Chapter 6: Rental Property (Part I)

Overview

Chapter Description
Upon completion of this chapter, students will understand the fundamentals of rental property and
Schedule E reporting. Most tax preparers have some experience preparing Schedule E. For many,
their experience is limited to the basic rental of one home. There are many facets involved with
the subject of rental property. This chapter will review the basic information and explore more
complex issues regarding rental property. Beginning 2018, the rental income is subject to section
199A deduction.

The following content is based on 2023 tax law for 2022 tax returns; however, discussions
of prior year tax law will be addressed as applicable.

Learning Objectives
1) Discuss how to report income and expenses for not-for-profit rental property.
2) Describe the reporting of rental income and expenses on Schedule E.
3) Discuss losses from rental real estate activities.
4) Explain the process of dividing expenses between personal use and rental use.

Key Terms
 Advance Rent
 Depreciation
 Improvements
 Lease
 Material Participation
 Not-for-Profit Rental
 Passive Activity
 Real Property
 Rental Income
 Repairs

Objective #1: Not-for-Profit Rental

If the taxpayer does not rent property to make a profit, or at fair rental value, rental expenses can
only be deducted to the extent of the rental income received. The taxpayer cannot deduct a loss.
Expenses that exceed the rental income cannot be carried forward.

Where to Report Rental Income and Expenses

For tax year 2022, the taxpayer should report not-for-profit rental income on line 8j of Schedule 1
(Form 1040). They would report mortgage interest (if the property is the taxpayer’s main home or
second home), real estate taxes, and casualty losses from federally declared disasters on the
appropriate lines of Schedule A (Form 1040), Itemized Deductions, if the taxpayer itemizes
deductions. However, the mortgage interest and property tax are subject to limitations.

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The Tax Cut and Jobs Act eliminated miscellaneous deductions and casualty and theft loss from
Schedule A. Only a casualty loss from a federally declared disaster is deductible on Schedule A
(Form 1040).

Other rental expenses (other than property tax and mortgage interest) related to the not-for-profit
rental activities are not deductible.

Prior Year Tax Law: Taxpayers can no longer claim other rental expenses after 2017 as
miscellaneous itemized deductions on line 23 of Schedule A (Form 1040). The total
miscellaneous itemized deductions subject to the 2% of the adjusted gross income limitation
has been repealed through 2025.

Presumption of Profit
If rental income is more than rental expenses for at least three years out of a period of five
consecutive years, it may be presumed that the taxpayer is renting property to make a profit. If so,
the taxpayer should report all rental income and expenses on Schedule E.

If the taxpayer is starting their rental activity and does not show a profit for three years, they can
elect to have the presumption made after the five-year period required by the test. They may
choose to postpone the decision of whether the rental is for profit by filing Form 5213, Election To
Postpone Determination as To Whether the Presumption Applies That an Activity Is Engaged in for
Profit.

Form 5213 must be filed within three years after the due date of the return (excluding extensions)
for the first tax year in which they engaged in the activity or, if earlier, within 60 days after receiving
written notice from the IRS proposing to disallow deductions attributable to the activity. This 60-
day period does not extend the three-year period referred to above.

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 Review Question 1
Jim’s friend, Phillip, lost his job and needed a place to stay. Jim rented out a spare bedroom to
Phillip for two months at below market value. Phillip paid $200 in cash and cut the grass and
maintained the lawn for the home, which saved Jim $100 for a private lawn service. How should
Jim report the income?

a) $300 on Schedule E
b) $200 on Schedule E
c) $300 on Schedule 1 (Form 1040), line 8i
d) $200 on Schedule 1 (Form 1040), line 8i

Review Question 2
Using the same information from Question 1, where would Jim deduct his mortgage interest and
property taxes?

a) He can’t take a deduction because he only rented out a room and did not make a profit.
b) On Schedule E
c) On Schedule A
d) Prorated to rental on Schedule E and the remainder on Schedule A

Objective #2: Reporting Rental Income and Expenses

Schedule E is used to report more than just rental income. The following is a list of the different
parts of Schedule E and the types of income that are to be reported on respective lines of the form:

Part I is used to report income or loss from rental real estate and royalties.

 Line 1a is used to show the address of the property. Up to three properties can be listed
here.
 Line 1b is used to describe the type of property. The codes can be found under “Type of
Property” in Part I of the form.
 Line 2 is used to answer questions about fair rental days and personal use days that would
determine whether the owner qualifies to claim the property as rental property. Line 2 is
also used to determine if the taxpayer meets the requirements to file as a qualified joint
venture.
 Line 3 is for reporting the income from the real estate property listed on Line 1a.
 Line 4 is for reporting royalties from oil, gas, or mineral properties; copyrights; and patents.
 Lines 5-19 list expenses connected with the rental or royalty properties.
 Line 20 is used to total the expenses from Lines 5-19 for each property.

Part II is used to report income or loss from partnerships and S corporations which is also reported
on a Schedule K-1 (partnerships – Form 1065 and S corporations – Form 1120-S). Schedule K-1
is a form which the S corporation or partnership uses to report income or losses to its shareholders
or partners.

Part III is used to report income or loss from estates and trusts, which is also reported on a
Schedule K-1 (Form 1041). (This is not discussed any further in this chapter.)

Schedule E is not used to report rental of personal property (e.g., the taxpayer rents their computer
to a neighbor for eight hours a week), real estate activities for which significant personal services
are provided (e.g., hotel, motel), or royalty income from artists, writers, etc. who are self-employed.
These self-employment incomes are reported on Schedule C and are subject to self-employment
tax.

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Rental activities operated as for-profit businesses which would be reported on Schedule E include
renting a house, apartment, or condo in which no personal services are provided beyond snow
removal, yard, and grounds maintenance, cleaning public areas, trash removal, and furnishing heat
and electricity.

Rental Income
Generally, the taxpayer must include in gross income all amounts received as rent. Rental income
is any payment the taxpayer receives for the use or occupation of their property. In addition to
normal rent payments received as rental income, there are other payments, discussed later, that
may be considered rental income.

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Rental income is reported on the return for the year the income was actually or constructively
received if the taxpayer is using the cash basis. Income is constructively received when it is made
available to the taxpayer. If the taxpayer is using the accrual basis, income is reported in the year
earned, regardless of when it was received, with exception for advance rent as noted below. You
generally deduct your expenses when you incur them, rather than when you pay them.

