Chapter 8
Rental Property,
Royalties, and
Income From FlowThrough Entities
(Line 17, Form 1040
and Schedule E)
“There is no simple tax, at least no simple
tax that is also fair.”
-- Joel Slemrod
McGraw-Hill Education
Copyright © 2015 by the McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or
distribution in any manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website in whole or part.
LO #1: Rental Property
• Income and expenses from rental
property are generally reported on
Schedule E.
• All ordinary and necessary expenses
related to a rental property are
deductible.
8-2
LO #1 Rental Property
• Ordinary expense is an expense that is
customary or usual for the rental property
activity.
• Examples of common rental activity
expenses include advertising, repairs and
maintenance, management fees and
depreciation.
8-3
LO #1: Rental Property
• Rental property is depreciated using
straight-line depreciation over 27.5 or 39
years.
• The IRS depreciation tables are used to
calculate the depreciation amount.
• Depreciate structure only.
• The tables to use for rental properties are
found in Ch 6.
8-4
LO #1 Rental Property
• If a taxpayer’s rental property is
considered a trade or a business, the
related income and expenses are reported
on Schedule C.
• Generally, if a taxpayer materially
participates in the rental activity and is
considered a real estate professional,
then the activity is considered a trade or
business.
8-5
LO #1 Rental Property
• Expenses paid by the tenant or services
provided in lieu of rental payments are
considered rental income. As such, the
amount must be included as rental income
and reported.
8-6
LO #1 Rental Property
• Example: Brady owns a rental property that he
rents to his friend, Jack, for $800 per month. In
November, Jack repairs a leaky roof of the rental
property for $450 and pays Brady $350 for rent.
• Brady would report $800 for rental income and
$450 for repair and maintenance expenses in
November.
8-7
LO #1: Rental Property
1. Rental income is generally reported on
Schedule E.
True
2. All expenses related to rental property
are deductible in the current year,
including capital improvements.
False
3. Rental property structures must be
depreciated using the straight-line
method.
True
8-8
LO #1: Rental Property
4. If a taxpayer’s rental property is considered
a trade or a business, he or she reports the
income on Schedule E.
False
5. If a tenant provides a service in lieu of rent,
the taxpayer is not required to report the
value of that amount as rental income.
False
8-9
LO#2 Rental of Vacation Homes
• A property that is used for both personal
use and rental activity, falls into one of
three categories for tax purposes:
– (a) primarily rental,
– (b) primarily personal, or
– (c) personal/rental.
8-10
LO #2: Rental of Vacation Homes
• The three categories are determined based
on the number of rental use days compared
to the number of personal use days.
• For example: Jose owns a vacation home.
He uses it over Christmas for 7 days and he
rented to vacationers for 90 days. Those
days determine the category of the property
(one of three discussed in the previous slide.)
• Jose’s home is a primarily rental property.
8-11
What is personal use of the home?
• Personal use is - use by the taxpayer, or
his family or non-family, free of charge.
• In case of a family member, the use is
considered personal even if that member
pays fair market value.
• Time spent working on the property (such
as doing repairs) is not considered
personal use.
8-12
Primarily Rental Homes
– A rental property that is used no more than
14 days for personal purposes (or 10% of
total rental days, whichever is greater), is
considered primarily rental property.
• All income and expenses of a primarily rental
property are reported on Schedule E.
• The expenses must be allocated between personal
and rental use, and if a net loss results, the loss is
allowed against other income up to $25,000 (subject
to passive activity loss rules).
8-13
Primarily Rental Homes
EXAMPLE:
Mandy rented her
home in Laguna
Beach, California for
190 days for
$36,000 and she
used it for 17 days.
Categorized:
primarily rental
Note: 10% of 190 days
is 19.
8-14
Primarily Personal Homes
– A home that is rented for less than 15
days but otherwise used as a personal
residence is considered a primarily
personal property.
• All income derived from the short rental period
does not have to be reported. Likewise, none
of the expenses are deductible except those
allowed as itemized deductions on Schedule A
(mortgage interest and property taxes).
