What counts as rental income
Start with the obvious: rent received during the year. Then add the items owners routinely forget.
- Advance rent — included in income in the year received, whatever period it covers
- Lease cancellation or early termination payments — treated as rent
- Expenses a tenant pays on the owner's behalf — treated as rental income
- A security deposit kept because the tenant broke the lease — income in the year kept
- A refundable security deposit you intend to return — generally not income when received
- A deposit that is really the last month's rent — advance rent, so income when received
Common deductible expenses
Ordinary and necessary costs of operating the rental are generally deductible in the year paid or incurred, depending on the owner's accounting method. Typical categories include mortgage interest, property insurance, property taxes, repairs and maintenance, management fees, advertising for tenants, utilities the owner pays, legal and professional fees related to the rental, and local transportation for rental purposes.
Some costs behave differently than they look. Insurance premiums paid in advance are allocated across the periods they cover rather than deducted all at once. Points and other costs of obtaining a mortgage are generally spread over the life of the loan rather than deducted immediately.
Vacancy does not necessarily end the deductions: a property held out for rent while temporarily vacant is generally still treated as a rental. Personal use of the property changes the picture and requires allocating expenses.
Repairs versus improvements
A repair keeps the property in ordinary operating condition — patching, fixing, replacing a broken part. It is generally deducted in the year incurred.
An improvement does one of three things: it betters the property, restores it, or adapts it to a new use. Improvements are capitalized and recovered through depreciation rather than deducted immediately. Adding a room, replacing an entire roof, or converting a garage into living space are improvements; fixing a leak, replacing a broken window pane, or repainting after a tenant moves out are usually repairs.
When repair work and improvement work happen at the same time, keep the invoices separate. Documentation at the time of the work is far easier than reconstructing it later.
Depreciation in one paragraph
Depreciation lets an owner recover the cost of the building — not the land, which is never depreciable — over a set recovery period. Residential rental property has a recovery period of 27.5 years under the general depreciation system, so roughly 1/27.5 of the depreciable basis is recovered each full year.
Depreciation begins when the property is placed in service, meaning ready and available for rent, and ends when the cost basis is fully recovered or the property is retired from service. Basis starts with cost — including certain settlement fees — is increased by improvements, and is reduced by items such as depreciation already taken. Because land cannot be depreciated, the purchase price has to be allocated between land and building.