Advance rent – Any amount that the taxpayer received before the period that it covers. The
taxpayer should include advance rent in rental income in the year it was received, regardless of the
period covered or the method of accounting used.

Student Note: It is normal for rent to be paid on the first of the month for that month’s rent
(i.e., paying rent on May 1st for May rent). This would not be considered advance rent.

Example 1: A tenant signed a 10-year lease to rent the taxpayer’s property. In the first year,
the taxpayer received $8,000 for the first year's rent and $8,000 as rent for the last year of the
lease. The taxpayer must include $16,000 in their income in the first year.

Security deposit – The taxpayer should not include a security deposit in income if it is to be
returned to the tenant at the end of the lease. If the taxpayer keeps part or all the security deposit
because the tenant does not live up to the terms of the lease, then the taxpayer is required to report
any amount they keep as income in that year.

A security deposit that is applicable to the final rent payment is advance rent. The landlord must
include it in income when it is received. If the security deposit is only to guarantee the condition of
the property at the end of the contract and cannot be used to pay the final month’s rent, it is not
advance rent.

Canceled lease – If the tenant pays to cancel a lease, the amount received is rent. The payment
is included in income in the year received, regardless of the taxpayer’s method of accounting.

Expenses paid by tenant – If the tenant pays any of the taxpayer’s expenses, the payments are
rental income. The taxpayer must include them in income and can deduct the expenses if they are
deductible rental expenses.

Example 2: The tenant pays the water and sewage bill for the taxpayer’s rental property and
deducts it from the normal rent payment. Under the terms of the lease, the tenant does not
have to pay this bill. Include this money as rent received and deduct as expenses.

Example 3: While the taxpayer is out of town, the furnace in the rental property stops working.
The tenant pays the necessary repairs for the taxpayer and deducts the repair bill from the
rent payment.

Based on the facts in each example above, the taxpayer must include both the net amount of the
rent payment and the amount the tenant paid for the utility bills and the repairs in rental income.
They can deduct the utility bills and repairs as rental expenses on Schedule E.

Property or services – If the taxpayer receives property or services as rent, instead of money,
they must include the fair market value of the property or services in rental income. If the services
are provided at an agreed upon or specified price, that price is the fair market value unless there is
evidence to the contrary.1

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 Example 4: John is a house painter. He offers to paint the rental property for his landlord
instead of paying one month’s rent. The landlord accepts his offer. The landlord must include
the amount John would have paid for one month's rent in rental income. The landlord can
include that same amount as a rental expense for painting the property.

Lease with option to buy – The taxpayer may include a clause in the rental agreement stipulating
that the tenant has the right to buy the rental property. Any payments received under the agreement
are generally considered rental income. Once the tenant exercises the right to buy the property,
the payments received for the period after the date of sale are part of the selling price.

Rental of property also used as a home – If the taxpayer rents their home for fewer than 15 days
during the tax year; they will not include the rent they received in gross income. The rental
expenses related to those 15 days cannot be deducted. The taxes, interest, and casualty and theft
losses from a federally declared disaster that are allowed for nonrental property can still be included
on Schedule A (Form 1040).

Partial Interest – If the taxpayer owns a partial interest in rental property, any part of the rental
income from the property allocated to the taxpayer must be reported.

Sale-Leaseback Transactions
When a real estate entity is in need of capital, an option is available for the owner of the property
to sell it and immediately lease the property from the acquirer of the property. This transaction is
referred to as a “sale-leaseback transaction.” The most common reason for this transaction would
be when a company needs to use the cash it has invested in a property for other investments, but
the asset is still needed in order to operate. In addition, if properly structured, such a transaction
can provide the seller-lessee with additional tax deductions. At the same time, it can provide the
buyer-lessor in the transaction with a lease with stable payments for a specified period of time.

The first issue that must be determined is whether the transaction should be characterized as a
“true” sale or whether the transaction is in actuality something else, such as a financing
arrangement (or maybe even a like-kind exchange under IRC §1031). If the transaction is
characterized as a true sale with a true lease between the seller and the buyer, the seller-lessee
will be subject to capital gains for the recognized gain on the transaction (in addition to depreciation
recapture, when applicable). In addition, the seller would be considered a lessee. The benefit of
this transaction is the ability to extract cash from the property without the restrictions generally
associated with bank loans using the property as collateral. Another benefit to the seller-lessee is
that the rent payments are currently deductible. The disadvantage of this transaction is that any
appreciation of the real property will benefit the buyer-lessor, not the seller-lessee.

However, if the sale-leaseback is not characterized as a true sale with an associated true lease, it
would then generally be considered a refinancing resulting in loan treatment. “Rent” payments
would need to be allocated between principal and interest with the interest portion a taxable event
to both parties of the transaction (while the principal portion of the payment would not). However,
it should be noted that in accordance with a number of revenue rulings, if the buyer-lessor ends up
with ownership at the end of the transaction, there will be sale treatment at that time.

So now we have to ask, and attempt to answer, the question of whether a sale-leaseback should
be recognized as a sale or a financing arrangement. There is no clear-cut answer; rather, it
depends on facts and circumstances surrounding the transaction. Some of the key items to
consider include:
 Is there an option for the seller-lessee to repurchase the property?
 Is the option price considered too low (which may be an indication of a financing
arrangement)?

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  Is the option price only equal to the present value of future rents?
 How are risks allocated regarding condemnation or casualty?
 Is the rent set at fair-market rates?
 Has the opportunity or risk for appreciation or depreciation in the value of the property
moved from the seller-lessee to the buyer-lessor?

In summary, much thought and due diligence must be performed to provide assurance that the
sale-leaseback transaction will be recorded as desired by both parties.

Rental Expenses
Generally, the taxpayer will deduct rental expenses in the year they are paid. If you use the accrual
method, see Publication 538 for more information.

Vacant rental property – If the taxpayer has property that is available to rent, they may be able to
deduct ordinary and necessary expenses involved in maintaining and managing the property for
the period that the property is vacant. The IRS does not allow the taxpayer to deduct any loss of
rental income for the time that the property is vacant.

