a small apartment building. Instead of taking title in their own names as joint tenants, they form a limited liability company (LLC). The LLC owns the building and they, in turn, own the LLC.
The tax deductions available from rental property are the same whether you own it in your own name or through a business entity.
This section provides only the briefest possible introduction to business entities. To learn more, refer to LLC or Corporation? How to Choose the Right Form for Your Business, by Anthony Mancuso (Nolo).
Types of Entities
There are several different business entities that can own rental property:
Partnerships. A partnership is a form of shared ownership and management of a business. The partners contribute money, property, or services to the partnership; in return, they receive a share of the profits it earns, if any. The partners jointly manage the partnership business. Although many partners enter into written partnership agreements, no agreement is required to form a partnership. A partnership can hold title to real estate and other property.
Limited partnerships. A limited partnership is a special type of partnership that can only be created by filing limited partnership documents with your state government. It consists of one or more general partners who manage the partnership and any number of limited partners who are passive investors—they contribute money and share in the partnership’s income (or losses) but do not actively manage the partnership business. Limited partnerships are especially popular for real estate projects that are owned by multiple investors.
Corporations. A corporation can only be created by filing incorporation documents with your state government. A corporation is a legal entity distinct from its owners, who are called shareholders. It can hold title to property, sue and be sued, have bank accounts, borrow money, hire employees, and perform other business functions. For tax purposes, there are two types of corporations: S corporations (also called small business corporations) and C corporations (also called regular corporations). The most important difference between the two types of corporations is how they are taxed. An S corporation pays no taxes itself—instead, its income or loss is passed on to its owners, who must pay personal income taxes on their share of the corporation’s profits. A C corporation is a separate taxpaying entity that pays taxes on its profits. C corporations are rarely used to own rental property.
Limited liability companies. The limited liability company (LLC) is like a sole proprietorship or partnership in that its owners (called members) jointly own and manage the business and share in the profits. However, an LLC is also like a corporation because its owners must file papers with the state to create the LLC and it exists as a separate legal entity.
Tax Treatment of Business Entities
Partnerships, limited partnerships, LLCs, and S corporations are all pass-through entities. A pass-through entity does not pay any taxes itself. Instead, the business’s profits or losses are passed through to its owners, who include them on their own personal tax returns (IRS Form 1040). When a profit is passed through to the owner, the owner must add that money to any income from other sources, and pay tax on the total amount. If a loss is passed through to the owner, he or she can deduct it from other income, subject to the restrictions on deducting rental losses discussed in Chapter 16. Because pass-through taxation permits property owners to deduct losses from their personal taxes, it is considered the best form of taxation for real estate ownership.
Although pass-through entities don’t pay taxes, their income and expenses must still be reported to the IRS as follows:
Partnerships and limited partnerships. These must file an annual tax form with the IRS (Form 1065, U.S. Return of Partnership Income). Form 1065 is used to report partnership revenues, expenses, gains, and losses. The partnership must also provide each partner with an IRS Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., listing the partner’s share of partnership income and expenses (copies of these schedules must also be attached to IRS Form 1065). The partners must then file IRS Schedule E, Supplemental Income and Loss, with their individual income tax returns, showing the income or losses from all the partnerships in which they own an interest. Partners complete the second page of Schedule E, not the first page, which individuals use to report their income and deductions from rental property. (See Chapter 18.)
S corporations. These entities must file information returns with the IRS on Form 1120-S, U.S. Income Tax Return for an S Corporation, showing how much the business earned or lost and each shareholder’s portion of the corporate income or loss. (An information return is a return filed by an entity that doesn’t pay any taxes itself. Its purpose is to show the IRS how much tax the entity’s owners owe.) Like partners in a partnership, the shareholders must complete the second page of Schedule E, showing their shares of the corporation’s income or losses, and file it with their individual tax returns.