8-15
Primarily Personal Homes
EXAMPLE: Maya rented her cabin in Big Bear
for $2,000 for 10 days over the holidays, and
she and her family used it for the rest of the
year.
Categorized as primarily personal – rented less
than 14 days.
8-16
Personal/Rental Homes
– A rental property that is used more than
14 days for personal purposes (or 10%
of total rental days, whichever is
greater), and rented for 15 days or
more, is considered a personal/rental
property.
• All income and expenses are reported on
Schedule E. The expenses must be allocated
between personal and rental. However, the
expenses are deductible only to the extent there
is rental income available (that is, no net loss is
allowed).
8-17
Personal/Rental Homes
EXAMPLE:
Adrianna rented
her lake house for
90 days for
$13,500, and she
and her family used
it for 50 days.
Categorized as
personal/rental
8-18
Vacation Homes Review
Darren rented his house at the lake for 48
days for $9,000 and stayed there on
weekends with his family for a total of 18
days. During his stay, he worked to
replace the roof for 6 days, while his
family went out on the boat and fished.
How should this property be categorized?
8-19
Vacation Homes Review
• Categorized as primarily rental.
• A rental property that is used no more than
14 days for personal purposes (or 10% of
total rental days, whichever is greater), is
considered primarily rental property.
• Darren’s personal use days is 12 days (18-6)!
• The days spent working on the roof does NOT count
as personal days!
8-20
Reporting Vacation Homes
• Rental expenses must be allocated between
personal and rental use. This is true for a
personal/rental property or a primarily rental
property. There are two methods available:
– The IRS method. Allocated based on the ratio of
the number of days of rental use to the total number
of days used.
– The Tax Court method. Interest and taxes are
allocated based on the ratio of the number of days of
rental use to the number of days in the year (365
days). The remaining expenses are allocated using
the IRS method.
8-21
Reporting Vacation Homes
The IRS method vs. Tax Court method:
– A rental property has the following expenses:
$4,300 of mortgage interest, $2,300 of property
taxes, $1,000 in repairs & maintenance and $2,500
in depreciation.
– The rental income from the property was $6,300.
The property was used 22 days for personal use
and rented for 84 days.
– THIS PROPERTY IS CONSIDERED
PERSONAL/RENTAL PROPERTY. All expenses
must be allocated.
8-22
Reporting Vacation Homes
IRS method: The ratio for allocation would be
–
–
–
–
84/106 FOR ALL EXPENSES (22+84 = 106).
Rental income
$6,300
Mort interest ($4,300x 84/106)
$3,408
Prop taxes($2,300x 84/106)
$1,823
R & M ($1,000x 84/106)
$ 792
Depreciation ($2,500x 84/106)
$1,981
Net income (loss)
($1,704)
Since this is a personal/rental property; the
amount you report on Schedule E would be $0.
REMEMBER: you cannot have a net loss on
personal/rental homes! The net loss of $1,704
must be carried forward.
8-23
Reporting Vacation Homes
• Tax Court method: The ratio for allocation would be
84/365 for interest and taxes AND 84/106 FOR ALL
OTHER EXPENSES. Tax court allows 365 days for
interest & taxes only.
Rental income
$6,300
Mort interest ($4,300x 84/365)
$ 990
Prop taxes($2,300x 84/365)
$ 529
– R & M ($1,000x 84/106)
$ 792
– Depreciation ($2,500x 84/106)
$1,981
– Net income
$2,008
These amounts would be reported on Schedule E.
The amounts NOT deducted above for interest and
taxes will still be deductible in Schedule A.
8-24
Reporting Vacation Homes Review
Jane & Richard own a vacation home.
During the year they rented the home for 75
days and used it for personal use for 30
days. The following are income and
expenses related to the property:
Rental income
Mortgage interest
Property Taxes
Insurance
Repairs & maintenance
Depreciation
$15,000
6,000
1,400
1,000
800
2,000
8-25
Reporting Vacation Homes Review
Which of the three categories of vacation
rental property would apply to this property
and why?
Answer:
• Jane & Richard’s home is categorized as
personal/rental;
• It was rented for 15 days or more and used
for personal use for greater than 14 days.