Pre-rental expenses – The expenses for managing or maintaining rental property can be deducted
as ordinary and necessary expenses from the time the taxpayer made it available for rent.

Depreciation – Depreciation is a capital expense. The taxpayer can begin to deduct depreciation
expenses of the rental property when it is ready and available for rent. Depreciation is discussed
later in this chapter.

Expenses for rental property sold – If the taxpayer sells the rental property, they can deduct the
ordinary and necessary expenses for managing or maintaining the property until it is sold.

Personal use of rental property – If the taxpayer occasionally uses the rental property for
personal purposes, they must prorate the expenses between rental and personal use. The rental
expense deductions may be limited.

Partial interest – If the taxpayer owns a partial interest (50%) in rental property, they can only
deduct the expenses allocated to their part of their interest (50%).

Repairs and Improvements

The taxpayer can deduct the cost of repairs to the rental property. Improvements are not
deductions, but they can be recovered through depreciation.

The taxpayer will need to separate costs of repairs versus improvements. The cost of
improvements is key information needed prior to depreciating or selling the property.

Repairs – A repair is to keep the property in good working condition. Repairs do not materially add
to the value of the property or substantially prolong its useful life. Repainting the inside or outside
of the property, fixing leaks, fixing gutters or floors, plastering, and replacing broken windows are
examples of repairs.

If repairs are made as part of an extensive remodeling or restoration of the property, the whole job
is an improvement.

Improvements – An expense is for an improvement if results in a betterment to the property,

restores the property, or adapts the property to a new and different use. If an improvement is made
to the property, any expenses paid for the improvement must be capitalized. The capitalized
expenses can generally be depreciated as if the improvement were separate property.

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Other items which would increase the property owner’s basis are zoning costs and the costs of
assessments for local improvements, such as extending utility service lines to the property, water
connections, and sidewalks.

Examples of Improvements

Practice Tip – Access expenditures credit or deduction: To assist taxpayers in complying

with the Americans with Disabilities Act, taxpayers that modify architectural components of a
building to remove barriers related to elderly individuals or those with disability may be eligible
to claim a credit or deduction related to those expenses and avoid capitalization of such costs
under Section 44 of the Internal Revenue Code. The election to claim the deduction is limited
to $15,000. If claiming the credit, Form 8826 should be completed. It is important to note that
taxpayer should not claim both a credit and a deduction related to the same expenditures.

Practice Tip – Routine maintenance safe harbor: Qualifying expenditures determined to

be improvements can be deducted rather than capitalized under the Routine Maintenance
Safe Harbor; expenditures are qualified if all the following criteria are met:
 The expenditure arises from use of the property in a trade/business/rental activity;
 The expenditure is made for recurring activities performed on tangible property;
 The expenditure keeps the property in efficient and ordinary function; and
 The expenditure is expected to be incurred again within 10 years for buildings/building
systems or more than once during the class life of all other depreciable property.

Other Expenses
Other expenses that can be deducted from gross rental income include advertising, cleaning and
maintenance services, interest, utilities, fire and liability insurance, taxes, ordinary and necessary
travel and transportation, commissions for the collection of rent, and other expenses (discussed
next).

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 Practice Tip – De minimis safe harbor election: Taxpayers may generally elect to deduct
amounts up to $2,500 per item or invoice [or up to $5,000 per item or invoice if the taxpayer
has an applicable financial statement (AFS)]. If the expenses exceed the applicable amounts,
they do not qualify for the de minimis safe harbor election and must be capitalized. Safe
harbor is an election, not a change in accounting method. The safe harbor election must be
made annually by the extended due date of the original income tax return. The election applies
to all expenditures which meet the safe harbor criteria during the taxable year. Once the
election is made, it is irrevocable. The taxpayer must attach a statement to the return (as
described in IRC Section 1.263(a)-1(f)(5)). No additional form is required.

Rental payments for property – The taxpayer can deduct the rent paid for property that they used
for rental purposes. For example, if the taxpayer rented an apartment and paid $500/month, then
they rented it out for $800/month, they can deduct the $500/month rent they paid as rental
expenses. Similarly, a leasehold allows equal deductions over the term of the lease.

Rental of equipment – The taxpayer can deduct the rent paid for equipment used for rental
purposes. However, in some cases, lease contracts are really purchase contracts. If so, taxpayers
cannot deduct those payments. The cost of purchased equipment is recovered through
depreciation.

Insurance premiums paid in advance – If the taxpayer paid an insurance premium for more than
one year in advance, the taxpayer is allowed to deduct only the amount that applies to the current
year. The total premium is not deducted in the year paid if it does not apply to a calendar year.

Local benefit taxes – Generally, the taxpayer cannot deduct charges for local benefits that
increase the value of their property. Water and sewer systems and sidewalks and streets are
nondeductible costs and are non-depreciable capital expenditures. They must be added to the
basis of the property. Local benefit taxes can be deducted if they are for repairing, maintaining, or
paying interest charges for the benefits.

Interest expense – The taxpayer can deduct mortgage interest they paid on rental property. When
you refinance a rental property for more than the previous outstanding balance, the portion of the
interest allocable to the loan proceeds not related to rental use generally cannot be deducted as a
rental expense. Chapter 4 of Publication 535 explains mortgage interest in detail.
 Expenses paid to obtain a mortgage: There are some expenses that the taxpayer must
pay in order to obtain a mortgage on rental property. These expenses cannot be deducted
as interest. These expenses include mortgage commissions, recording fees, and abstract
fees. These expenses are capital expenses and should be added to the basis and
amortized over the life of the mortgage.
 Form 1098: If the taxpayer paid mortgage interest on rental property to any one person,
of $600 or more, then they should receive a Form 1098, Mortgage Interest Statement, or
similar statement showing the interest paid for the year. If the taxpayer and at least one
other person (other than a spouse on a joint return) were liable for and paid interest on the
mortgage, and the other person received the Form 1098, the taxpayer should report their
share of the interest on line 13 of Schedule E (Form 1040). A statement should be attached
to the return showing the name and address of the other person. For paper returns, in the
left margin of Schedule E, next to line 13, the taxpayer would write “See attached.”

