VITA: Winter 2011
Lesson 12: Rental Income and K-1s
Winter 2011
Kristina Shroyer
© Kristina Shroyer 2011
Lesson 12 – K-1's
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Some K-1's are in scope for VITA
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Certain entities: for example partnerships, S-Corporations, Trusts do not
themselves pay taxes
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Instead taxes are passed through the shareholders or beneficiaries of these entities
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For example in a 50/50 partnership the income and expenses of the partnership would be
reported 50/50 to each partner and each partner would report that income on their individual
tax returns – This type of income is reported on Schedule K-1
Income reported to a shareholder or beneficiary on Schedule K-1 is included in various places
on the shareholder's individual tax return depending on the type of income
Partners/Members/Beneficiaries of these entities are taxed on their share of the entity's
income regardless of whether or not that income was distributed to them
The only K-1 type income in scope for VITA is:
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Interest Income (goes to Schedule B)
Dividend Income (goes to Schedule B)
Net short term capital gains and losses (goes to Schedule D – line 5)
Net long term capital gains and losses (goes to Schedule D – line 12)
Tax Exempt Interest Income (Form 1040 line 8b)
New this year – Royalty Income (goes to Schedule E – line 4)
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Royalty income is only in the scope of VITA if it's reported on a Schedule K-1
Any other income on K-1 is out of scope of VITA so the taxpayer with anything else on their
K-1 should be referred to a professional tax preparer
© Kristina Shroyer 2011
Lesson 12 – K-1's
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If you enter the K-1 correctly in Taxwise the amounts should transfer to
the correct places on the tax return that I indicated above, YOU
SHOULD DOUBLE CHECK THOUGH
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K-1's are slightly different depending on what type of entity they come
from but the main idea is the same…let's look at a K-1 from each type
of entity
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Taxwise does NOT know if you entered something incorrectly and can have
errors
If you do the return by hand (we don't do that) you would have to put the items in
the correct places yourself
K-1 (Form 1041 – Trust)
K-1 (Form 1065 – Partnership)
K-1 (Form 1120S – S Corporation)
The general information on the K-1 goes on page 2 of Schedule E and
the rest of the items in scope go to the places on the return listed on the
previous page
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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Introduction
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This lesson is going to show you how to report rental income and expenses
for US Citizens and resident aliens
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There are some parts in this lesson that are difficult and outside the VITA
scope except in certain situations, I'll point them out as we go
Let's look at the Schedule E for a second and line 17 of Form 1040
A lot of this is out of scope for VITA EXCEPT in the situation
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This is for taxpayers that rent out their home or other property but renting is
not their actual business
This is not for taxpayers in the business of renting properties
of assisting military and other government employees living abroad with
limited access to professional taxpayers and other resources
Where are rental income and expenses reported?
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Part I of Schedule E
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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What is rental income?
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A taxpayer who rents out a home, a room or some other property is
engaged in an income producing activity
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Gross rental income includes:
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Rental income is reported when received and expenses when paid
Accrual Method of accounting
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Ordinary rent payments
Advance rent
Payments for breaking a lease
Security deposits (in some cases – see the tip on page 12-3)
Expenses paid by the tenant
FMV for services received instead of rent payments
Cash Method of accounting (MOST INDIVIDUAL TAXPAYERS)
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This type of income received by US citizens and resident aliens must be
reported for property located in the US or a foreign property
Rental income is reported when earned and expenses when incurred
Read CAUTION on page 12-3 regarding Fair Rental Value
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Basically this is talking about the situation of renting to friends or relatives for
less than fair rental value (this situation would be out of scope for VITA)
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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What qualifies as a Rental Expense
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Mortgage Interest and Property Taxes
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When a taxpayer rents out a home instead of living in it these are no longer itemized
deductions (we'll talk about itemized deductions in Chapter 20) but rental expenses
If the taxpayer rents the home out part of the year and lives in it part of the year
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Mortgage Interest and Property taxes must be allocated between the Schedule E and the
Schedule A
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It also could be that the taxpayer only rents out part of the home
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In this case also mortgage interest and Property taxes must be allocated between the Sch
E and Sch A
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The allocation can be based on time (say the property was a rental 5 months and a home 7 months)
This could be based on area (sq feet of rental vs sq feet of home part)
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Mortgage Interest is still reported on Form 1098 (just like it is for mortgage interest
deductible as an itemized deduction)
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Form 1098 may include property taxes or the taxpayer may need to provide other
documentation (such as a property tax statement and canceled check)
Example at the bottom of page 12-4, Exercise on page 12-5
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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What qualifies as a Rental Expense (continued)
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Property Insurance
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This is a deductible rental expenses for the time the property is considered a
rental property
If the property is only rented for a portion of the year only the property
insurance allocable to that portion of the year is deductible
If only a portion of the residence is rented an allocation must also be done
Insurance premiums paid more than a year in advance cannot be
deducted all in one year
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Other deductible rental expenses
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The only deductible portion in the current year is the amount that covers that
year
See list on page 12-4
The expenses may only be deducted in full if they are solely for the rental
property (so they must be allocated if they are for a property where only a
part of it is rented out or for a property not rented the entire year)
Read tip on page 12-4 at the top
