Accounting Basics for Rental Property

If you don’t want to pay more income tax than is required for a landlord, an accounting system is needed that accurately tracks your tax-deductible expenses. Knowing what expenses to record is part of the puzzle. In addition, your accounting system must separate expense totals by category. You also need to capture rental income and associated expenses for each rental property separately if you are a landlord with multiple properties.

Rental Income

Your rental income for a property is the gross amount you receive before any deductions. Include only amounts that are payment for actually occupying the property. You don’t include security deposits as rental income because these are refundable to the tenant. However, any part of the security deposit you retain upon the departure of a tenant is income when it is no longer refundable. The part of a security deposit that you do refund is therefore not an expense because you never recorded it as income.

Mortgages

The entire monthly mortgage payment on a rental property is not an expense. Only the interest paid for financing the property is recorded as an expense. Principal payments create equity for you as a landlord because they reduce debt.

Accounting for the amount of interest in each mortgage payment is impossible if that component is unknown. However, the lending institution will report the amount of interest paid each year. Your accounting system therefore should consistently account for every mortgage payment in the same way until an adjustment is make for year-end. A simple method of accounting for monthly mortgage payments considers the entire payment amounts as principal until the amount of interest is known.

Pass Through Expenses

Any expenditure you incur to hold and maintain rental property for generating income is a tax-deductible expense. This can be complicated when you use a management company. A property manager normally collects rent and pays for various types of expenses—such as maintenance and utilities—before remitting the remaining balance to you. A management fee is also deducted.

Your landlord accounting system must record the gross rent received and the amounts for each category of expense deducted by the management company.

Direct Expenses

Even if you have a property manager, there are some expenses you pay directly. Your accounting system should record the bills you receive and pay for each separate rental property. Expense categories that landlords customarily pay directly include property taxes and insurance.

Depreciation

Depreciation is the expense deduction taken over several years of your cost basis in a rental property. To calculate depreciation, you need to know your basis in the property. This is normally the purchase price plus acquisition cost. Landlords should consult their tax advisers about basis for property that’s inherited or converted to rental purposes after use as a personal residence.

Capital improvements to rental property are also depreciated. This includes costs for new appliances, a new roof, new carpet, or new doors and windows. Anything that adds to the value of a rental property is a capital improvement. Do not account for these costs as repair expenses. Depreciation begins as soon as the property is placed in service. At that time, you can determine the depreciation for each year in the future. Or you can simply wait until the end of each year.

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