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Reporting Taxable Income and Expenses for Real Estate Investments

It’s tax time once again. And if you’re a real estate investor and you’re anything like me, it is about this time every year when you contemplate switching your investment portfolio to something like a savings account. Granted, savings accounts return about 1.5% per year, but at least you don’t have to fill out another Schedule E. Well, to attempt to help remove some of the pain for my fellow investors, I decided to put together the TwoWiseAcres quick and dirty guide to taxes for the real estate investor. I’m going to quickly cover the basics, but will be so bold as to run through some rules for calculating depreciation deductions.

Let’s all just keep one thing in mind at the outset. I will warrant this information only to the extent of Rob’s contribution to the process of calculating our taxes on the TWA investments. This, as you can imagine, is the most limited of the limited warranties. I will say, however, that this article generally covers the process that I follow in preparing my return, and I’m still a free man. So, with that said, let’s get busy.

Reporting Taxable Income from Residential Real Estate

For the beginners, if you haven’t figured this one out yet, taxable income and loss for residential real estate is reported on Schedule E. If you are using any form of accounting software to track your income and expenses, it’s probably a good idea to set up your accounts (either “chart of accounts” or “categories” or whatever terminology your software uses) to pattern the income and expense categories of Schedule E.

As a real estate investor, your primary income will be from rents. But you may also have other income, such as application fees, late fees, and what have you. For Schedule E tax purposes, you only have two choices for reporting all income—“Rents Received” and “Royalties Received”. Unless you are a songwriter, as well as real estate investor, in all probability, you can ignore the “Royalties Received” part. (If you haven’t guessed, Schedule E isn’t just for real estate investor types). So, all rents and fees paid by tenants will be reported as “Rents Received.” For software tracking purposes, consider setting up subaccounts under a primary “Rents” account to the extent that you want to separately track other specific fee items.

Reporting Taxable Expenses from Residential Real Estate

Most of the Schedule E expense categories are relatively self-explanatory, and many follow how you would probably track your expenses in any event. For example, Schedule E expense categories include advertising, insurance, utilities, and legal and professional fees. However, a few categories deserve a little explanation. For example, two of the Schedule E expense categories are “Cleaning and Maintenance” and “Repairs”. So, when you send the handyman out to fix the handle on the toilet so it stops running in perpetuity, have you just incurred a “maintenance” cost or a “repair” cost. My simple answer: Who cares? The effect on your taxable income or loss is the same regardless of which category you use, so let’s not get too hung up here. As a rule of thumb, I’ll categorize items like lawn care, painting, cleaning, and the like as maintenance and expenditures to fix the thing that isn’t working as a repair and most importantly not spend more than 10 seconds to debate the difference.

Schedule E expenses, of course, include a line item for mortgage interest. The interest portion of your mortgage payment is deductible. The principal portion is not. Since I’m generally more interested in tracking cash flow for my properties on a monthly basis, I will track my mortgage payment (both principal and interest) as an expense. This allows me to run a profit and loss report that is really reporting my cash flow. In short, this method is both a software “workaround” and a reflection of the fact that I don’t want to manually enter a mortgage payment each month that breaks down principal and interest. So, I have to do some year-end adjustments for tax purposes. Since mortgage lenders are required to issue Form 1098s to you, as borrower, that show the interest paid for the calendar year, the adjustment is a relatively simple one. Use the amount reported on Form 1098 to report Schedule E mortgage interest. (But periodically check the bank’s reporting of interest against your own amortization schedule. They do, in fact, make mistakes from time to time.)