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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What qualifies as a Rental Expense (continued)
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Auto and Travel Expenses
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These expenses can be deducted on Schedule E as long as they are attributable to the
production of rental income
Taxpayer must separate personal and business portions of the travel and be able to
substantiate it with records (taxpayers MUST keep mileage records, total and
business)
If the taxpayers personal auto is used for the travel the rental-related portion of the
expenses may be deducted using
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Repairs vs. Improvements
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Repairs keep the property in good working condition and is a current year deduction as
a rental expense
Improvements add to the life or material value of the property and the cost must be
recorded as an asset and depreciated over the asset's useful life
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The total cost of an improvement includes labor, material and installation
Look at the table on page 12-6 for a list of common repairs and improvements
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Standard Mileage method (same rules as with business travel – 50 cents per mile)
Actual Expense method (out of VITA scope)
It's important NOT to deduct improvements as a current year expense
Question 3 of the Exercises on page 12-6
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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How to handle depreciation of rental property
A property or improvement has a useful life of more than one year
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Depreciable property includes: buildings, equipment, machinery,
furniture vehicles, improvements
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Land is NOT depreciable property, the taxpayer gets no expense deduction for land
When a property is depreciated each year (a year of expense is deducted), the
taxpayer's basis in that property is reduced by the depreciation
It is important that taxpayers claim the correct amount of depreciation
each year
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This means the cost of a property or improvement cannot be deducted as an expense
all in one year
Instead the cost of the property is expensed (depreciated) over the useful life of the
asset (property or improvement)
Even if they don't claim all depreciation they are entitled to they must reduce their
property's basis by the correct amount of depreciation
What factors affect depreciation
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In calculating depreciation for an asset, three factors affect the calculation
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Depreciation Method (usually MACRS for tax)
Basis of the property (usually purchase price plus any improvements or costs to bring the
property to operating condition)
Recovery Period for the property (What is its useful life…how long to depreciate)
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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How to handle depreciation of rental property (continued)
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Depreciation Methods used in Tax (We focus only on MACRS)
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Exercises 12-7 (Question 4 and 5)
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Basis and Adjusted Basis of a Rental Property
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Basis is generally
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The purchase price of the property + any improvements but NOT including the value of
the land on which the property sits
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When a property is converted from personal use to a rental property the basis is:
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The lesser of the adjusted basis or FMV at the time of the conversion
Read Example on page 12-8
Total Depreciation Expense taken of all the years can NEVER exceed the property's
basis, stop taking depreciation when the property's basis is reduced to zero
What is a Recovery Period?
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So the purchase price needs allocated between land and building, this is usually done with
a property tax assessment
This is the number of years over which the taxpayer recovers (deducts as an expense)
the cost or other basis of the property
The MACRS method assigns specific recovery periods to different classes of property
Exercise (Question 7) Page 12-9
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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How to handle depreciation of rental property (continued)
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How to Figure out the MACRS Depreciation Deduction
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You need to know three things
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Placed in Service Date
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Placed in Service Date
Recovery Period
Depreciable Basis - We just went over how to calculate this
When the asset (property or improvement) is a condition of readiness and
used in the rental for the production of income
Read the example at the bottom of page 12-9
Recovery Periods Under MACRS
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Depends on the class the property is in – basically classes of assets (such as
"Machinery", "Residential Rental Property" etc) are assigned recovery periods
by MACRS
Publication 527 Page 12 has a table of MACRS recovery periods (the
software may also have the information)
Recovery Periods Under MACRS you'll likely use (see page 12-10)
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27.5 years for a residential rental property converted to such in 1986 or later
5 years for a Stove or appliance used in a residential rental
Property located outside the US has different rules and recovery periods
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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When the Rental Property is a Portion of the Taxpayer's
Residence
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Expenses must be allocated between the rental and the taxpayer's personal
residence
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Expenses that apply only to the rental property are reported in full on the
Schedule E
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Installing a second phone line in the rental
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Repairing an appliance in the rental
Painting the rental unit only
Expenses that benefit the ENTIRE property (both the rental and the personal
residence)
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Must be divided up and only the rental portion deducted on the Schedule E
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Taxpayer cannot deduct any part of the cost of the first phone line in a partially rented
property
Mortgage interest and property taxes may be split up between the Sch E and the Sch A,
so if the rental is 10% of the property 10% of Mortgage Interest and Prop taxes go on
Sch E and 90% on Sch A
The taxpayer can use any reasonable method to divide up the expenses –
square footage and number of rooms are the most common methods
Read the example at the bottom of page 12-11
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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Reporting Rental Expenses that Exceed Income
How rental expenses are reported depends on how much the taxpayer uses
the rental property personally
How taxpayers report rental expenses that exceed income (losses) depends
on how much the taxpayer uses the property personally
1.
