If you own a property and are renting out a room to a friend or acquaintance, you might wonder whether or not you have to declare that rent as income for federal income tax purposes. The answer is simply yes, you do have to declare and report the monies you are paid as rental income. The good thing about this is that the IRS allows you certain deductions so that you do not have to pay taxes on the full amount. We’ll run through the basics here, but always go to a tax professional for advice for your specific situation.
A regular rental property is like any other business entity — you collect revenue, subtract out your expenses, and whatever is left is your profit. Then, you pay taxes on your profit. Renting out one room in your house is exactly the same — you collect rental income, subtract expenses, and then pay taxes on your profit. But with rental property, which includes renting out just one room, you also can take advantage of some additional expenses/write-off benefits.
At tax time, you will have to do your normal IRS 1040 Form and fill out in line 17 that you're a rental property owner. The exact amount you put on line 17 comes from your calculation that you do on Schedule E . So to go through this, print out Schedule E on page 1, and let’s take a look.
As you can see, you record your actual rent collected and subtract all the expenses related to that rental property. Also, if you have a two-bedroom house and you rent out one bedroom, you are effectively renting out half of the house. This means that since half of the house is a rental business property, you can deduct half of the house expenses you pay against the rental income you receive. Those expenses could be half of your mortgage interest, property taxes, repairs and maintenance, gardening, and utilities. In the end, you might collect $12,000 in rent and have $11,000 in expenses (that is half of $22,000 total household expenses), leaving you a profit of $1,000 which you would declare to the IRS and pay taxes on.
But you get another great deduction too! It’s called depreciation, and in some instances, it will help you save money on taxes. Here’s how it works. When you buy a property and place it in service as a rental property (like you are doing by renting out a room), you estimate what portion of the purchase price is related to the building structure and what portion is related to the land/lot. For example, let’s say you buy a $150,000 town home and allocate $100,000 to the structure and $50,000 to the land market value. For depreciation purposes, you take the building structure cost of $100,000 and divide it by 27.5 years (per IRS rules) to get an annual depreciation figure of $3,636 per year. Then, since you are renting half your house, you would only take half of that amount as your allowable depreciation deduction, or $1,818 per year.
So, remember that you previously calculated that you had $1,000 in profit. But with rental property, you also get to deduct the $1,818 from that $1,000, leaving you a net taxable loss of $818 for the current year rental operations. That number goes on line 25 of Schedule E.
And that $818 will flow to your 1040 Form on line 17 and effectively reduce the amount of income you earned, and hence reduce the amount of taxes you have to pay. So in the above noted case scenario, you actually save money in the current year from having the rental property.
This may be a little complicated to understand, but your tax advisor can help you figure out all the above issues, and hopefully you will get some tax savings in addition to the extra cash flow from having a renter in your property.
One note to keep in mind, though, is that you will need to keep records of all rental income, expenses, and depreciation for when you sell the property down the road. Your gain or loss on the sale will be impacted by the rental property deductions you took in prior years, so just beware and read up on this if you want to learn.
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