Reporting income from rental properties may seem straightforward, but that’s not always the case. The IRS’s definition of rental income, for example, might be broader than property owners realize. Such misunderstandings could prove costly if uncovered by an IRS audit.
What constitutes rental income
Rental income is any payment you receive for the use or occupation of your property. In addition to normal rent payments, rental income includes:
Advance rent. This is any amount you receive before the rental period it covers.
Amounts paid to cancel a lease. If a tenant pays a fee to cancel a lease, that amount is considered rent.
Expenses paid by a tenant. If a tenant pays any of your expenses (such as a bill for garbage removal although the lease doesn’t require the tenant to do so), those payments are rent.
Property or services. When you receive property or services as rent in lieu of money, the fair market value of the property or services is rental income. If services are provided at an agreed upon or specified price, that price generally represents the fair market value.
Any rent described above must be included in your rental income in the year you receive it, regardless of the period covered by the rent or the method of accounting you use.
What about security deposits?
A security deposit shouldn’t be included in your income if you might have to return it at the end of the lease. If you keep some of the deposit because the tenant breaches the lease, you must include that amount in your income for that year.
But, if you keep part or all of the security deposit because a tenant damaged the property and you must make repairs, you need include the amount you retain to cover those expenses only if your regular practice is to deduct the cost of repairs as expenses. If it isn’t, you aren’t required to include any amount of the security deposit that reimburses those expenses.
If you use the security deposit as the tenant’s final month of rent, you must include the money as income when you receive it — as opposed to when you apply it to the last month’s rent. This amount is considered advance rent.
The bottom line
As you can see, there are many twists and turns on how to report rental income for tax purposes. That’s why it’s important to work with your tax advisor. He or she can help you ensure you’re reporting rental income properly and avoid interest and penalties for underreporting.