LLCs. LLCs with only one member are ordinarily treated like a sole proprietorship for tax purposes. The member reports profits, losses, and deductions from rental activities on Schedule E. An LLC with two or more members is treated like a partnership for tax purposes, except in the unusual situation where the owners choose to have it treated like a C or S corporation. However, an LLC owned by just one person is treated as a “disregarded entity” for tax purposes. This means that the single LLC owner is treated the same as a sole proprietor.
Landlords who own their properties through business entities don’t use individual Schedule Es to report their rental income or losses. Instead, the partnership, limited partnership, LLC, or S corporation files IRS Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, to report the income and deductions from the property owned by the entity. This form is very similar to Schedule E.
Why Form a Business Entity?
The primary reason small landlords form business entities to own their property has nothing to with taxes. Rather, they use business entities to attempt to avoid personal liability for debts and lawsuits arising from rental property ownership.
Forming a business entity may help show your rental activity is a business. Another reason to form a business entity that may be more important now than it was in the past is to help establish that the rental activity is a business for tax purposes, not an investment activity. Qualifying as a business provides a landlord with many benefits. (See “Business Owner Versus Investor” in Chapter 2.) Moreover, real estate professionals whose rental activities qualify as a business can completely avoid the 3.8% Net Investment Income tax that went into effect in 2013. (See Chapter 19.)
When you own rental property in your own name, alone or with co-owners, you are personally liable for all the debts arising from the property. This means that a creditor—a person or company to whom you owe money for items you use in your rental activity—can go after all your assets, both business and personal. This may include, for example, your personal bank accounts, your car, and even your house. Similarly, a personal creditor—a person or company to whom you owe money for personal items—can go after your rental property. The main creditor that rental property owners worry about is the bank or some other financial institution from which they have borrowed money to purchase their property. If they default on their loan, they could be personally liable for the debt. (However, this isn’t always the case. It depends on the nature of your loan and how your state law deals with real estate foreclosures.)
If you own property in your own name, you’ll also be personally liable for rental-related lawsuits—for example, if someone slips and falls at your rental property and sues for damages.
In theory, limited partnerships, LLCs, and corporations provide their owners with limited liability from debts and lawsuits. (Only the limited partners in a limited partnership have limited liability. General partners are personally liable for partnership debts and lawsuits.) Limited liability means that you are not personally liable for the debts incurred by your business entity, or for lawsuits arising from its ownership of rental property. Thus, your personal assets are not at risk; at most, you’ll lose your investment in the business entity (which, of course, is often substantial).
In real life, however, limited liability is often hard to come by, even when you form a business entity. Lenders may require small landlords who form business entities to personally guarantee any loans their entities obtain to purchase property. This means the landlord will be personally liable if there is a default on the loan. In addition, you’ll always be personally liable if someone is injured on your property due to your personal negligence. For example, if someone slips and falls on your property, they can sue you personally by claiming your own negligence caused or contributed to the accident. This is so even though your property is owned by a business entity, not you personally. You can far more effectively protect yourself from such lawsuits by obtaining liability insurance for your rental property. The cost is a deductible rental expense. (See Chapter 14.)
However, if you’re dead set on owning your rental property through a business entity, the entity of choice is the LLC. It provides the same degree of limited liability as a corporation, while also giving its owners pass-through taxation—the most advantageous tax treatment for real property. As a result, LLCs have become very popular among real property owners in recent years.
Out of an abundance of caution (or paranoia), some landlords set up a separate LLC for each rental property they own. However, this can be expensive, especially in states that make LLCs pay minimum annual taxes or fees, no matter how much money they earn. For example, LLCs in California must pay $800 per year. Thus, if you set up five California LLCs to own five buildings, you’d have to pay $4,000 in fees every year—even if your rental activates incurred losses. Again, you’d probably be better off spending the money on rental property insurance.
For detailed guidance about LLCs, refer to Form Your Own Limited Liability Company: Create an LLC in Any State, by Anthony Mancuso (Nolo).
