Tax Tips for Rental Real Estate Investors

A new report says that more than half of all individual taxpayers with rental real estate “misreport” related activities when they file their taxes for the year. The …

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A new report says that more than half of all individual taxpayers with rental real estate “misreport” related activities when they file their taxes for the year. The IRS believes this resulted in a loss of the better part of $13 billion in taxes in 2001, and the congressional report recommended some changes in tax reporting requirements for rental real estate activities.

The report, issued by the Government Accountability Office (GAO), is sure to intensify the IRS’s efforts to ensure tax compliance for rental real estate activities. Here’s what GAO found, followed by some tax reporting tips for rental real estate investors.

Misreporting of income and expenses

![filekey=|2415| align=|left| caption=|Rental income is misreported more than any other type of income| alt=|Rental income is misreported more than any other type of income|]GAO found that 8.7 million individual tax returns reported rental real estate activity for 2001, and the number grew to 9.1 million (5 percent) by 2005. GAO said individuals owned about 83 percent of the 15.7 million rental housing properties with fewer than 50 units, and about two-thirds were managed by their owners.

Individuals (or couples filing joint returns) tend to misreport their net income from rental real estate activities more frequently than other types of income. For example, only about 10 percent of taxpayers misreported their wage income in 2001, while 53 percent misreported rental real estate income. Although some of these mistakes resulted in taxpayers reporting too much rental income, mostly it worked the other way around.

The most common type of error was misreporting related expenses, which GAO estimated for 43 percent of taxpayers with rental real estate income. About a quarter of the tax returns with rental real estate activities were considered to have misreported expenses because owners couldn’t substantiate their expenditures. That amounts to 3.9 million taxpayers misreporting expenses and 2.1 million considered to have misreported simply because they didn’t keep proper documentation.

GAO estimated that 1.3 million tax returns misreported the amount of rental income owners received. Some taxpayers didn’t report any rental income, while others reported rental income on only some of their properties and some didn’t report the correct amount of rent received.

The agency said the main reason for misreporting is lax or confusing information reporting requirements. Among the examples cited in the report:

  • Neither payers nor receivers of mortgage interest have to report the address of the rental property, making it difficult for IRS to determine what properties a taxpayer owns.
  • Taxpayers with rental real estate activities not considered a trade or business don’t have to file information returns, Forms 1099-MISC, reporting payment made to individual contractors for repair services, but a sole proprietor engaged in a trade or business does.
  • The rules for calculating depreciation are not clear, and many owners are not aware that they need to depreciate some expenses over time. The IRS doesn’t provide guidance on how to determine the value of land, which is not depreciable.

GAO’s suggestions

Not surprisingly, GAO’s recommendations were mostly about changes to information reporting requirements and tax forms to make it easier for the IRS to match up income and expenses related to rental real estate properties. A change in the tax law (action by Congress) would be needed to effect one of the suggestions: to make all taxpayers with rental real estate activity subject to the same information reporting requirements as other taxpayers operating a trade or business.

![filekey=|2416| align=|right| caption=|| alt=|rental income tax|]Many of GAO’s suggestions can be carried out by the IRS without any action by Congress. Among the recommendations, GAO said IRS should:

  • require all mortgage holders to report property addresses on Form 1098 mortgage interest statements, and then require taxpayers to report the exact address of their rental real estate properties on Schedule E;
  • require taxpayers to report the basis amount attributed to land versus structure when depreciating rental real estate, and publicize resources available for determining how to distinguish between the cost of land versus the cost of structures;
  • provide guidance on the requirement for some taxpayers with rental real estate activity to report payments to contractors on Form 1099-MISC; and
  • explain, in the instructions for Schedule E, the recordkeeping requirements and potential for disallowed expenses and penalties if taxpayers cannot produce documentation for reported expenses.

Tips for rental property owners

Even without making these changes, the IRS is sure to step up its rental real estate compliance activities following release of the GAO report. With that in mind, here’s an explanation of where some property owners have made mistakes on their tax returns:

  1. If the owner requires prepayment of the first and last months’ rent, both payments must be reported when received. However, any amount considered a security deposit does not have to be reported up front.
  2. Income from rental activities includes not only the monthly rent payments, but also the amount of expenses tenants pay and then deduct from their rent. This includes the fair market value of any services the owner receives from the tenant in lieu of rent.
  3. Rental income also includes any portion of the security deposit that is not returned to the tenant at the end of the lease (known as “kept security deposits”). This should be reported at the end of the lease.
  4. The costs of property improvements that add to the value of a property or extend its useful life, such as a bathroom addition or new built-in appliances, must be depreciated rather than deducted when paid. In other words, taxpayers must deduct these costs on their tax returns over multiple years. Property owners also must depreciate the cost of acquiring a rental property, except for the cost of the land.
  5. The tax treatment of rental property also used by the owners for personal purposes depends on whether they use it as a residence. The test for residential use is whether the owners use the property for personal purposes for more than 14 days a year or 10 percent of the number of days the unit is rented at a fair rental price, whichever is greater. Personal use also includes all rentals below market value,  and rentals to family members at market value unless the renters use the property as their principal residence.
  6. If the owners use the property as a residence, they must apportion the expenses between personal and rental use based on the number of days it was used for each purpose. In addition, they can only deduct expenses up to the amount of income they report for the property. In other words, they can’t report a loss on their rental real estate activity, as they could if  they didn’t use the property as a residence.
  7. Penalties and interest related to late payment of real estate taxes are not “allowed expenses” and can’t be written off.
  8. Property owners need to keep good records related to rental activities, even if they don’t rent properties as a “trade or business.” Decisions about whether you can write off a loss on rental activities should be made on a case-by-case basis, so you may need to keep your records on a property-by-property basis—particularly if you use any of the properties or rent them to family members.

GAO said most individuals who report rental real estate activities use paid tax return preparers (about 80 percent). Because paid professionals are regulated by the IRS, expect them to ask property owners for more documentation of their income and expenses in the future.

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