A potential limitation to the deductibility of interest expense came as a result of the passage of the
Tax Cuts and Jobs Act in December of 2017. The purpose of this particular provision of the Act is
to discourage entities from becoming too highly debt laden. Businesses (including real estate
entities) have long been incentivized to borrow, not only by the low current interest rates but also
by the knowledge that the interest will be fully deductible.

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However, beginning in 2018, a real estate entity can only deduct its net interest expense (defined
as interest expense paid/incurred net of recognized interest income) up to 30% of its “EBITDA.”
EBITDA is defined as an entity’s earnings before interest, taxes, depreciation, and amortization.
Any amount of interest the real estate entity pays/incurs in excess of this 30% limitation cannot be
currently deducted but may be carried forward to future tax years. Beginning in 2022, they become
even more restrictive when the deductibility of interest expense will be capped at 30% of earnings
before interest and taxes but after depreciation and amortization expenses. This will usually result
in a significantly lower allowable amount of currently deductible interest.

A few rules concerning the applicability of this interest deduction limitation:

 It only impacts entities whose average gross receipts are in excess of $27 million in 2022
($29 million in 2023). It will have no impact for entities with average gross receipts less
than this threshold.
 A real estate entity can avoid this limitation, even if their 2022 average gross receipts
exceed the $27 million threshold ($29 million in 2023) if they are engaged in what is defined
as a “real property trade or business” under the meaning of IRC §469(c)(7). Accordingly,
if a real estate entity is engaged in the following lines of business, they have an opportunity
to avoid the limitation:
o Leasing
o Construction
o Development
o Acquisition
o Management
o Brokerage
 If the real estate entity is not involved in the above-detailed activities, they can make an
election to avoid the imposition of the 30% rule. However, by making that election, they
will be required to depreciate their residential and nonresidential real property in addition
to their qualified improvement property utilizing longer depreciation lives known as the
Alternative Depreciation System (ADS).

Points – Points are the charges a borrower pays when they take out a loan or a mortgage. Points
are also referred to as loan origination fees, maximum loan charges, or premium charges. Points
are basically prepaid interest; therefore, the borrower must deduct the interest over the term of the
loan. They cannot deduct the full amount in the year paid. If any of these points paid are only for
the use of money, then they are interest.

Loan origination fees (points) paid when the taxpayer borrows by taking out a loan or mortgage,
results in original issue discount (OID). In general, the OID is deductible as interest unless it must
be capitalized. How the taxpayer figures the amount of OID that can be deducted each year
depends on whether the total OID, including the OID resulting from the points, is insignificant or de
minimis. If the OID is not de minimis, the taxpayer must use the constant-yield method to figure
how much they can deduct.

De minimis OID: Generally, if the OID is less than one-fourth of 1% (0.0025) of the stated
redemption price at maturity (usually, the principal amount of the loan) multiplied by the term of the
loan, then the OID is de minimis. If the OID is de minimis, the taxpayer can choose one of the
following ways to figure the amount that can be deducted each year.
 On a constant-yield basis over the term of the loan.
 On a straight line basis over the term of the loan.
 In proportion to stated interest payments.
 In its entirety at maturity of the loan.3

The taxpayer makes this choice by deducting the OID in a manner consistent with the method
chosen on their timely filed tax return for the tax year in which the loan or mortgage is issued.

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 Example 5 – De minimis amount: On January 1, 2022, Michelle took out a loan for
$100,000 to buy a house that she will use as a rental during 2022. The loan matures on
January 1, 2051 (a 30-year term). During 2022, Michelle paid $10,000 of mortgage interest
(stated interest) to the lender. When the loan was made, she paid $2,000 in points to the
lender. The points reduced the principal amount of the loan from $100,000 to $98,000,
resulting in $2,000 of OID. Michelle determines whether the points (OID) paid are de
minimis based on the following computation:

Redemption price at maturity (principal amount of the loan) $ 100,000

Multiplied by: The term of the loan in complete years × 30
$ 3,000,000
Multiplied by × .0025
De minimis amount $ 7,500

The points (OID) paid ($2,000) are less than the de minimis amount; therefore, Michelle
has de minimis OID and can choose one of the four ways discussed earlier to figure the
amount that can be deducted each year. Under the straight line method, $67 each year
for 30 years can be deducted.

The yield to maturity (YTM): The YTM is commonly shown in the literature received from the
lender. If the taxpayer does not have this information, they should consult the lender. The YTM is
the discount rate that, when used in computing the present value of all principal and interest
payments, produces an amount equal to the principal amount of the loan.4

Qualified stated interest (QSI): Generally, QSI is stated interest that is unconditionally payable
in cash or property (other than debt instruments of the issuer) at a single fixed rate at least annually
over the term of the loan.

Constant-yield method: If the OID is not de minimis, the taxpayer must use the constant-yield
method to figure how much can be deducted each year. The deduction for the first year is
determined in the following manner:

1. Calculate the issue price of the loan:

Principal amount
– Points paid on loan
= Issue price of the loan
2. Interest on the issue price:
× YTM
= Interest on the issue price of the loan
3. OID deductible for the 1st tax year:
– Qualified stated interest (QSI)
= OID deductible for the 1st tax year

To figure the taxpayer’s deduction in any subsequent years, start with the adjusted issue price.

1. Calculate the adjusted issue price:

Issue price of the loan
+ OID deducted in prior years
= Adjusted issue price
2. Interest on the adjusted issue price:
× YTM
= Interest on the adjusted issue price
3. OID deductible for the sub. tax year:
– Qualified stated interest (QSI)
= OID deductible for the subsequent tax year

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 Example 6 – Constant yield: The facts are the same as in the prior example. The yield
to maturity of the loan is 10.2467%, compounded annually. Figure the amount of OID
(points) to be deducted in 2022 as follows:

Principal amount of the loan $ 100,000

Minus: Points (OID) – 2,000
Issue price of the loan $ 98,000
Multiplied by: YTM × .102467
Total 10,042
Minus: QSI – 10,000
Points (OID) deductible in 2022 $ 42

Figure the deduction for 2023 as follows.

