Rental Income Taxes for Small Landlords

Rental income is taxed as ordinary income: you report the rent you collect and subtract your rental expenses and depreciation on Schedule E of Form 1040, and the net profit (or loss) flows into your tax return. Most small landlords can deduct mortgage interest, property tax, insurance, repairs, utilities they pay and management costs, and must depreciate the building (not the land) over 27.5 years.

This guide follows IRS Publication 527, Residential Rental Property, the IRS’s own plain-language rulebook for landlords. It is federal tax information only, not tax advice; New York State and City income taxes generally start from your federal figures, and a tax professional can confirm how the rules apply to you.

What counts as rental income

Pub 527 defines rental income as any payment you receive for the use or occupation of property. That includes more than the monthly check:

• Advance rent is income in the year you receive it, whatever period it covers. Last month’s rent collected at lease signing counts now.
• Security deposits are not income when you receive them if you plan to return them. If you keep part of a deposit for damage or unpaid rent, or apply it as the final month’s rent, that amount becomes income.
• Lease cancellation payments from a tenant are rent.
• Expenses a tenant pays for you (for example, the tenant pays a plumber and deducts it from rent) are income, and you can deduct them if they are deductible rental expenses.
• Services or property instead of rent are income at fair market value.

Most individuals use the cash method: income counts when received and expenses when paid. Rent you never collect is not income, and a cash-method landlord cannot deduct it as a loss either.

Deductible rental expenses

Repair or improvement?

This is the line that causes the most mistakes. Fixing a leak, patching plaster or replacing a broken pane is a repair. Replacing the whole roof, gutting a bathroom or adding a unit is an improvement you depreciate. The IRS offers two safe harbors that help small landlords:

• De minimis safe harbor: if you elect it, you can deduct items costing up to $2,500 per invoice or item (for taxpayers without an audited financial statement). You make the election with a statement attached to a timely filed return.
• Safe harbor for small taxpayers: if your average annual gross receipts are $10 million or less and the building’s unadjusted basis is $1 million or less, you can elect to deduct all of the year’s repairs, maintenance and improvements on that building, but only if their total is no more than the lesser of 2% of its unadjusted basis or $10,000. Go over that limit and the safe harbor is not available for the year. You elect it each year with a statement attached to your return.

Depreciation: the 27.5-year rule

You recover the cost of a residential rental building through depreciation. Under the General Depreciation System, Pub 527 sets a 27.5-year recovery period, straight line, with the mid-month convention: in the first year you get half a month for the month the property is placed in service. Depreciation starts when the property is ready and available for rent, not when the first tenant moves in. Shorter-lived items such as appliances and carpets are depreciated over shorter periods.

Your basis is generally what you paid plus certain settlement costs, such as legal and recording fees, title insurance and transfer taxes. Loan costs like points are not part of it. Because land is not depreciable, you split the basis between land and building, using fair market values or, if those are unknown, the ratio of assessed values. In NYC you can find the assessed land and total values on the property’s Notice of Property Value from the Department of Finance.

Renting part of your home

Many NYC landlords live in one unit of a two- or three-family house. Pub 527 says you divide shared expenses between the rental part and the personal part, most commonly by number of rooms or by square footage. Its own example: a 180-square- foot rented room in an 1,800-square-foot house gets 10% of shared costs, so a $600 heating bill gives a $60 rental expense. Costs only for the rented part, like a repair inside the tenant’s unit, are 100% rental. The personal share of mortgage interest and property tax may still be deductible on Schedule A if you itemize.

If you rent out a home you also use yourself, such as a vacation house, the rules change. You use a unit as a home if your personal use is more than the greater of 14 days or 10% of the days it is rented at a fair price. If you rent a home for fewer than 15 days in the year, you do not report the rent at all and cannot deduct rental expenses.

Worked example: a two-family house in Queens

Last year you bought a two-family house with two equal units for $1,000,000 and paid $20,000 of settlement costs that went into basis. You live upstairs, and this year the downstairs unit is rented all twelve months at $2,800 a month. The Notice of Property Value shows land at 30% of the total assessed value, so 70% of basis is building. Half of the building is rental.

Because this is the second year of ownership, the depreciation line is a full year. In the first year the mid-month convention applies: a unit placed in service in July would get 5.5 months, or about $5,950.

The result is a loss of about $12,082. Rental losses are passive, but Pub 527 lets you deduct up to $25,000 of losses from a rental you actively participate in (you own at least 10% and make management decisions such as approving tenants and setting rent) against other income. The allowance is limited to 50% of the amount by which $150,000 exceeds your modified adjusted gross income, so it starts shrinking above $100,000 and disappears at $150,000 (lower limits apply if you are married filing separately). With MAGI of $120,000, the allowance is $15,000, so this whole loss is usable this year. Losses you cannot use carry forward. The other half of the interest and property tax is personal and goes on Schedule A only if you itemize.

Records to keep

1. 1

   A separate bank account for the rental

   Deposit all rent and pay all rental bills from it. It turns your statements into a ledger.
2. 2

   Closing statement and basis worksheet

   Keep the purchase closing statement, the land/building split and every improvement receipt for as long as you own the property and for years after you sell.
3. 3

   Repair vs improvement file

   Pub 527 recommends separate records of repairs and improvements. Note what was fixed and why.
4. 4

   Leases, deposits and rent ledger

   Track deposits separately from rent so you can show which amounts are income.
5. 5

   Mileage log

   Date, purpose and miles for each trip to the property, if you deduct car expenses.

Next steps

Run the numbers before you buy or raise rent with the rental property cash flow calculator and the rental property depreciation calculator. If you are thinking of renting out an apartment you own, read Renting out your NYC condo or Buying a two- to four-family house in NYC.