As service members move to new duty stations throughout their careers, they often purchase homes that they later rent to supplement their income and offset mortgage payments. This rental income is taxable and comes with a unique set of filing requirements that service members should be aware of.

How is rental income reported?

Rental income is reported on a Schedule E form which is attached to the 1040 tax return. In addition to rents received this form also contains the taxpayer's deductible expenses. The expenses are subtracted from the rents to arrive at the net profit or loss on the property. This amount is then added to the taxpayer's total income for the tax year.

What expenses are deductible?

Some taxpayers are not fully aware of what expenses they can deduct from their rental property. The IRS allows for the deduction of all expenses that are ordinary and necessary costs of renting the property. Examples include the cost of repairs, advertising, management fees, and depreciation of the property. This can even include a deduction for mileage if the taxpayer takes trips to check on the property. To claim these deductions it is critical for taxpayers to maintain accurate records of their expenditures. This will help ensure they take full advantage of these deductions and protect against IRS audits.

Although many of the costs associated with a rental property can be deducted, some expenses cannot. Improvements, which can be thought of as upgrades rather than repairs, are not deductible. For example, the costs of renovating a kitchen or adding a new roof are considered improvements to property and cannot be claimed as repairs.

However, improvements are factored into the taxpayer's basis in the property and can result in tax savings if/when the property is resold. Often, it is uncertain whether something is a repair or an improvement and in those situations, it is recommended to consult with a tax professional before claiming a deduction.

Finally, there are limits on what expenses can be deducted for taxpayers trying to claim a net loss on the property. To take a loss, the taxpayer must have actively participated in the management. Although this does mean the taxpayer had to be involved in day-to-day operations, they still had to be involved in some of the important decision making. When it comes to renting a property, it is important for service members to think of it as operating a business, and therefore, they should be keeping careful track of their expenses so they do not end up paying more taxes than necessary.

What state is rental income taxable to?

Often, service members' rental properties are not located in their state of residency, which can create confusion when it comes to filing state tax returns. In general, rental income should be reported both to the state of residence and to the state where the rental property sits. To do this, the service member will have to file two state returns: a resident return in their state of residency; and, a nonresident return in the rental property state. To avoid double taxation, the service member may receive a credit for taxes paid on the nonresident return from their resident state.

Service members should also be careful about having their rental income trigger tax liability on their state returns. Many states exclude military pay from income. As a result of this exclusion, many service members end up having no taxable income on their state returns and therefore, end up owing nothing to the state.

However, tax breaks for military pay rarely extend to other sources of income. Most states tax service members' rental income and expect it to be included on the tax return. Therefore, when service members start renting properties they begin earning taxable income and incurring tax liability. If they did not have any taxes withheld to the state throughout the year, they run the risk of owing when it comes time to file.

Can the Fort Knox Tax Center assist with the preparation of rental tax returns?

The Fort Knox Tax Center can prepare tax returns with up to one rental property. However, the tax center cannot help with calculating depreciation nor can it help with tax returns involving the sale of a rental property. If you need assistance with either of these issues, we suggest seeking the advice of a tax professional.

To schedule a tax appointment with the tax center and verify that we can assist you, call us at (502) 624-0044.