Issue price $ 98,000

Plus: Points (OID) deducted in 2022 + 42
Adjusted issue price $ 98,042
Multiplied by: YTM × .102467
Total 10,046
Minus: QSI – 10,000
Points (OID) deductible in 2023 $ 46

Loan or mortgage ends: When the taxpayer’s loan or mortgage ends, they may be able to deduct
the remaining OID (points) in the tax year that the loan or mortgage ends. A taxpayer’s loan or
mortgage may end due to refinancing the loan, prepayment of the loan, foreclosure, or similar
event. If the taxpayer is refinancing their loan with the same lender, the remaining OID (points)
usually are not deductible in the year refinancing occurs but may be deductible over the term of the
new mortgage or loan.

Points when loan refinance is more than the previous outstanding balance: When the
taxpayer refinances a rental property for more than the prior outstanding balance, they generally
cannot deduct the portion of the points allocable to loan proceeds not related to rental use as a
rental expense. For example, if an individual refinanced a loan with a balance of $110,000, the
amount of the new loan was $140,000, and the taxpayer used $30,000 to purchase a car, points
allocable to the $30,000 would be treated as nondeductible personal interest.

Travel expenses – The taxpayer can deduct travel expenses if the primary purpose of the trip was
to collect rental income or to maintain or manage their rental property. The travel expenses must
be considered necessary and ordinary for rental property. The expenses must be split between
rental and nonrental activities. The taxpayer cannot deduct the travel expenses if the primary
purpose of the trip was the improvement of their property. The cost of improvements is recovered
by taking depreciation. For information on travel expenses, see Chapter 1 of Publication 463.

Local transportation expenses – The taxpayer can deduct ordinary and necessary local
transportation expenses if they were for collecting rental income or managing, conserving, or
maintaining their rental property. However, transportation expenses incurred to travel between the
taxpayer’s home and a rental property generally constitute nondeductible commuting costs unless
they use their home as their principal place of business. See Publication 587, Business Use of
Your Home (Including Use by Daycare Providers), for information on determining if a home office
qualifies as a principal place of business.

If the taxpayer uses their personal car, pickup truck, or light van for rental activities, the expenses
can be deducted using either actual expense or the standard mileage rate. For 2022, the rate is

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58.5 cents per business mile through June 30, 2022, and increases to 62.5 cents for mileage
incurred/paid between July 1, 2022, to December 31, 2022. In 2023, the standard mileage rate is
65.5 cents per business mile. For more information, see Publication 463, Chapter 4,
“Transportation.”

Tax return preparation – The taxpayer can deduct, as a rental expense, the part of tax return
preparation fees (and other legal and professional fees) paid to prepare Part I of Schedule E (Form
1040). For example, on the 2022 Schedule E, fees paid in 2022 to prepare Part I of their 2021
Schedule E (and associated forms) can be deducted on line 10, Legal and other professional fees.
Additionally, any expense paid to resolve tax underpayment issues related to their rental activities
can be deducted as a rental expense.

Review Question 3
On October 1, 2022, the Smiths rented out a home for $500 a month. The lease term is one
year. They received the following income:
 Security deposit that will be returned at the end of the lease in the amount of $500
 Prepaid rent for the first two months in the amount of $1,000
 Tenant paid $300 for the third month’s rent because they paid $200 in repairs and
deducted that from the $500 regular rent amount

How much income do the Smiths need to report on their Schedule E for 2022?

a) $1,500
b) $1,300
c) $1,800
d) $2,000

Review Question 4
Sam paid for the following for his rental property: assessment for sewer construction, real estate
property taxes, and rent for a power washer to clean the outside. Which of these items can he
deduct on his Schedule E?

a) Power washer rental and sewer assessment

b) Real estate taxes and power washer rental
c) Sewer assessment and real estate taxes
d) All the items listed are deductible.

Review Question 5
In 2022, Bill drove 186 miles during the year to collect rent from his tenants. Additionally, he
purchased a few supplies for $300 from Home Depot for some minor repairs. He paid $250 to
have his taxes prepared, of which $50 was for his Schedule E. He also paid off his mortgage
early and still had $600 in points that had not been amortized. How much can he deduct on his
Schedule E for this property?

a) $1,263
b) $1,013
c) $1,063
d) $ 463

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Objective #3: Losses From Rental Real Estate Activities

Limits on Rental Losses

If a taxpayer has a loss from rental real estate activities, two sets of rules may limit the amount of
loss that they can deduct on Schedule E.
1. At-risk rules: These rules are applied first if there is investment in their rental real estate
activity for which the taxpayer is not at risk. If the real property was placed in service after
1986, then the at-risk rules apply to it.
2. Passive activity limits: Generally, rental real estate activities are passive activities.
Rental losses are not deductible unless the taxpayer has income from other passive
activities to offset them. However, there are exceptions.

In addition to at-risk rules and passive activity limits, excess business loss rules apply to losses
from all noncorporate trades or businesses. This loss limitation is figured using Form 461 after you
complete your Schedule E. Any limitation to your loss resulting from these rules will not be reflected
on your Schedule E. Instead, it will be added to your income on Form 1040 and treated as a net
operating loss that must be carried forward and deducted in a subsequent year.

At-Risk Rules
A taxpayer may be subject to the at-risk rules if they have:
 A loss from an activity carried on as a trade or business or for the production of income,
and
 Amounts invested in the activity for which he is not fully at risk.5

Losses from holding real property placed in service before 1987 are not subject to the at-risk rules.

Any loss from an activity subject to the at-risk rules is normally allowed only to the extent of the
total amount that the taxpayer has at risk in the activity at the end of the tax year. The taxpayer is
considered at risk in an activity to the extent of their contribution of cash plus the adjusted basis of
other property they contributed to the activity plus amounts borrowed for use in the activity.
Because of the at-risk limits, any loss that is disallowed in the current year is treated as a deduction
from the same activity in the next tax year. For more information about the at-risk rules, please see
Publication 925.

Form 6198: If you are subject to the at-risk rules, file Form 6198 with your tax return.

Passive Activity Limits

Most rental activities are passive activities (except those meeting the exception for real estate
professionals discussed later). For this purpose, a rental activity is an activity from which the
taxpayer receives compensation mainly for the use of tangible property, rather than for services.

Limits on Passive Activity Deductions and Credits

Deductions or losses from passive activities are limited. Only passive income can be used to offset
passive losses, and only credits from passive activities can be used to offset taxes on passive
income. The taxpayer must carry forward any excess loss or credit to the next tax year.