The Airbnb Landlord:
Short-Term and Partial Rentals
Millions of Americans rent their main homes, vacation homes, or other residential property through online rental platforms such as Airbnb, VRBO, HomeAway, FlipKey, Craigslist, and others. Typically, these rentals are short term—averaging less than 30 days (and often less than seven). Some people rent their entire primary residence, vacation or second home, or other property to short-term guests, while others rent a room or rooms in their home while they continue to live there.
Typically, Airbnb landlords do not rent their property for 365 days a year. Indeed, the average Airbnb landlord rents his or her property for 66 days per year. However, some people rent all or part of their property full time throughout the year to a succession of short-term guests. For example, you may convert a room in your home to full-time rental use—that is, the room is either occupied by short-term guests or available for rent and never used by you personally.
These Airbnb and other short-term or partial rentals of a home are treated like a regular rental activity for tax purposes. This means:
you’re entitled to the same deductions as any other landlord, although you must prorate many expenses between the rental and nonrental use of your property
you file Schedule E, the tax form for landlords, to report your rental income and expenses (see Chapter 18), and
your rental income is not subject to self-employment taxes (Social Security and Medicare).
If you provide substantial services to your tenants, rent your property for less than 15 days, or incur a loss on your rental activities, then special rules (discussed below) may apply.
Prorating Deductions for Short-Term or Partial Rentals
Airbnb landlords can take advantage of all the tax deductions covered in this book. Any expenses you incur just for your short-term rental activity —for example, Airbnb fees—are fully deductible. However, other expenses are only partly deductible. Deductions such as depreciation and repairs must be prorated according to the amount of time you rent your property during the year compared with the time you use it personally; and, if you don’t rent your entire property, by the amount of space that is rented.
For example, if you rent your entire vacation home 25% of the year, you’ll be able to deduct 25% of the depreciation you’d be able to claim for a full-time rental. If you rent for 25% of the year a room in your home that takes up 10% of the space in the home, you’d be entitled to a 2.5% depreciation deduction. How to calculate the rental and personal use of your property, and how to allocate your deductions, is covered in detail in Chapter 15.
Landlords Who Provide Substantial Services
Some Airbnb landlords provide their guests with personal services that are typically not provided by traditional landlords. If you provide services and they are substantial, you are treated by the IRS the same as a person who is operating a hotel or a bed and breakfast—that is, you’re engaged in a service business, not a rental activity.
The services we’re talking about do not include the kinds of services provided by most long-term residential landlords, such as utilities (water, electricity, heat, air conditioning), trash collection, cleaning of public areas, or building repairs and maintenance. Rather, they are hotel-like services provided for guests’ convenience as opposed to maintaining the property. Examples include daily maid service, meals or snacks, laundry services, concierge services, or amenities like linens, irons, hangers, shampoo, soap, books, videos, and games.
The IRS provides no precise guidelines on how much services must be worth to be substantial, but examples in IRS regulations indicate they must be worth at least 10% to 15% of the total rent paid by the guests. (IRS Reg. §§ 1.1402(a)-4(c)(3), 1.469-1T(e)(3)(viii), Ex. 4.) Thus, for example, simply supplying your guests with towels and soap or a few other amenities of limited value would likely not rise to the level of substantial services. On the other hand, if you provide meals and maid and laundry services to your guests, this might rise to the level of substantial services.
If you provide substantial services, you are still entitled to all the deductions covered in this book, and may deduct the costs of the services as well. However, because your activity is classified as a regular business for tax purposes and not a rental activity, you report your income and expenses on IRS Schedule C, Profit or Loss From Business (Sole Proprietorship), not Schedule E, which is filed by regular landlords. When you have a Schedule C business, you must pay Social Security and Medicare tax on your profits as well as regular income tax. On the plus side, however, your activity is not subject to the net investment income tax (see Chapter 19). If you own your rental through a multi-member LLC, corporation, or partnership, you file the appropriate return for that type of business entity (single-member LLC owners still file Schedule C).
