 Income tax 2022-2023. Residential rental property, rental income and expenses if no personal use of dwelling. Part number one, let's do some wealth preservation with some tax preparation. Most of this information comes from publication 527 residential rental property including rental of vacation home tax year 2022. You can find on the IRS website irs.gov, irs.gov. Support accounting instruction by clicking the link below giving you a free month membership to all of the content on our website broken out by category further broken out by course. Each course then organized in a logical reasonable fashion making it much more easy to find what you need than can be done on a YouTube page. We also include added resources such as Excel practice problems PDF files and more like QuickBooks backup files when applicable. So once again click the link below for a free month membership to our website and all the content on it. Connect the income tax formula we're focused online one income remember in the first half of the income tax formula is in essence an income statement but just an outline other forms and schedules flowing into these line items. One of those the schedule E having rental income minus rental expenses the net rental income in essence flowing into line one income of our income tax formula. Let's get on to the rental income and expenses if no personal use of dwelling. So this is the most straightforward rental scenario noting that generally we want to keep our business income and expenses separate than our personal expenses because that helps us to do our bookkeeping properly which helps us to populate our tax return properly. However things get a lot more confusing when there's co-mingling which we can't help sometimes such as if we have a personal residence that we are also using partially for rental purposes or if we have say a vacation home that we're using partially for rental as well as personal use. So let's start off with a clean cut case where we have just rental property it's being used just as rental property and those concepts related to the clean cut case will also be applicable to those less clean cut cases where we have personal use of the rental property in some way either renting part of the property and using part of it for personal or having a vacation home type of scenario. Alright so this chapter discusses the various types of rental income and expenses for a residential rental activity with no personal use of the dwelling. Generally each year you will report all income and deduct all out of pocket expenses in full that's the general rule any income that you get from an IRS perspective is typically included in income unless there's an exception for it. The income and expenses the bookkeeping in essence for the rental property is actually more straight forward than other kind of deductions on the form 1040s. The natural kind of deductions we would expect we in essence have an income statement income minus expenses the expenses for the most part being those that were necessary ordinary and necessary in order to generate the income. Therefore the income tax should be based on or applied to not the gross income but the net income. So the deduction to recover the cost of your rental property depreciation is taken over a prescribed number of years and is discussed in chapter two. So depreciation takes on a significant importance when we're talking about rental property because a huge expense is of course the cost of the property. And there's always this tension with depreciation on the income taxes because we as taxpayers typically want to take the depreciation as soon as possible to get the tax benefit as soon as possible. There are exceptions and whatnot. But the IRS will typically want to then need stringent rules in order to allow us depreciation according to these stringent types of rules which becomes quite important when doing tax planning for rental property. So rental income in most cases you must include your gross income all amounts you receive as rent that would be fairly straightforward. Rental income is any payment you receive for the use of or occupation of property that would make sense. That's what rental income is someone used your property the rental property and you're receiving income for that in the form of rent. It isn't limited to amounts you received as normal rental payments when to report when you report rental income on your tax return generally depends on whether you are a cash or an accrual based tax payer. So oftentimes for the rental property many people use like a cash based kind of system because they don't have the same like inventory needs that you might have in some other businesses for it. When we think of a cash versus accrual based system normally for like 1040 reporting reporting deductions on like a schedule a we typically think of a cash based system because we have to have actually given the cash to charity for example. And that's the year in which we would record that kind of deduction. When we think of a business the cash based system is still kind of easier in some ways because you can basically tie the income and expenses to the cash flows. However the cash based system can be manipulated by using prepayments you know adjusting the cash flows or advanced payments and that kind of stuff. So the tax of the IRS code will then come in and put limitations on those kind of manipulations. So the bottom line though is that when you first start your rental property you typically want to make sure to pick the appropriate method of accounting because it can be difficult to change. The method of accounting once you have chosen it because the IRS does not want people to be flip flopping between methods they want consistency otherwise they can manipulate the cutoff dates. So most individual taxpayers use the cash method. Cash method you are a cash basis taxpayer if you report income in your return in the year you actually or constructively receive it regardless of when it was earned. You constructively receive income when it is made available to you for example by being credited to your bank account. So for example if you had rental use of the property your tenant use the property in December of two thousand twenty two twenty one but you got paid in January of two thousand twenty two under a cash based system. You would record the income when you got paid in two thousand twenty two but under an accrual based system you would record the income in this in December. So on a cash based system when you got paid in two thousand twenty two January of two thousand twenty two on an accrual based system you would record it when you earned the income when the rental property was used in December. In our example of two thousand twenty one you can see that you have this timing difference which could manipulate the income and expenses similar scenario on the expenses around the cutoff of the end of the year for example. So a cruel method if you are an accrual taxpayer you generally report income when you earn it rather than when you receive it you generally deduct your expenses when you incur them rather than when you pay them. So if you're on an accrual based system typically if you think about accounting software if you invoice someone for work done that you haven't yet received payment for in the case of rental property. You can like if you were to