5
2022 Publication 527, page 13

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The taxpayer may have to complete Form 8582, Passive Activity Loss Limitations, to determine the
amount of any passive activity loss for the current tax year for all activities and the amount of the
passive activity loss allowed on the tax return.

Practice Tip – Deducting vs. capitalizing expenses: While completing tax returns, it is
common for tax preparers to do their best to minimize taxable income, but these elections and
method changes should be made looking at all factors relevant to the taxpayer. For instance,
minimizing net profit in a specific activity may not be the goal for a taxpayer who may have
suspended passive losses, and thus, making safe harbor elections would be less preferable
to capitalizing and depreciating relevant costs, which would result in proper utilization of
expiring tax attributes. Elections like this should only be made in light of all facts and
circumstances, including any considerations related to at-risk and passive loss limitations.

Exception for Real Estate Professionals

Rental activities in which the taxpayer materially participated during the year are not passive
activities if, for that year, the taxpayer was a real estate professional. Losses from these activities
are not subject to the passive activity rules. For this purpose, unless the taxpayer chooses to treat
all interests in rental real estate activities as one activity, each interest the taxpayer has in a rental
real estate activity is a separate activity. If the taxpayer qualifies as a real estate professional for
the current tax year, line 43 (Part V) of Schedule E (Form 1040) should be completed.

Real Estate Professional

The taxpayer is considered to be a real estate professional if, during the tax year, they meet both
of the requirements listed below.
 For the personal services they performed in all trades or businesses during the tax year,
more than 50% of these are performed in real property trades or businesses in which they
materially participate.
 The taxpayer’s hours performed during the tax year in real property trades or business in
which they materially participate are more than 750 hours.

A real property trade or business is one that acquires, converts, develops, redevelops,
constructs, reconstructs, rents, operates, manages, leases, brokers, or sells real property.

Services performed for the tenants as an employee are not treated as performed in a real estate
trade or business unless the taxpayer owned (or are considered to own) more than 5% of the stock
(or more than 5% of the capital or profits interest) in the business.

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If the taxpayer filed a joint return, each spouse must separately meet both of the above
requirements, without regard for services performed by the other spouse.

For additional coverage of the real estate professional exception, please review Chapter 5.

Material Participation
The taxpayer materially participated in an activity for the tax year if their involvement in its
operations was on a regular, continuous, and substantial basis during the year. If the taxpayer is
married, material participation in an activity is determined by also counting any participation in the
activity by their spouse during the year. This applies even if the taxpayer’s spouse owns no interest
in the activity or files a separate tax return for the year.

Losses are not subject to the passive activity rules if the taxpayer is a real estate professional and
meets the material participation requirements.

Choice to Treat All Interests as One Activity

The taxpayer can choose to treat all passive activities interests as one activity if they are a real
estate professional and had more than one rental real estate interest during the year. The choice
can be made in a later tax year even if it was not made during the current year.

The choice is binding for the tax year in which it is made and for any later year the taxpayer is a
real estate professional. This is true even if the taxpayer is not a real estate professional in any
intervening year. (For that year, in determining whether the taxpayer’s activity is subject to the
passive activity rules, the exception for real estate professionals will not apply).

See the Instructions for Schedule E for information about making this choice.

Active Participation
The taxpayer actively participated in a rental real estate activity if they (and their spouse) owned at
least 10% of the rental property and they made management decisions or arranged for others to
provide services in a significant and bona fide sense.

Management decisions include approving expenditures, approving new tenants, deciding on rental
terms, and other similar decisions.

Example 1: David is single and had the following income and losses during the tax year:

Salary $ 42,500
Dividends 500
Interest 1,500
Rental loss (5,000)

The rental loss resulted from rental real estate David owned. David advertised and rented the
house to the tenant himself. He also collected the rents, which usually came by mail. David
did all repairs by himself, or he contracted it out. Though his rental loss is a passive activity
loss from a rental real estate because David actively participated in the rental property
management, he can use the entire $5,000 loss to offset his other income.

Maximum Special Allowance

If the taxpayer actively participated in a passive rental real estate activity, they may be allowed to
take a deduction up to $25,000 from nonpassive income to offset the loss from the rental real estate

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for both single individuals and married individuals filing a joint return. This special allowance cannot
be more than $12,500 if the taxpayer is married, filed a separate return, and lived apart from their
spouse for the entire year. It is not available if the taxpayer is married, filed a separate return, and
lived with their spouse at any time during the year. The maximum special allowance is $25,000 for
a qualifying estate reduced by the special allowance for which the surviving spouse qualified.

If the taxpayer’s modified adjusted gross income (MAGI) is more than $100,000 ($50,000 for
Married Filing Separately), then the maximum amount of the special allowance is limited to 50% of
the difference between $150,000 ($75,000 if Married Filing Separately) and the taxpayer’s MAGI.
Generally, if the taxpayer’s MAGI is $150,000 ($75,000 if Married Filing Separately), no special
allowance is permitted as the limitations phase out the maximum $25,000 allowance.

There is no relief from the passive activity loss limitation if the taxpayer’s MAGI is $150,000 or more
($75,000 or more for MFS).

Example 2: Lauren is single and has $45,000 in wages, $2,200 of passive income from a
limited partnership, and $3,800 of passive losses from a rental real estate activity in which she
actively participated. Lauren’s $2,200 passive income is used to offset her $3,800 loss. The
remaining $1,600 loss can be deducted from her $45,000 in wages.

