Turning your home into a rental is a busy time -- and a confusing one if you've never done it before. There's so much to know: how to price the property, what should be in your lease and how to do your taxes.
Taxes are an important part of being a landlord, and there aren't simple directions for doing them. (Or, at least, I haven't found them.) I recommend a tax professional, especially for your first year of renting. But these tips will help you understand what that professional is saying and maybe help you catch any errors before they snowball.
Disclaimer: This is not meant to instruct you how to do your taxes as a landlord. You must get specific advice from a tax professional for your specific situation. Military OneSource offers free telephone tax consultations via its MilTax program.
Get to Know the Tax Forms
Print out IRS Form 1040 Schedule E, Supplemental Income and Loss. Your rental income and expenses will be reported on the first page of this form. Just reading this form will give you a good idea how the overall taxable profit or loss calculations work.
Understanding the Pros and Cons of Depreciation
For many landlords, depreciation (Line 18 on Schedule E linked above) is like a magical tax gift that lowers your tax bill. In reality, it's a lot more complicated than that.
Depreciation refers to the idea that most objects lose value over time. If you own a company and buy a stapler, your stapler is worth less every year that you own it. Therefore, the IRS allows you to use that reduction in value each year as part of your tax calculations.
However, when you sell the property ("dispose of," in IRS language), you are expected to sell it for less than the value that it is supposed to have, based on the depreciation that you've taken over the years. For a stapler, that's probably going to work out.
But real estate is different. It often doesn't lose value. We're all hoping that it increases in value. When you sell the property, you'll be taxed on all that depreciation that you took over the years but didn't happen ("not realized," in IRS language). This can result in a huge tax bill at the time of sale.
Calculating Depreciation Correctly
One of the hardest parts about the first year as a landlord is figuring out how to calculate your depreciation. A key term in depreciation is "basis." Basis is a complicated and sometimes-involved calculation, but basically it is the amount of money you spent to obtain the property. In the case of rental real estate, your basis has a few parts: the land, the dwelling and the contents of the dwelling. You don't depreciate land because the law assumes it is not going to go down in value. You do depreciate the dwelling and the contents, such as appliances.
Getting your original basis wrong will result in wrong calculations as long as you own the property. No fun!
Maintenance vs. Repairs vs. Improvements
As you see when looking at Schedule E, there is a line for cleaning and maintenance and another for repairs. What you won't see is a line for improvements, and that's important. While you can deduct maintenance and repairs in the year they occur, improvements must be depreciated over time. (Subject to special rules.)
How do you know what is what?
- Routine maintenance, the IRS says, which "keeps your property in a normal efficient operating condition, but that doesn't materially increase the value or substantially prolong the useful life of the property, is deductible in the year that it is incurred." This might mean HVAC service or gutter cleaning.
- Repairs are smaller fixes to the existing structure or systems; for example, changing the hose on a sink sprayer or repainting a door.
- Improvements are anything that would potentially increase the value of the property; for example, replacing windows or adding landscaping.
As you can see, there's a lot to figuring out your taxes as a first-time landlord. Professional help is smart, but understanding these basic concepts can help those conversations feel a little less confusing.
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