actually invoice every month for the rent that you're going to receive if you're receiving monthly rent when the invoice goes out in December you would then record an increase in accounts receivable and income at the point in time that you issue the invoice. But sometimes you might not be issuing the invoice so so much in a rental property because it's a standard reoccurring payment once the contract has been made. But if you're tracking accounts receivable then accounts receivable is an accrual account the other side is usually income when accounts receivable goes up. More information you can see publication 538 accounting periods and methods for more information about when you constructively receive income and accrual methods of accounting. So types of income the following are common types of rental income advanced rent advanced rent is any amount you receive before the period that it covers include advanced rent in your rental income in the year you receive it regardless of the period covered for the method. Of accounting so if you're on a cash based system for example and someone pays you advanced rent for the next month or for the next six months or whatever you would still record it as revenue because you're on a cash based system even though they haven't yet used the property. However if you're on an accrual based system then you would get the money but you would have to record it as a liability unearned revenue or something like that an advanced payment because you haven't yet given them the use of the property. So in that case you would you would expect you wouldn't record it in income till they use the property at some point in the future. But this is where the iris comes in and says I want an exception here you got the money we want our part of the money because you can pay us now given the fact that it's in your in your hand. So example on March 18 2022 you signed a 10 year lease to rent your property so 10 years during 2022 you receive 9600 which is you would think the rent for the first year which makes sense and that would be income you would expect. But then you got 9600 of rent for the last year 10 years later on the lease you must include 19200 both of those amounts and your rental income for 2022 because the second payment was for advanced rent even if you're on an accrual basis. However a lot of times they'll they'll structure this in a lease agreement as a security deposit or something like that at which point it's not the last month rent but it's a security deposit in that case because you're assuming to give it back to to the tenant. You probably won't but the idea is that you're going to give it back to them then then it's not the same kind of structure and you might not have to include it in income until you actually kind of claim it in some way shape or form. So counseling a lease if your tenant pays you to cancel a lease the amount you receive is rent include the payment in your rental income in the year you receive it regardless of your method of accounting expenses paid by tenant. So if your tenant pays any of your expenses those payments are rental income. Now oftentimes this is just kind of a logistical type of thing that can get a little bit confusing that we'll talk about more shortly. But you can also think of like a landlord trying to get around of rental income by saying hey tenant I would like you instead of paying me the rent pay it to I don't know my ex wife or something for alimony and child support or something like that. And therefore because I didn't get the money personally I don't have to record it as income which will lower my taxes. Now that of course you cannot do because that would be constructively the same as though you told the tenant you told the tenant to give you the money and then you paid for your personal type of expenses. So you can't really get out of income by saying pay me pay me the the someone else my personal expenses or by by saying that you're going to receive something other than cash cash hour cash hour cash hour. If you receive property or something like that it's still income. But then you have this other kind of format where the tenant might have paid for something that is really the landlords responsibility and then lowered the rental payment by what they paid. And so now you have like kind of a bookkeeping problem to record the proper amount of income and the expense. So because you must include this amount in income you can also deduct the expenses if they are deductible rental expenses. So in other words if the if they if you told the landlord to pay something personal like alimony or child support then you don't get a deduction for that it would just have to be included in income. But if they paid for some repairs or something that are the landlords responsibility you should record it an income and then record the expenses which gets to the net same result but it's more properly recorded. We'll see some examples. So for more information you could see rental expenses later. Let's look at an example. Your tenant pays the water and sewage bill for your rental property and deducts the amount from the normal rent payment. Under the terms of the lease your tenant doesn't have to pay these bills. So now they're paying something now under some leases they might be responsible to pay the water and sewage. But if the lease term says that they are not responsible the landlord is responsible then what you should be doing is recording the income for the full amount. Including the amount that they paid not reducing it and then recording the expenses of the water and sewage you know payments that they made so you're properly recording income and expenses. The net result is the same because you'll have either a lower amount of income and no expense or you'll have a higher amount of income and then the expense income minus the expense the net amount being the same. But it should be properly recorded with the revenue being correct. The next example I think is more clear so include the utility bill paid by the tenant and any amount received as a rent payment in your rental income. You can deduct the utility payment made by your tenant as a rental expense. Let's look at this one I think is a little bit more clear example to while you are out of town the furnace in your rental property stops working. Your tenant pays for the necessary repairs and deducts the repair bill from the rent payment. So let's just assume the rent was 2000 each month and then one month the furnace goes out while the landlord is gone and the tenants like hey look I'll just take care of it myself and then I'll reduce my rent payment by that. You're like OK that makes sense. So now you had 2000 2000 2000 and then all of a sudden they pay you $1500 and like November or something. Well well that's you shouldn't record it as income of $1500 instead of 2000. We should be recording it as revenue of 2000 and then and expense of the 5000 or 500 or whatever if it was for the for the expense so that you have the proper income recorded. And then the expense the net result on net income is the same for that month of 1500 but instead of recording just revenue of 1500 and no expense. We should record the 2000 revenue so it kind of matches everything makes sense and then the expense OK include the repair bill paid by the tenant and any amount received as a rent payment in the