8-26
Reporting Vacation Homes Review
Using the IRS method, how much of the
expenses can be allocated to Jane &
Richard’s rental property? Answer:
• Expenses to allocate is $8,000 as follows:
Mortgage interest
6,000
Property taxes
1,400
Insurance
1,000
Repairs & maintenance
800
Depreciation
2,000
Total expenses
$ 11,200
• $11,200 x (75/105) = $8,000
8-27
Reporting Vacation Homes Review
IF using the Tax Court method, which
expenses would use a different ratio
(NOT 75/105) to allocate the expenses
of the rental property?
Answer:
• Mortgage interest ($6,000) and property
taxes ($1,400).
What is the ratio?
• 75/365
8-28
LO #3: Royalty Income
• A royalty is a payment for the right to use
intangible property.
• Generally, royalty income is reported on
Schedule E.
• If the royalty payment is a result of a trade
or business, then the income should be
reported on Schedule C.
8-29
LO #3: Royalty Income
• Additionally, if a royalty payment is
received while performing a service
related to the royalty-producing asset, the
royalty income should be reported on
Schedule C.
8-30
LO #3: Royalty Income
• Here are some examples:
• Jay is a full-time author and receives royalties from his
novels. Since the royalty income is received from Jay’s
trade or business, the income is reported on Schedule
C and any related expenses are deductible.
• Katherine owns land that produces oil and receives
royalty income. Katherine is a full-time dentist. Since
Katherine’s royalty income is derived from an
investment rather than a trade or business, the income
is reported on Schedule E. Any related expenses are
also deductible.
8-31
LO #3: Royalty Income
Indicate whether the following items would be reported
on Schedule E or Schedule C.
1. Royalty income received by Debra, a full-time
author, for her mystery novel.
Schedule C
2. Royalty income received by Mark, a professional
baseball player, for coal mined on his land in
Wyoming.
Schedule E
8-32
LO #3: Royalty Income
3. Nathan recently wrote a book on proverbs. He
received income for his readings at various
bookstores throughout the country.
Schedule C
4. Royalty income that Jane, a full-time professor of
psychology at the University of San Diego,
received for a textbook she wrote.
Schedule E
8-33
LO#4: Flow-Through Entities
• Partnerships, Limited Liability Companies
(LLC), S corporations, certain types of trusts
and estates, are called flow-through entities.
• These entities are known as flow-through
entities because rather than being taxed
directly, the income and expenses “flowthrough” to the partners (shareholders or
owners).
8-34
LO#4: Flow-Through Entities
• Flow-through entities file “informational returns”
and provide its partners (shareholders or owners)
with Schedule K-1s.
• The information from the K-1 is reported on the
individual partner’s (shareholder’s or owner’s)
personal tax return.
• The income and loss from K-1 is reported on the
partner’s or shareholder’s or owner’s Schedule E.
8-35
LO#4: Flow-Through Entities
• Depending on the particular partner’s
(shareholder’s or owner’s) situation, certain items
may also be reported on a Schedule A, B, or D.
• Certain limited partnerships and rental activities
are considered passive activities and as such, the
amounts of net loss that may be deductible against
active or portfolio income, are limited by the
passive activity rules.
8-36
LO#4: Flow-Through Entities
• Generally, losses from a passive activity may
ONLY be offset against passive income (and not
against active or portfolio income).
• One exception to this tax rule is rental activities.
Although rental activities by definition are
considered passive activities, tax law allows up
to $25,000 in net losses that may be offset
against active or portfolio income. This is
subject to an AGI amount limitation and phase
outs (discussed in more detail in a later chapter).
8-37
LO#4: Flow-Through Entities
1. Flow-through entities allocate an appropriate share of
the entity’s income, expenses, or loss to their partners or
shareholders or owners, on a Schedule K-1.
True
2. Ordinary income from all flow-through entities is
considered self-employment income.
False
3. The partners (shareholders or owners) must report the
income and loss from the K-1s they received on a
Schedule E of their individual tax returns.
True
4. By definition, rental properties are passive activities.
However, a taxpayer may deduct rental losses, subject
to limitations and phase outs.
True
8-38