Figure Modified Adjusted Gross Income

Modified adjusted gross income is adjusted gross income from line 11, Form 1040, or Form 1040-
NR, U.S. Nonresident Alien Income Tax Return, line 11, figured without considering:
 Taxable part of Social Security benefits or equivalent tier 1 railroad retirement benefits.
 Deductible contributions to qualified retirement plans, such as IRA and certain other
retirement plans, and section 501(c)(18) pension plans, etc.
 The exclusion amount allowed from income for qualified Series EE and I U.S. savings bond
interest used to pay higher education expenses.
 The exclusion of benefits received under an employer’s adoption assistance program.
 Any income or loss from passive activities included on Form 8582.
 Any rental real estate loss allowed to real estate professionals (discussed earlier).
 Any overall loss from a PTP (publicly traded partnership). (For more information about
PTPs, see Publicly Traded Partnerships (PTPs) in the instructions for Form 8582.)
 The deduction allowed for one-half of self-employment tax.
 Student loan interest deduction.
 The §250 deduction for foreign-derived intangible income (FDII) and global intangible low-
taxed income (GILTI).6

Form 8582 Not Required

Do not complete Form 8582 if all the following conditions are met:
 The taxpayer actively participated in rental real estate activities. These were their only
passive activities.
 The taxpayer’s total net loss from these passive activities was not more than $25,000 (not
more than $12,500 if Married Filing Separately and lived apart from the spouse).
 The taxpayer does not have any disallowed losses from previous years’ passive activities.
 If Married Filing Separately, the taxpayer did not live with their spouse at any time during
the year.
 The taxpayer has no current or prior year disallowed credits from passive activities.

6
2022 Publication 527, page 14

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  The modified AGI is $100,000 or less ($50,000 or less if Married Filing Separately and the
taxpayer lived apart from their spouse all year); and
 The taxpayer does not hold any interest in a rental real estate activity as a limited partner
or as a beneficiary of an estate or a trust.

If the taxpayer meets all the conditions listed above, then their rental real estate activities are not
limited by the passive activity rules and Form 8582 does not have to be completed. The taxpayer
should enter each rental real estate loss shown on lines 23a through 23e of Schedule E (Form
1040).

If the taxpayer does not meet all the conditions listed above, see the instructions for Form 8582 to
find out if they must complete and attach that form to their tax return.

Review Question 6
Mike is a real estate professional who buys, sells, and manages real estate property. This is his
only source of income, and he devotes all his time to it. His MAGI for 2021 was $200,000, and
he had real estate losses of $50,000. He is currently filing for a divorce and will have to file a
separate tax return. How much of the loss can he deduct?

a) $ 0
b) $12,500
c) $50,000
d) $25,000

Review Question 7
Jan is not a real estate agent, but she actively participates in managing multiple real estate
properties. She has a MAGI of $160,000, and $10,000 of her income was from nonpassive
partnership activities. Her rental losses from all her rental properties totaled $28,000. How will
the losses be handled on her tax return?

a) $10,000 offsets partnership income; $18,000 is carried forward.

b) $10,000 offsets partnership income; $18,000 is deductible.
c) $3,000 offsets partnership income; $25,000 is deductible.
d) $0 is deductible on current tax return; $28,000 is carried forward.

Review Question 8
Donna and Mike are married, and they have a rental property that they both actively participated
in. They file jointly and have a modified AGI of $80,000. They have a net loss of $10,000 from
rental activities and do not have any prior disallowed losses. How is this loss reported?

a) It is reported on Form 8582.

b) It is reported on Schedule E.
c) It is reported on Schedule C.
d) It is not reported at all since the loss is limited.

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Objective #4: Dividing Expenses – Rental Use and Personal Use

Property Changed to Rental Use

If the taxpayer changes their home or other property (or a part of it) to rental use, the yearly
expenses between rental use and personal use must be divided. Only the portion of the expenses
attributable to the part of the year the property was used or held for rental purposes can be
deducted as a rental expense. See the example below. This is covered in more detail in Chapter
7: Rental Property (Part II).

Example 1: Faith owns a home that she decided to convert to a rental property. She moved
out of the home prior to March 1st to prepare it for rental. She immediately began advertising
the home as being available for rent. She obtained a tenant for the home and signed a
lease agreement, which became effective May 1st.

The expenses she incurred prior to March 1st are personal expenses and are not deductible
as a rental expense. Expenses incurred after the home became available for rent are
deductible on Schedule E. Faith must allocate the deductible rental expenses by
determining the number of days the home was available for rent.

Rental Use and Personal Use

If a unit is used for both rental and personal use, the expenses must be divided. For purposes of
determining rental expenses, the unit is considered rented on any day that a fair rental price is
received (even if the taxpayer uses it on that day), but it is not considered rented on days when it
is held out for rent but not actually rented.

If the taxpayer does not have a profit from the rental, then deductible expenses will be limited.
Dividing expenses is explained in detail in Chapter 7: Rental Property (Part II).

Example 2: A ski lodge is available for rent from November 1st through March 31st (a total
of 151 days). The taxpayer’s family uses it for 14 days in October. No one rents it the first
week of November or at any time in March. The person who rented it the first week in
December was called home on an emergency and let the taxpayer's daughter use it for two
days. For the remainder of the year, the lodge is closed and not used by anyone.

Rental Days 151

– 38 Days held out but not rented (7 days in Nov. and all of March)
113 Days used for rental purposes (Days used by taxpayer/family on
which fair rental price was received count as rental days.)

Total Use 113 Rental use

+ 14 Personal use
127

Percentage of Rental Use: 113/127 = 89%. 89% of the expenses will be deductible.

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Depreciation
When the taxpayer uses property to produce income, such as rents, some or the entire amount
paid for the property can be recovered through depreciation. Several factors determine how much
depreciation can be deducted. The main factors are:
 The taxpayer’s basis in the property
 The recovery period for the property
 The depreciation method used

The taxpayer can deduct depreciation only on the part of their property used for rental purposes.
Any part of property held for personal use is not depreciated. Depreciation reduces the basis for
figuring gain or loss on a later sale or exchange. The “allowable” amount of depreciation is
considered when a sale of property used for rental purposes occurs. This means that even if the
taxpayer does not depreciate the property on their tax return, the allowable amount of depreciation
may be taken into consideration during the sale of the property, instead of the actual amount taken
or allowed.

Residential rental property has a property life of 27.5 years. See Publication 946, How To
Depreciate Property, Chapter 4 for more information.

Practice Tip – Avoiding Form 4562: A Form 4562 must be completed for each activity
reported in a taxpayer’s return if claiming depreciation on property placed in service during the
tax year. However, if the taxpayer did not place any new assets in service during the tax year
and is not claiming a Section 179 deduction, depreciation on listed property, or claiming tax
amortization, a Form 4562 is not required to be completed.

Real Property
Real property is land and, typically, anything that is built on, growing on, or attached to it. Real
property includes buildings, fences, sidewalks, trees, etc.

