Small landlords are increasing in number throughout the country. With the advent of vacation and short-term rentals as well as the financial benefits of owning just one, two, or three rental units as a side business, the appeal is easy to see.
But new landlords can get themselves into sticky tax trouble or end up with a tax bill if they fail to understand certain specific rules that apply to the landlord profession. For instance, do you know how to properly account for various types of rental income? Here are a few key points to keep your landlord business on the up-and-up in three common situations.
1. Security Deposits
Most landlords require some kind of refundable security deposit in case the tenants, their friends, or their pets damage the home. Security deposits can run into the thousands of dollars and they generally get settled up months or years after collected.
So, when are they considered income? Generally, refundable deposits are not reported as income when received because that money may or may not be kept by the landlord. The income is recognized when the tenant ends their lease and the deposit is accounted for, fully returned, partially returned, or kept.
2. Prepaid Rent
Prepaid rent often includes payment for the final month in advance when a person rents the unit. While this may seem very similar to security deposits, it is treated differently for taxes. In this case, the rent is income when it is paid to the landlord (including short-term rental owners).
Why the change? Simply put, prepaid rent is not generally given back to the tenant. Since it will be kept, the landlord must report it as income when he or she receives it. This holds true whether the landlord uses the cash method of accounting or the accrual method.
3. Tenant Improvements
What if your tenant does improvements to the unit? The tax treatment depends on whether or not this improvement is accepted in lieu of rent. If it was, the improvements are considered rental income when accepted. If the improvements are not in lieu of rent, then they are not rental income. Changes that increase the unit's value, though, may need to be capitalized as part of the tax basis of the building.
For some small landlords, incorrect treatment of income might not have a large effect on their tax bill. But if your units turnover often, they have high dollar values, or you plan to keep growing your business, these dollar amounts can turn into thousands of dollars. And that adds up quickly.
Your best bet is to work with a qualified CPA (certified public accountant) with experienced in the rental industry. Contact a firm, like John M Vlasac & Company, to learn how to avoid any IRS entanglements.