Rental Income

Rental income is the gross amount an owner receives for the use or occupation of property. Publication 527 states the scope in a sentence worth reading twice: "Rental income is any payment you receive for the use or occupation of property. It isn't limited to amounts you receive as normal rental payments." That breadth is the whole point of the definition. A payment does not have to be called rent, arrive monthly, or come in cash to be rental income, and several of the receipts owners most often leave off a return are squarely inside it.

Rental income is a gross figure, not a profit. It is the top of the calculation, from which the ordinary expenses of the activity are deducted to produce the taxable result most individual owners report on Schedule E. It is also a different quantity from net operating income, the measure used to price income property, which is computed after operating expenses but before financing and depreciation. The two are easy to conflate because both describe money from a building, and neither is the other.

The inclusion list is where most of the errors live, and Publication 527 enumerates it. Five categories account for nearly all of them.

Advance rent is any amount received before the period it covers, and the rule overrides the usual timing question: include it "in your rental income in the year you receive it regardless of the period covered or the method of accounting you use." An accrual-method landlord does not get to spread it. A cash-method landlord has no argument for deferring it either.

A payment to cancel a lease is rent. If a tenant pays to get out of the remaining term, that money is rental income in the year received, again regardless of accounting method.

Expenses a tenant pays on the owner's behalf are rental income, and the same amount is deductible if it is a deductible rental expense. The classic case is a tenant who pays a bill the lease makes the owner responsible for and subtracts it from the rent check. The net cash is smaller, and the gross income reported is not.

Property or services received instead of money go in at fair market value. Where services are provided at an agreed or specified price, Publication 527 treats that price as fair market value unless there is evidence to the contrary. A tenant who paints the building in place of two months' rent has produced two months of taxable rental income for the owner, along with a deduction for the painting.

A lease with an option to buy produces rental income while it is a lease. The payments received under the agreement are generally rental income, and if the tenant exercises the option, payments received for the period after the date of sale become part of the selling price rather than rent.

Security deposits sit outside income until something changes them. An owner does not include a deposit in income on receipt if the plan is to return it at the end of the lease. Whatever is kept because the tenant did not live up to the lease is income in the year it is kept. And the characterization rule matters more than the label: "If an amount called a security deposit is to be used as a final payment of rent, it is advance rent. Include it in your income when you receive it."

The self-employment line is drawn by services, not by effort. Rent from real estate is generally not subject to self-employment tax. IRC 1402(a)(1) excludes "rentals from real estate" from net earnings from self-employment "unless such rentals are received in the course of a trade or business as a real estate dealer." A landlord who spends significant time on the property is still receiving rentals from real estate; time spent is not the test.

What moves the income across the line is set out in Treasury Regulation 1.1402(a)-4(c). Its first paragraph confirms the ordinary case: payments for the use or occupancy of entire private residences, or of living quarters in duplex or multiple-housing units, "are generally rentals from real estate." Its second paragraph supplies the exception. Payments for the use or occupancy of rooms or other space "where services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services," do not constitute rentals from real estate and are included in net earnings from self-employment. The regulation then states the principle and illustrates it: services count when they are "primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only," so that "the supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, the collection of trash, and so forth, are not considered as services rendered to the occupant." Heat, light, common-area cleaning and trash collection are the ordinary incidents of renting property out. Daily housekeeping and hotel-style services are something else, which is why short-term renting with substantial guest services can produce a different answer from renting the same property on an annual lease.

Two further regimes reach rental income and neither is decided by the rent itself. The net investment income tax can apply, and the section 199A deduction can be available, but both turn on facts about the activity, notably whether it rises to a trade or business and how the owner participates in it. Each is its own subject and neither is settled by looking at the receipts.

The owner totals every receipt for the use of the property during the year, including the categories above, deducts the allowable expenses of the activity, and reports the result, in most individual cases on Schedule E. Depreciation is deducted alongside the cash expenses and belongs to the separate question of what the property cost and when it was placed in service.

A hypothetical timing example. Zoya's tenant takes a three-year lease beginning March 1. During that first calendar year the tenant pays $2,100 a month for the ten months from March through December, a total of $21,000. At signing the tenant also pays $2,100 as the final month's rent for the end of the lease in year three, and a separate $2,100 security deposit that Zoya intends to return. Zoya's rental income for year one is $23,100: the $21,000 of ordinary rent plus the $2,100 of advance rent, which goes in when received even though it covers a period more than two years away. The security deposit is not income at all in year one. If Zoya later keeps $400 of it for damage at the end of the lease, that $400 is income in the year she keeps it.

A hypothetical tenant-paid-expense example. In one month the tenant pays a $180 water bill that the lease makes Zoya responsible for and remits $1,920 instead of $2,100. Zoya reports $2,100 of rental income for that month and deducts $180 as a rental expense. The taxable result is identical to receiving the full rent and paying the bill herself; only the cash moved differently.

Pros

• Rent from real estate is generally outside self-employment tax, so an ordinary rental does not carry the 15.3 percent charge a service business does.
• The gross-up on tenant-paid expenses is neutral in substance, because the same amount is income and deduction.
• Ordinary operating costs of the property, including insurance, repairs, management and interest, are deductible against the income.
• The rules are mechanical and published, so an owner who reads Publication 527 once can classify nearly every receipt without professional help.

Cons

• The definition is broad enough that the receipts most likely to be overlooked, such as a lease-cancellation payment, are inside it.
• Advance rent is taxed on receipt, so collecting a final month's rent at signing accelerates tax by the whole length of the lease.
• Labeling money a security deposit does not make it one if the lease says it will be applied as the last month's rent.
• Adding services to attract short-term guests can move the income into self-employment tax, and the change is easy to make without noticing.
• Rental income is gross, so a property that produces a healthy income figure can still produce a loss, and losses have their own limitations.