Taxpayers do NOT use their rental home has their residence
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2.
Taxpayers who rent out their personal residence 15 days or more during the year
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3.
Include the rent received as income
Deduct all rental expenses even if those expenses exceed income (there are still other
deductibility limitations that may apply though – Passive Activity Limitations and At Risk
Limitations)
Include all of the rent received as income
Expenses that exceed rental income may not be deductible (we'll look at the rules)
Taxpayers who rent out their personal residence fewer than 15 days during the year
may NOT include the rent as income or deduct the rental expenses (LOOPHOLE!)
♦
Los Angeles Olympic Games~
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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What is considered "personal use" of the rental property?
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The taxpayer is considered to be using the dwelling as a home if he or she meets any of the personal
use test rules on pages 12-12 (let's take a look)
There are also some exceptions to the personal use rules (see page 12-13)
Read the example page 12-13
Limitations on deducting rental expenses (Vacation Home Rules) (situation 2 on the
previous page)
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Deductibility limitations apply to rental expenses for a dwelling the taxpayer uses as a home (so if the
dwelling is used for "personal use" as defined above) for the greater of
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See #2 on part 1 of Schedule E (these questions must be answered for each property)
1.
2.
If the above limitations do NOT apply, "No" will be answered and the expenses are not limited by the
vacation home rules (HOWEVER, the expenses may be limited by the At Risk Rules or Passive Activity
Loss Rules)
If the "Yes" box is checked and the property was rented out at least 15 days (remember less than 15
days means don't report income or losses) the amount of expenses the taxpayer may deduct are limited
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14 days OR
10% of the number of days during the year the property is rented at FAIR MARKET VALUE
Let's look at the rules for this situation at the bottom of page 12-13
General Idea: A LOSS cannot be taken on the property, any unused expenses are carried forward
indefinitely
Answer Question 10 (Exercise) at the bottom of page 12-14
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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How to handle rental losses?
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Rental losses are not always fully deductible
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Two restrictions on how much a rental loss can offset other
income
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Just because the last set of rules allowed the taxpayer to report all
their rental expenses (even if they exceeded income) does NOT
mean that the resulting loss will be deductible
A deductible loss would be recorded on line 17 of Form 1040 and
could be used to offset other income
At-risk rule
Passive Activity Rule (book says law)
At-risk Rule
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Basically this says a taxpayer can only deduct a loss up to they
amount they have at risk in an activity
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So how much has the taxpayer put into the rental that they could
lose? They can only deduct losses up to this amount
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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How to handle rental losses? (continued)
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Passive Activity Rule (Law)
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Basically this says that passive losses can only be used to offset passive income
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Some common sources of active income are wages, dividends and investments…so passive losses can
not be used to offset these types of income
Rentals in most cases are passive activities and therefore there losses are considered passive
Passive losses that exceed passive income are not deductible
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There are other sources of passive income than rental income though
Passive vs. Active
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The limits on deducting rental losses have to do with
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How much of the rental activity is considered a passive activity
If the activity involves active participation (then losses may be less limited)
Passive Rental Activity
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One where income is received mainly from the use of the property rather than the services
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Most rentals are this
Passive Rental Activity with Active Participation
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Active participation
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means making significant management decisions, such as approving tenants, approving rental terms,
approving repairs and expenses…etc
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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How to handle rental losses? (continued)
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Passive Activity Rule (Law) (continued)
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Why do we care about active participation?
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Exception
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Remember we said rental income is usually passive and therefore losses are usually not deductible
(can only be used to offset other passive income)
However there is an Exception
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More non-passive income examples on page 12-13 (salary, dividends, interest, capital gains and
losses are all NON-passive and can NOT be offset with passive rental income unless the exception
is met and then only $25,000 of the rental expenses can be deducted)
It is considered active participation when taxpayers own at least 10% of the rental property and
make significant management decisions as defined earlier
Phase out
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Taxpayers who actively participate in the rental company can use up to $25,000 of their rental expenses
to offset non-passive income (up to $12,500 for MFS)
This exception can be limited by AGI
Active Participation Defined
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because there is an exception to the passive activity rule for this
The $25,000 exception may be reduced or completely gone depending on the taxpayers AGI
Example on page 12-15
© Kristina Shroyer 2011
Lesson 12: Rental Income & Expenses
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How to handle rental losses? (continued)
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How are Passive Rental Losses Reported
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Disallowed passive losses are carried forward to future years (in case future
years have passive income that can be offset by them)
Also once the rental is sold all passive losses for that property can be
deducted
Form 8582 is used to figure the amount of any passive losses for the current
tax year as well as carry forwards
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See rules for when Form 8582 is not required on page 12-14
TaxWise will automatically generate and complete the Form 8582
for you if required
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However you should check the taxpayers prior year return for any passive
loss carry forwards from prior years and enter them in the appropriate place
© Kristina Shroyer 2011