As the U.S. housing market has continued to struggle with plummeting property values, more homeowners who originally intended to sell their homes are deciding to rent them out instead. Still others have decided to rent out a portion of the home they currently live in as a means of generating cash to cover some of the escalating energy and maintenance costs that make it harder to meet mortgage payments.
Whether homeowners turn to renting by choice or are forced into it due to unforeseen circumstances, becoming a landlord has tax advantages they need to be aware of. Becoming an "accidental landlord" carries major responsibilities, but also significant rewards.
Account for Rental Income
The Internal Revenue Service rules for reporting rental income apply to second homes, vacation homes and even cover renting a room within your primary residence. If you rent any space for 14 days or less during the year, the IRS gives you a pass, and you don't have to report it. But rent for 15 days or more, and you must report the added income on the Schedule E: Reporting Rental Income and Loss form. Accounting for rental income is easy because you can keep copies of the deposited rent checks from your tenants.
Track Expenses for Deductions
Bob Meighan, vice president of TurboTax, says once you know that you'll have rental income to report, you must begin keeping detailed records of all expenses related to the upkeep of that property. Whether you are renting an entire residence or a room within your personal home, you'll need to track all expenses related to making that space available for rental because they are all potentially deductible.
Meighan says mortgage payments for investment property, property taxes, energy costs, landscaping fees, clean up and fix-up expenses, advertising costs to rent the space and insurance costs are all potential deductions.
"You can even track your mileage if you have to run over to the rental property on a regular basis," he says.
Keep in mind that if you're renting out a room, you can deduct only a portion of the total expenses of the property. For example, if the room you 're renting covers 400 square feet and the total living area of the home is 2,000 square feet, you can deduct one-fifth of the total cost of painting the entire home as a business expense. You could also deduct one-fifth of the insurance, energy and other costs keeping in proportion with the rental space.
Take Depreciation on Eligible Property
Depreciation is an annual allowance for the wear and tear on rental property. Landlords may deduct the depreciation expense for their residence and other items purchased for the upkeep or renting of the property (this can include furniture and appliances used by or for tenants). Meighan recommends using tax software like TurboTax, which can make the calculations for you, or he says seek help from a tax professional that has experience with clients who hold real estate.
"At www.IRS.gov, there are a lot of good publications to help people navigate this somewhat complex area," he adds.
When you take depreciation, it's based on the price you paid for the property, not the current market value. This helps those people who have seen their property values erode over the last few years due to the financial crisis. For example, if you purchased your home for $300,000 and it now appraises for $175,000, the depreciation deduction is based on $300,000, not the current market value. It should be noted that the depreciation expense is also made in proportion to the space being rented -- if you are renting a room, only the portion used for rental can receive a depreciation deduction.
Other Pros and Cons
Renee Collins, president of RKC Tax and Financial Services in Chicago, reminds new landlords that it's important that they receive every deduction that's due them, so they should avoid doing anything that will eliminate deductions. Once they've declared their property for business use and begun collecting rents, it can't arbitrarily be reverted back to personal use without penalty.
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"If for any reason the property should turn back into personal use in the same year that you converted it to investment property, people need to know that they then can't take the depreciation deduction," says Collins.
Property owners should also know that in most cases, due to expenses and upkeep, renting a property is going to produce a loss. However, Meighan says this can be used as an advantage because, "at least a loss will help you offset other income you may have, so your tax liability goes down."
Decreasing your tax liability should lead to an increase in the size of your tax refund. But it can also increase something not so desirable.
"Those who have a business rental property have a higher chance of being audited," Meighan warns. But if you keep excellent records, becoming an accidental landlord is worth the risk.