Income received from the rental of real property is considered taxable income and must be reported on the owner’s personal tax return. Rental activity for the year is detailed on federal Schedule E, and the net profit or loss is then carried forward to federal Form 1040. Yearly rental revenue is offset by all routine expenses related to the property itself, including a deduction for depreciation.
Depreciation as the Largest Rental Write-Off
Depreciation is a tax deduction to recover the cost of an asset and to account for the presumed decline in its value due to usage. Residential real property is depreciated over a period of 27.5 years, so the annual deduction is over 3 percent of the original property acquisition cost. The annual depreciation tax deduction also reduces the ongoing carrying value or basis of the property. In the event of a future property sale, the adjusted basis figure is used to calculate gain or loss at that time. Unlike depreciation, other rental property tax deductions require actual monetary outlays during the tax year.
Routine Expenses of Rental Property
Rental properties require various types of expenses in order to remain marketable. Interest applicable to a loan on a specific property is deductible. Personal travel to a rental property is deductible at the standard business mileage rate. The owner may incur costs for essential services such as advertising and cleaning. The legal aspects of property ownership may require payments for professional services. All expenses related to the promotion and maintenance of the property are deductible and are included along with depreciation on Schedule E.
State and Local Taxes
Most states levy an income tax, so rental income or loss affects those state returns as well. The county in which the property is located will levy its own property tax. If the property is located within a city, an additional property tax is likely to be assessed. Property taxes are fully deductible and are included with all other deductible expenses on Schedule E to determine overall gain or loss.
Security Deposits
An amount received as a security deposit is not included as current revenue if there is a possibility of its return to the leaseholder. If it is eventually returned to the leaseholder, it is never included in income. If the deposit amount is not returned at the conclusion of the lease for some reason, it is included at that later time as additional rental revenue.
Rental income reported on Form 1040 is combined with all other return components and is taxed at regular rates. Depreciation deducted on Schedule E effectively reduces taxable income even though the actual value of the property may be steady or even increasing in some cases. The owner’s basis is also adjusted downward by the annual depreciation deduction, increasing the likelihood of a future gain on a sale. If the market value of the real estate remains steady, the depreciation deduction successfully defers current income to a future taxable gain on a sale of the property.