Schedules E includes categories for “taxes” and “insurance”. For the real estate investor, the taxes category means property taxes. Insurance includes property insurance and mortgage insurance (if your loan required mortgage insurance). Pretty straightforward, but there are a couple of things to keep in mind here. If your mortgage loan requires that you pay taxes and insurance into escrow, the amounts you pay into escrow may not (and, in fact, probably won’t) reflect your actual expenses for these items. Banks set up escrow accounts to make sure these items get paid. The mysterious calculations that the banks use to calculate your contribution to this escrow account are designed to insure that the bank has enough of your money the cover the costs as they arise. What will never ever ever happen is the bank advancing these expenses because there wasn’t enough in your escrow account to cover the costs. That means that there will always be more than enough in the escrow account to cover anticipated costs. Your expenses, for tax purposes, are the actual expenses paid by the bank from the escrow account. For property taxes, you can again refer to Form 1098. Mortgage lenders maintaining an escrow are required, as with mortgage interest, to report property taxes paid on your behalf for the year on this form. As with mortgage interest, the occasional check against the county auditor’s records (mostly available online) wouldn’t hurt.

Insurance is a bit different. Form 1098 includes mortgage insurance; it doesn’t include property insurance. So, you need to know what your mortgage lender paid from the escrow account for property insurance during the calendar year. Most larger mortgage lenders provide online access to reports of escrow activity during the year. (They also should have sent you a statement of escrow activity that will show this expense). Otherwise, you may have to thumb through your monthly mortgage statement to extract the information. Typically, property insurance is paid in one annual premium, so it shouldn’t be that difficult to find if you haven’t tracked it during the year.

Finally, Schedule E includes a category for “other” expenses. My advice—track your expenses as “other” expenses sparingly. You’re going to have to include an itemized list for this category for the IRS’ amusement and edification. So, it’s best not to use other as a casual default category. I will typically have costs such as credit reports, lockboxes, and the like here.

So there you go. You now have your Schedule E Income and your Schedule E Expenses. The result is your net income before depreciation, or in Schedule E terms, your “add lines 5 through 18”. Calculating depreciation is always just a bit—how shall I put this?—maddening. So, let’s all take a break, grab a short nap, perhaps a beer, and then return for the next part on calculating depreciation.

In the meantime, if you still have questions on the income and expense side of Schedule E, here’s a handy IRS publication for your reference. It might just answer a couple of questions that I haven’t covered, but I warn you, it’s not for the feint of heart.

{ 4 comments… add one }

  • Ernesto@InsuranceYak.com April 14, 2008, 2:58 pm

    You crack me up.. I think when they include ‘royalties’ they mean revenue from oil, gas wells and such located on the property (not unheard of in Ohio where I live). I’d guess musicians report money somewhere else.

    If you keep good records, don’t be afraid of ‘other’ expenses; like Mr.Crabs says: “that’s costin’ me money!!” If you don’t include these, it’s deductions you’re missing out on:

    Mileage driving to and from properties (that’s BIG).
    Advertising costs
    Postage & office supplies
    Home office expenses

    Just remember to keep good records!

  • Mike-TWA April 14, 2008, 6:50 pm

    Ernesto,

    OK, fair enough. Let’s just compromise and say its for oil, gas and the possibility of one-hit wonder revenue.

    Indeed a good point on the records and taking all deductions to which you’re entitled. On this front, my point on the “other expenses” is categorize all expenses where reasonably appropriate in the schedule E line items without going through the itemization necessary by throwing expenses into the “other” category.

    Thanks for the good comments.

  • Ernesto@InsuranceYak.com April 15, 2008, 11:34 am

    OK, it seems we’re both correct; JKlasser says:

    “Royalties are payment for use of copyrights or for the use and exhaustion of mineral properties. Royalties are taxable as ordinary income and are reported in Schedule E (Form 1040).

    But if you are a self-employed author, artist, or inventor, you report royalty income and expenses on Schedule C.

    Royalty income includes:

    License fees received for use, manufacture, or sale of a patented article
    Renting fees received from patents, copyrights, and depletable assets (such as oil wells)
    Author’s royalties including advance royalties if not a loan
    Royalties for musical compositions, works of art, etc. ”

    No wonder I don’t do taxes anymore.

  • onthuhlist October 28, 2008, 11:41 am

    OK, this is great for rental properties. Do you have a guide for those of us who decided to rehab a home and sell it in these times of cheap real estate?

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