Personal Property
Personal property is property which is not real property. Property such as furniture, appliances,
and lawn mowers are personal property.

Land
Land can never be depreciated. The cost of clearing, grading, and planting is included in the cost
of land. Unless land preparation costs are very closely associated with other depreciable property
on the land, they are not depreciable.

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 Practice Tip – Cost segregation between land and building: Taxpayers can generally
depreciate property used in a rental activity if it meets all of the following requirements: the
taxpayer owns the property, the property is used in the taxpayer’s trade/business/rental
activity, the property has a determinable useful life, and the property is expected to last more
than one year. Generally, the depreciable basis of property is the amount paid in acquiring
the building for use in a rental property, however, the purchase price generally includes the
value of both the land and the building. Because land is never depreciated, the purchase
price must be separated between the land and building to determine the depreciable basis of
the building. The preferred method to do this is by allocating the purchase price to land and
the building based on the relative fair values at the time of purchase. If the reliable information
is unavailable, the taxpayer may subtract the assessed value of the land for real estate tax
purposes from the total purchase price to determine the depreciable basis of the building.

Rented Property
If the taxpayer pays rent on property, that property cannot be depreciated. Usually, only the owner
can depreciate it. If the taxpayer made permanent improvements to the property, those may be
depreciated.

Review Question 9
Steve purchased an apartment two years ago for $100,000. He lived in it until June 2022 when
he relocated to another city. He decided to rent it out for $1,100/month (fair rental value). The
apartment was available for rent on July 1, 2022. A tenant moved in on the same day. During
2022, Steve had the following expenses for the apartment:

Property tax $ 600 Mortgage interest: $1,800

Utilities (January-June) $ 580 Utilities (July-December) $ 720
Repairs in March $ 200 Repaint in June for rent $ 450
Homeowners’ insurance $ 350 Depreciation (July-Dec.) $1,667

What amount of his expenses would be reported on Schedule E as rental expenses?

a) $6,367
b) $4,387
c) $4,212
d) $3,012

Reading References for Chapter 6:

 Publication 527, Residential Rental Property (Including Rental of Vacation Homes)
 Schedule E (Form 1040) Instructions

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Chapter 6: Rental Property (Part I) Summary

Objective #1: Discuss how to report income and expenses for not-
for-profit rental property
 For tax year 2022, the taxpayer should report not-for-profit rental income on line 8j of
Schedule 1 (Form 1040).
 If the taxpayer itemizes deductions, they would report mortgage interest (if the property is
the taxpayer’s main home or second home), real estate taxes, and casualty losses from
federally declared disasters on the appropriate lines of Schedule A (Form 1040), Itemized
Deductions.
o However, the mortgage interest and property tax are subject to limitations.

Objective #2: Describe the reporting of rental income and

expenses on Schedule E
 Part I is used to report income or loss from rental real estate and royalties.
o Line 1a is used to show the address of the property. Up to three properties can
be listed here.
o Line 1b is used to describe the type of property. The codes can be found under
“Type of Property” in Part I of the form.
o Line 2 is used to answer questions about fair rental days and personal use days
that would determine whether the owner qualifies to claim the property as rental
property. It is also used to determine if the taxpayer meets the requirements to
file as a qualified joint venture.
o Line 3 is for reporting the income from the real estate property listed on Line 1a.
o Line 4 is for reporting royalties from oil, gas, or mineral properties; copyrights;
and patents.
o Lines 5-19 list expenses connected with the rental or royalty properties.
o Line 20 is used to total the expenses from Lines 5-19 for each property.
 Schedule E is not used to report rental of personal property (e.g., the taxpayer rents their
computer to a neighbor for eight hours a week), real estate activities for which significant
personal services are provided (e.g., hotel, motel), or royalty income from artists, writers,
etc. who are self-employed.
o These self-employment incomes are reported on Schedule C and are subject to
self-employment tax.

Objective #3: Discuss losses from rental real estate activities

 If a taxpayer has a loss from rental real estate activities, two sets of rules may limit the
amount of loss that they can deduct on Schedule E.
o At-risk rules: These rules are applied first if there is investment in the
taxpayer’s rental real estate activity for which the taxpayer is not at risk; if the real
property was placed in service after 1986, then the at-risk rules apply to it.
o Passive activity limits: Generally, rental real estate activities are passive
activities. Rental losses are not deductible unless the taxpayer has income from
other passive activities to offset them; however, there are exceptions.

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  Real estate professional exception:
o Taxpayers who qualify as real estate professionals can treat their rental activities
as non-passive.
o To qualify, the taxpayer must spend more than 50% of their working hours and
over 750 hours per year in real estate trade or business activities, and materially
participate in each rental property.
 Maximum special allowance: If the taxpayer or spouse actively participated in a passive
rental real estate activity, they can deduct up to $25,000 of loss from the activity from
their nonpassive income.
o Active participation can involve making management decisions, arranging
services, or participating in the day-to-day operations of the rental properties.
o The taxpayer does not need to be involved in every aspect of the rental activity,
but their participation should be regular, continuous, and substantial.
o The active participation requirement applies to each rental real estate activity
separately, so a taxpayer may need to meet the criteria for each property.
o The deduction for rental losses under active participation begins to phase out for
taxpayers with adjusted gross income (AGI) above certain thresholds ($100,000
for single filers and $150,000 for married filing jointly in 2022).
o Active participation is distinct from material participation, which has more
stringent requirements and allows for greater flexibility in deducting rental losses.

Objective #4: Explain the process of dividing expenses between

personal use and rental use
 If the taxpayer changes their home or other property (or a part of it) to rental use, the
yearly expenses between rental use and personal use must be divided.
 Only the portion of the expenses attributable to the part of the year the property was used
or held for rental purposes can be deducted as a rental expense.
 Dispositions by like-kind exchange: Because §1031 exchanges are generally
nontaxable, passive loss carryovers are not fully deductible until a taxpayer disposes of
their interest in a property in a fully taxable transaction.

Objective #5: Report losses on required forms

 The purpose of Form 8582 is to figure the amount of passive activity loss for the current
year and track and report any losses that were not allowed in a prior year.
 There are specific worksheets to determine the entries for Part I.
o Worksheet 1 is for active rental real estate activities.
o Worksheet 2 is for all other passive activities.

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