If You Rent Your Home for 14 Days or Less
Some short-term rentals are completely tax-free. This is the case if, during the year:
you rent out your entire home (dwelling unit), or a room or rooms in your home, for a total of 14 days or less, and
the home is used personally by you for more than 14 days (or more than 10% of the number of days during the year the property is rented for a fair rental). (I.R.C. § 280A(g).)
This kind of tax-free treatment applies whether it’s your main home or a second or vacation home or a room in any of those homes, as long as it’s for a total of 14 days or less during the year. Obviously, you need to keep careful track of the number of rental days and make sure not to exceed the magic number of 14. (See Chapter 15 for guidance on how to calculate personal and rental use.)
As far as the IRS is concerned, it’s as if the rental or rentals never occurred. You need not list the rental income on your tax return or file Schedule E. However, you may have to pay local lodging taxes on the rental income. (See “Local Lodging Taxes on Short-Term Rentals,” above).
Because they are tax-free, you get no tax deductions for the rental use of the property. For example, you can’t deduct the fees you pay to Airbnb or other rental platforms or deduct any other expenses, such as repairs, insurance, or depreciation. Instead, if you’re a homeowner, you continue to take the normal personal tax deductions to which any homeowner is entitled—that is, you may deduct your real estate taxes and home mortgage interest as personal itemized deductions on IRS Schedule A.
Keep records showing that your rental met the tax-free criteria, including a copy of your rental agreement, the dates the home was rented, and the amount of rent charged.
If You Incur Rental Losses
Short-term rentals tend to be profitable—that is, the rental income Airbnb landlords earn usually exceeds their expenses. However, if you incur a loss, special rules may apply to prevent you from deducting them from your other income.
Vacation home rules. If you incur a loss from your part-time rentals, your activity could be subject to the vacation home tax rules (these rules apply to all types of rentals, not just vacation homes). These rules apply if you live in the property more than 14 days during the year, or more than 10% of the days you rent all or part of it. For example, if you live in your home 300 days and rent it for 30 days, you’ll be subject to the vacation home rules if you incur a loss. Most Airbnb landlords who rent their property part time are subject to these rules if they incur a loss. These rules prevent you from deducting your rental losses from other nonrental income—ever. You file Schedule E to report your rental income and expenses, but must take your deductions in a prescribed order. The vacation home tax rules are covered in detail in Chapter 16.
Hobby loss rules. If you keep incurring losses year after year, or otherwise act like you don’t care whether you earn a profit from your rental, you could run afoul of the hobby loss rules. If the IRS determines that the primary motive you have for renting your property is something other than to earn a profit, it will conclude that your short-term rental activity is a not-for-profit activity, also called a hobby. Taxwise, this is even worse than being subject to the vacation home tax rules: You can never deduct your rental losses from nonrental income, and can only deduct your rental expenses from your rental income to the extent they exceed 2% of your adjusted gross income—a tax disaster. To avoid being subject to these rules, you must behave so that the IRS will believe that you want to earn a profit from your short-term rental activity. (See Chapter 2 for a detailed discussion on profit motive.)
Passive loss rules. If your money-losing short-term rental activity is not subject to the vacation home rules or hobby loss rules, it will be subject to the passive loss rules. These rules restrict the ability of all landlords to deduct rental losses from other nonrental income. However, your activity may have to be classified as a regular business for purposes of the passive loss rules instead of a rental activity. This will always be the case if your average rental period is seven days or less or you provide substantial personal services to your tenants. In this event, you’ll be able to deduct your losses only if you materially participate in the activity. You won’t be able to take advantage of the $25,000 offset or real estate professional exemption that can make it easier for many traditional landlords to deduct their losses. (See “Deducting Loses for Airbnb and Other Short-Term Rentals,” in Chapter 16.)