This chapter discusses rental income and expenses. It covers the following topics.

If you sell or otherwise dispose of your rental property, see Publication 544, Sales and Other Dispositions of Assets.

If you have a loss from damage to, or theft of, rental property, see Publication 547, Casualties, Disasters, and Thefts.

If you rent a condominium or a cooperative apartment, some special rules apply to you even though you receive the same tax treatment as other owners of rental property. See Publication 527, Residential Rental Property, for more information.

You generally must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. In addition to amounts you receive as normal rent payments, there are other amounts that may be rental income.

This part discusses expenses of renting property that you ordinarily can deduct from your rental income. It includes information on the expenses you can deduct if you rent part of your property, or if you change your property to rental use. Depreciation, which you can also deduct from your rental income, is discussed later.

Repairs and Improvements

You can deduct the cost of repairs to your rental property. You cannot deduct the cost of improvements. You recover the cost of improvements by taking depreciation (explained later).

Separate the costs of repairs and improvements, and keep accurate records. You will need to know the cost of improvements when you sell or depreciate your property.

Repairs.   A repair keeps your property in good operating condition. It does not materially add to the value of your property or substantially prolong its life. Repainting your property inside or out, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows are examples of repairs.

  If you make repairs as part of an extensive remodeling or restoration of your property, the whole job is an improvement.

Improvements.   An improvement adds to the value of property, prolongs its useful life, or adapts it to new uses. Improvements include the following items.

• Putting a recreation room in an unfinished basement.

• Paneling a den.

• Adding a bathroom or bedroom.

• Putting decorative grillwork on a balcony.

• Putting up a fence.

• Putting in new plumbing or wiring.

• Putting in new cabinets.

• Putting on a new roof.

• Paving a driveway.

   If you make an improvement to property, the cost of the improvement must be capitalized. The capitalized cost can generally be depreciated as if the improvement were separate property.

Other Expenses

Other expenses you can deduct from your rental income include advertising, cleaning and maintenance, utilities, fire and liability insurance, taxes, interest, commissions for the collection of rent, ordinary and necessary travel and transportation, and other expenses, discussed next.

Rental payments for property.   You can deduct the rent you pay for property that you use for rental purposes. If you buy a leasehold for rental purposes, you can deduct an equal part of the cost each year over the term of the lease.

Rental of equipment.   You can deduct the rent you pay for equipment that you use for rental purposes. However, in some cases, lease contracts are actually purchase contracts. If so, you cannot deduct these payments. You can recover the cost of purchased equipment through depreciation.

Insurance premiums paid in advance.   If you pay an insurance premium for more than one year in advance, each year you can deduct the part of the premium payment that will apply to that year. You cannot deduct the total premium in the year you pay it.

Local benefit taxes.   Generally, you cannot deduct charges for local benefits that increase the value of your property, such as charges for putting in streets, sidewalks, or water and sewer systems. These charges are nondepreciable capital expenditures. You must add them to the basis of your property. You can deduct local benefit taxes if they are for maintaining, repairing, or paying interest charges for the benefits.

Travel expenses.   You can deduct the ordinary and necessary expenses of traveling away from home if the primary purpose of the trip was to collect rental income or to manage, conserve, or maintain your rental property. You must properly allocate your expenses between rental and nonrental activities. You cannot deduct the cost of traveling away from home if the primary purpose of the trip was the improvement of your property. You recover the cost of improvements by taking depreciation. For information on travel expenses, see chapter 26.

  

To deduct travel expenses, you must keep records that follow the rules in chapter 26.

Local transportation expenses.    You can deduct your ordinary and necessary local transportation expenses if you incur them to collect rental income or to manage, conserve, or maintain your rental property.

  Generally, if you use your personal car, pickup truck, or light van for rental activities, you can deduct the expenses using one of two methods: actual expenses or the standard mileage rate. For 2005, the standard mileage rate for all business miles driven before September 1 is 40½ cents a mile. The rate is 48½ cents a mile for all business miles driven after August 31. For more information, see chapter 26.

  

To deduct car expenses under either method, you must keep records that follow the rules in chapter 26. In addition, you must complete Form 4562, Part V, and attach it to your tax return.

