One of the potential benefits of owning your own home is the opportunity to generate a little extra income. Some homeowners rent out a spare bedroom or a garage that’s been converted into an apartment, while others live in one unit of a multifamily property and rent out the others.

When tax time rolls around, the question of how to report rental income and expenses often comes up. 

While reporting only the extra income may result in higher taxes, in some cases a homeowner may be able to use shared expenses – along with a partial depreciation expense – to actually lower the homeowner’s taxable annual income.

Key takeaways

• Rental income is cash received from a tenant, or work done by a tenant in lieu of paying rent.
• Shared expenses are a tenant’s share of expenses – such as repairs, insurance, mortgage, interest, and property taxes.
• Two common ways to calculate shared expenses are by the number of rooms or the square footage of the home.
• A homeowner may also claim a partial depreciation expense as an additional deduction from the rental income collected.
• When shared expenses are in excess of rental income, a homeowner may be able to use the loss to reduce other income or carry the loss forward to use as a deduction in future tax years.
• If a homeowner elects not to rent for profit, shared expenses claimed on a tax return may not exceed the amount of income collected.

What is rental income?

Rental income is any payment received from someone who is using or occupying a home that they do not own. Income can be generated by:

• Renting out a second property, such as a single family rental house.
• House hacking by renting a spare bedroom or a basement that has been converted into a studio apartment.

According to Real Estate Tax Tips from the IRS, rental income payment does not have to be in cash. 

For example, a landlord may waive one or two month’s of rent due from a tenant in exchange for a tenant painting the home. In a case like this, a landlord would include in rental income the amount of rent that a tenant would have paid. 

When a home is used 100% of the time as a rental property, reporting income and expenses is pretty straightforward. Many landlords use free rental property financial management software from Stessa to automatically track income and expenses, and generate tax-ready financial reports. 

Rental income includes monthly rent received from a tenant, prepaid rent such as when a landlord collects the first and last month of rent, extra income like pet rent, and any fee a tenant pays for canceling a lease early. 

Rental expenses include money spent on items such as property management and leasing commissions, repairs and maintenance, property taxes and insurance, and utilities that are paid directly by a landlord.

Example of rental income

Assume that an investor owns a home that is rented out 100% of the time. The income statement (also known as a P&L or profit and loss statement) might look something like this:

Income

• Rental income: $14,000
• Pet rent: $240

Total Income: $14,240

Expenses

• Property management: <$1,140>
• Repairs and maintenance: <$1,000>
• Property taxes: <$1,500>
• Insurance: <$700>
• Mortgage interest expense: <$3,600>

Total Expenses: <$7,940>

Profit/Loss: $6,300

The above example is pretty clear-cut. However, when a home is partially rented, tracking expenses becomes a little bit trickier.

What are shared expenses?

Shared expenses are a tenant’s share of expenses when a home is partially rented out, such as a spare bedroom in a primary residence or a free standing garage that has been converted into a separate apartment.

The costs of owning a home – including repairs and maintenance, property taxes, mortgage interest,  and homeowner’s insurance – are shared or split as personal and business expenses.

In addition to these costs, expenses that are not normally deductible by a homeowner are deductible when a property is rented out. Examples include the tenant’s share of utilities, the cost of repainting the outside of the home, and depreciation on the part of the home used for rental purposes.

Other expenses directly related to renting out part of a home – such as painting the tenant’s room or the premium for additional landlord liability insurance purchased – are completely deductible.

How to divide expenses between business and personal use

As IRS Publication 527, Residential Rental Property explains on page 16, when part of a property is rented out, expenses must be divided between the portion of the property used as a rental and the portion used for personal use. 

Another way of thinking about shared expenses is by imagining the home is two separate pieces of property, one a business rental and the other for personal use. The two most common methods of calculating shared expenses are by the number of rooms in the home or the square footage of the home.

For example, if a 200 square foot bedroom with an ensuite bathroom in a 2,000 square foot home is rented out, 20% of the expenses could be deducted as rental expenses on Schedule E (Form 1040).

Examples of shared expenses

Now let’s look at two common situations a homeowner might face with shared expenses. 

In the first example, we’ll assume a bedroom in a primary residence is rented out. In the second example, we’ll look at a 2-unit duplex that an investor purchased using a low down payment FHA or VA loan. To satisfy the loan conditions, the owner is living in one unit as a primary residence and renting the remaining unit out.

In both of the following examples, rental income and expenses are categorized according to Schedule E (Form 1040). Recording income and expenses this way makes filing taxes easier, which is why Stessa uses the same system for automatically recording income and expenses for a rental property.

Single-family home with 1 bedroom rented out

Assume that a single-family home is 2,000 square feet in size, and that a 200 square foot bedroom with ensuite bath is rented out. For depreciation purposes, the cost basis of the home is $150,000 (excluding the land value) and straight-line depreciation over 27.5 years is used.

Because the tenant is renting 10% of the home, 10% of the expenses can be claimed on the homeowner’s tax return using Schedule E.

So, even though the homeowner collected a rental income of $2,400, a loss of $4,484 may be claimed on the tax return. Depending on the homeowner’s specific tax situation, this loss may be able to be used to offset other income, or carried forward and used as a deduction in future tax years.

Multifamily property with 1 unit rented out

Now let’s look at an example where an investor purchased a 2-unit duplex. 

One of the units is occupied by the investor as a primary residence, and the other unit is rented out. Both units have approximately the same square footage, which means that 50% of the property expenses can be claimed as shared expenses. 

Each rental unit is metered for electricity, and remaining utilities (water, sewer, gas, and trash) are on a single account and paid by the owner. The property was purchased for $180,000 (excluding the land value), and straight-line depreciation over 27.5 years is used.

Even though the owner collected rental income of $12,000, a loss of $4,755 may be claimed on the tax return. As with the previous single-family home example, the owner of this multifamily property may be able to use the loss to offset other income, or carry the loss forward and use it as a deduction in future tax years.

What happens if a home is not rented for profit?

In both of the examples above, the owner was able to report a loss for income tax purposes by renting part of the property for profit and sharing the expenses. Depending on the owner’s specific tax situation, the loss may be used to offset other income, or carried forward and used as a deduction in future tax years.

However, if an owner is not able to make a profit by renting out part of a property, shared expense deductions can not exceed the amount of rental income collected. While there may be less paperwork involved, not renting for profit may result in the loss of significant potential tax deductions for a homeowner.

Before deciding whether to rent out part of a home for profit, an investor may wish to speak with a tax advisor to examine the pros and cons of each option.