A rental property is reported on Schedule E, and most of the work is straightforward: rent received at the top, expenses beneath it, depreciation, and a result that flows onto your return. The complications sit in three specific places, and one of them accounts for more wrong rental returns than everything else combined.
That one is the distinction between a repair and an improvement.
Repairs come off now, improvements do not
A repair is deducted in the year it was paid. An improvement is capitalised and recovered over years through depreciation. Both leave your bank account the same way, which is exactly why they get treated the same way on a return, and why it is wrong.
The test has three parts. An expense is an improvement if it is a:
- Betterment. It fixes a pre-existing defect, enlarges or expands the property, or increases its capacity, strength, or quality.
- Restoration. It replaces a substantial structural part, repairs casualty damage, or returns the property to a like new condition.
- Adaptation. It alters the property to a use inconsistent with what it was originally intended for.
Anything that trips one of those is capitalised. Everything else is a repair.
The practical line runs roughly between keeping something working and making it better than it was. Replacing a broken window is a repair. Replacing every window with better ones is a betterment. Patching a roof is a repair. Putting on a new roof is a restoration.
The safe harbour that removes most of the argument
There is a de minimis safe harbour, and for a small landlord it disposes of most of these questions before they arise.
If you do not have an applicable financial statement, you may deduct amounts up to 2,500 dollars per invoice, or per item as substantiated by the invoice. With an applicable financial statement, which most individual landlords do not have, the figure is 5,000 dollars.
Two conditions catch people. It is an election, made by attaching a statement titled “Section 1.263(a)-1(f) de minimis safe harbor election” to a timely filed original return, including extensions. Miss the election and the safe harbour is not available for that year. And it does not cover inventory or land.
Depreciation, and the record nobody has
Residential rental property is depreciated over 27.5 years under the general depreciation system, straight line, with a mid month convention.
Land is not depreciable. It does not wear out and it is never used up, so the purchase price has to be split between land and building, and only the building is depreciated. Land preparation such as clearing, grading, and landscaping generally goes onto the land basis rather than being depreciated.
That split is the record almost nobody has when it is needed. It is decided at purchase, it governs every year of depreciation afterwards, and it is required again at the sale. A reasonable allocation documented at the time, from the purchase contract or the property tax assessment, takes minutes. Reconstructing it nine years later does not.
The losses may not be usable this year
A rental is generally a passive activity, and passive losses are limited.
There is a special allowance where you actively participate. Up to 25,000 dollars of loss can be taken against nonpassive income. It reduces by 50 cents for every dollar of modified adjusted gross income above 100,000 dollars, and is gone entirely at 150,000 dollars.
The married filing separately rules are harsher than people expect. The allowance is 12,500 dollars for a married person filing separately who lived apart from their spouse for the entire year. If you filed separately and lived together at any point in the year, the special allowance is not available at all.
A loss you cannot use is not lost. It carries forward, and when you dispose of your entire interest in the activity, the previously disallowed losses become fully deductible. That final point is worth remembering, because a property carrying years of suspended losses is worth more at sale than the sale price alone suggests.
The two questions that change which form you are on
Is it a rental at all, for the year in question? If the property is a dwelling unit you also use personally and it is rented for fewer than 15 days in the year, the rental income is excluded from your income entirely and the expenses are not deductible as rental expenses. Nothing goes on a Schedule E.
Are you providing substantial services? If you are, the activity is a business rather than a rental, and it belongs on a Schedule C rather than Schedule E. That changes more than the form: business income is subject to self employment tax, which rental income generally is not. Short term letting with hotel like services is where this most often bites, and people who have moved into that model rarely notice they have crossed a line.
Where it does land on a Schedule C, the rules for what comes off are the ones in which expenses actually hold up, not these.
What to fix now rather than later
Find the land and building allocation for each property you own and write it down with its source. Decide whether you are making the de minimis election this year, because it has to be attached to the return. Keep invoices in a way that makes the per invoice test answerable, since the safe harbour is applied per invoice or item rather than per year.
And keep the depreciation schedule itself, year by year. It decides your deduction now and your gain at the sale, and it is the single document that is hardest to rebuild after the fact.
Getting the repair and improvement split right, and the allocation documented before it is needed, is a large part of preparing a return with property in it.