Tax return preparation.   You can deduct, as a rental expense, the part of the tax return preparation fees you paid to prepare Schedule E (Form 1040), Part I. For example, on your 2005 Schedule E, you can deduct fees paid in 2005 to prepare your 2004 Schedule E, Part I. You can also deduct, as a rental expense, any expense (other than federal taxes and penalties) you paid to resolve a tax underpayment related to your rental activities.

If you do not rent your property to make a profit, you can deduct your rental expenses only up to the amount of your rental income. You cannot carry forward to the next year any rental expenses that are more than your rental income for the year. For more information about the rules for an activity not engaged in for profit, see chapter 1 of Publication 535.

If you change your home or other property, (or a part of it), to rental use at any time other than at the beginning of your tax year, you must divide yearly expenses, such as taxes and insurance, between rental use and personal use.

You can deduct as rental expenses only the part of the expense that is for the part of the year the property was used or held for rental purposes.

For depreciation purposes, treat the property as being placed in service on the conversion date.

You cannot deduct depreciation or insurance for the part of the year the property was held for personal use. However, you can include the home mortgage interest and real estate tax expenses for the part of the year the property was held for personal use as an itemized deduction on Schedule A (Form 1040).

If you rent part of your property, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes, as though you actually had two separate pieces of property.

You can deduct the expenses related to the part of the property used for rental purposes, such as home mortgage interest and real estate taxes, as rental expenses on Schedule E (Form 1040). You can also deduct as a rental expense a part of other expenses that normally are nondeductible personal expenses, such as expenses for electricity or painting the outside of your house.

You can deduct the expenses for the part of the property used for personal purposes, subject to certain limitations, only if you itemize your deductions on Schedule A (Form 1040).

You cannot deduct any part of the cost of the first phone line even if your tenants have unlimited use of it.

You do not have to divide the expenses that belong only to the rental part of your property. For example, if you paint a room that you rent, or if you pay premiums for liability insurance in connection with renting a room in your home, your entire cost is a rental expense. If you install a second phone line strictly for your tenants' use, all of the cost of the second line is deductible as a rental expense. You can deduct depreciation, discussed later, on the part of the property used for rental purposes as well as on the furniture and equipment you use for rental purposes.

If you have any personal use of a dwelling unit (including a vacation home) that you rent, you must divide your expenses between rental use and personal use. See Figuring Days of Personal Use and How To Divide Expenses, later.

If you used your dwelling unit for personal purposes, it may be considered a “dwelling unit used as a home.” If it is, you cannot deduct rental expenses that are more than your rental income for the unit. See Dwelling Unit Used as Home and How To Figure Rental Income and Deductions, later. If your dwelling unit is not considered a dwelling unit used as a home, you can deduct rental expenses that are more than rental income for the unit subject to certain limits. See Limits on Rental Losses, later.

You recover your cost in income producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of the cost on your tax return each year.

Three basic factors determine how much depreciation you can deduct. They are: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures and equipment, as an expense.

You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

You may have to use Form 4562 to figure and report your depreciation. See How To Report Rental Income and Expenses, later.

Rental real estate activities are generally considered passive activities, and the amount of loss you can deduct is limited. Generally, you cannot deduct losses from rental real estate activities unless you have income from other passive activities. However, you may be able to deduct rental losses without regard to whether you have income from other passive activities if you “materially” or “actively” participated in your rental activity. See Passive Activity Limits, later.

Losses from passive activities are first subject to the at-risk rules. At-risk rules limit the amount of deductible losses from holding most real property placed in service after 1986.

If you rent buildings, rooms, or apartments, and provide only heat and light, trash collection, etc., you normally report your rental income and expenses on Form 1040, Schedule E, Part I. However, do not use that schedule to report a not-for-profit activity. See Not Rented for Profit, earlier.

If you provide significant services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C (Form 1040), Profit or Loss From Business or Schedule C-EZ, Net Profit From Business (Sole Proprietorship). Significant services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc. For information, see Publication 334, Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ). You also may have to pay self-employment tax on your rental income.