in your rental income. You can deduct the repair payment made by your tenant as a rental expense. For example your tenant is a house painter. He offers to paint your rental property instead of paying two months rent. You accept the offer. So include your rental income in the payments the tenant would have paid for two months of rent. You can deduct that same amount as a rental expense for painting your property. So you've got a painter. He's not just doing it on himself on his own. He says hey look I'll paint the property in exchange for two months of rent. So so clearly same kind of scenario if the rent was 2000 each month and then in like October and November there's no rent. It's not like you got no rent because you still are charging them 2000. It's just that he's paying you now in the painting of the building. So you want to record it as rental income of 2000 and then an expense of the payment of the building. Otherwise doesn't it doesn't look quite right. Because you still now if they note that if they if they the painter said I'm going to go ahead and paint your house which isn't the rental property in exchange for two months rent. Well in that case you it's not like you didn't get any rent once again for October and November you still got the two months of rent. We could say 2000 and 2000 but you don't get an expense for the rental property because in that case they didn't paint the rental property. They painted your personal home. So that would be an attempt to try to avoid the the income altogether and not have to pay income taxes on it. But you can't do that because they paid you in something other than cash something equivalent you would think would be the general idea if it was an arms length market transaction. All right security deposit don't include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease term. So we talked about the last month's rent where you have to record that an income if you receive it. But if it's a security deposit because it's securing like damage and it's not something that you expect to give back to them or at least in theory then you don't have to include an income even though you received it. But if you keep part or all of the security deposit during any year because your tenant doesn't live up to the terms of the lease include the amount you keep in your income in that year. So if you say OK you did something you broke the wall you cracked the window or whatever and I'm going to keep some of the security deposit or something like that. Now it's income because now you have to you don't have to give it back. But of course you're probably going to use it to pay for whatever the crazy tenant did throwing the keg out the window or whatever whatever happened. But if an amount if an amount called a security deposit is to be used as a final payment of rent it is advanced rent included in your income when you receive it. So if it's categorized as advanced rent then it's rent and you've received it in advance and the IRS wants a portion of it. So other sources of rental income lease with and lease with option to buy. So this is where it gets a little bit confusing on the lease terms because it's kind of like well what is this is this really a sales transaction or is it a leasing transaction. Right. So if the rental agreement gives you your tenant the right to buy or rent property by your rental property the payments you receive under the agreement are generally rental income. If your tenant exercises the right to buy the property the payments you receive for the period after the date of sale are considered part of the selling price. So one reason that becomes messy is because if it's rental income you'd have to record it as rental income that could be subject to passive activity rules and all that kind of stuff. But if it's a sale of the property then it might be a capital gain situation where you might have different income regulations from ordinary income to capital gain income. That's a little bit more unusual situation part interest if you own a part interest and rental property you must report your part of the rental income from the property. So you own the property part of it with someone else. Maybe you have a partnership or something like that in which case you might have a flow through entity entity like a partnership where the K one would flow through to your to your your 1040s rental of property also used as your home. Here's where the messy situations get where there's that co you know the commingling of business and personal will talk more about in future sections here. But if you rent property that you also use as your home and you rent it less than 15 days during the tax year don't include the rent you received in your home. The idea there being I believe that it would be immaterial too small to really matter because it was only rented for 15 days. Also expenses from this activity are not considered our rental expenses. Also by the way the reason one reason the IRS might do that is to say don't include that an income is because if you included an income then it's likely you're going to have expenses you're going to that might be over that amount greater than that amount in which case you're going to try to take losses. The IRS is trying to avoid you from taking losses all the time. So or they're skeptical of losses. So also expenses from this activity are not considered rental expenses for more information see used as a home but rented less than 15 days under reporting income and deductions in chapter five. So rental expenses and most cases the expenses of renting your property such as maintenance insurance taxes and interest can be deducted from your rental income. So similar to to a schedule C situation you've got pretty natural expenses when you're thinking about an income tax system. Those that are in essence ordinary and necessary to generate revenue makes sense to be deductible because the tax should be imposed not on gross income but on net income. All right personal use of rental property. This is where it gets commingled again messing getting messy. If you sometimes use your rental property for personal purposes you must divide your expenses between rental and personal use. Also your rental expense deductions may be limited. So for that we'll dive into it more in chapter five or later on part interest. If you own a part interest and rental property you can deduct expenses you paid according to your percent of ownership. So if you own a part interest then you're going to have to parse out the expenses that would be applicable to you. Example Roger owns a one half undivided interest in a rental house. Last year he paid nine hundred and sixty eight for necessary repairs on the property so Roger can deduct four hundred and eighty four fifty percent as a rental. Expense he is entitled to reimbursement for the remaining half from the co-owner. When to deduct you generally deduct your rental expenses and the year you pay them because we usually think of it on a cash based system. But if you use the accrual method you can see publication five three eight for more information there. Oftentimes rental property will be on a cash based system in part because you don't have some of the issues that that force people onto an accrual system. Which are like like inventory for example you're not tracking like inventory in the same kind of fashion.