In the past two posts we covered the first 8 out of the 20 most common tax forms used by taxpayers who need to report foreign income and/or assets to the IRS. Today, we are going to talk about Schedule E. Schedule E is common enough and tricky enough that it merits its own post.
Let’s get started!
Schedule E- Supplemental Income and Loss
Schedule E is used to report several types of income: royalties, gains and losses from trusts and estates, income and losses from partnerships and S corporations, and most commonly, rental income.
Income from trusts, estates, partnerships, and S corporations is entered into the relevant sections of Schedule E from information reported to you in your Schedule K-1.
Schedule K-1 is a tax form that you should receive every year from the accountant or the responsible party that takes care of the tax filings of an estate, trust, partnership, or S-corporation in which you have a beneficial ownership.
In a similar manner, royalties and rental income will usually be reported to you on a Form 1099-Misc.
We are going to focus on attention on rental income reporting because this is the most common type of income reported on Schedule E by the likely readers of this newsletter.
It is not that unusual for globetrotters who moves to a different country, whether a foreigner living in the USA like me, or an American living abroad, to keep their home in the former country of residence either as a vacation home for visits back during the year, or as a rental property, or even a combination of vacation home and rental property, at least during the first years of foreign residency.
If you are in this situation, what do you need to be aware of?
Converting your formal primary residence into a rental property or mixed-use vacation/rental is referred to as placing the property “in service”.
Once you place a property in service and rented to a tenant, many expenses that were not tax deductible when the property was exclusively your primary home, can become tax deductible. Examples of such expenses include home-owners association dues, home maintenance expenses like lawn-care, home insurance, the cost of fixing a leaky faucet, the cost of touching up the paint, of cleaning the gutters, etc.
These are now “business related” expenses that can help you reduce your gross rental income and arrive at the rental profit that will be taxable for income tax purposes. Because of their power to reduce your taxes, it’s important to track these expenses with care.
If you remember from one of our early issues of CBP, tax deductions are a matter of “administrative grace”. This means that you are not automatically entitled to any deductions. The burden of proof rests on you to show that you incurred the deductions and that the deductions are genuinely business related. The IRS has the right to demand this proof in a tax return examination. Therefore, you are required keep records of all these deductible expenses and retain the supporting documentation to substantiate the expenses.
Luckily, technology makes keeping these records a lot easier than it used to be.
“The dog ate my receipts” is no longer a valid excuse not to keep good expense records!
If you have a smart phone, you have a camera that you can use to post photos of your adorable puppy on Instagram or take silly selfies…. or even take photos of all these receipts as you incur the expenses!
It only takes one second save a photo of an expense receipt. To boot, there are several apps that can help you organize the receipts to make things easier for you come tax-time.
Speaking of deductible expenses, an expense that is missed with some frequency, or that it is calculated incorrectly with even more frequency, is depreciation.
Depreciation is fantastic because unlike the other expenses that require making a cash outlay, depreciation is an expense that only exists on paper, and yet, it has the ability to reduce your taxable income.
However, a lot of people are not aware of the power of depreciation, do not understand well how it works and are intimidated by it. As a result, they fall into a common misconception about depreciation: that it is a voluntary deduction and that they can choose not to take it.
I hear this a lot:
“I don’t want to deduct depreciation. I’m going to mess it up, plus I heard I have to pay it back when I sell the home anyway, so I rather not take it”
Taking this position would make sense if ignoring the depreciation expense was a valid option.
Unfortunately, it is not. The US tax code makes taking depreciation mandatory.
Whether you calculate your depreciation deduction or not, whether you deduct it as an expense in your Schedule E every year or not, you MUST pay back your depreciation “allowed or allowable” when you sell the rental property at a gain.
Might as well take the deduction every year then! You get no benefit from ignoring this deduction and you may get a big tax bill if you eventually sell your rental home.
With the understanding that depreciation is mandatory, what else do you need to know about it to make it less intimidating?
Let’s explore the different points:
Depreciation is a function of value and time:
THE VALUE OF HOME THE HOME % A NUMBER OF YEARS = ANNUAL DEPRECIATION
- VALUE: Depreciation is calculated on your adjusted cost basis in the property or on the fair market value of the property at the time it was placed in service, whichever is lower.
- Your adjusted cost basis is the cost at which you acquired the property (purchase price + closing costs, for example) plus the cost of any improvements you made to the property (the cost of a bathroom addition, for example) net of any deprecation you may have taken in the past. This is the value you are required to use as the basis for depreciation, unless its fair market value is lower, as explained below.
- The fair market value is the value at which the property could be sold to an independent third party buyer on the date it is placed in service. Generally, determining the fair market value requires obtaining a qualified appraisal. If the fair market value of the property is lower than your adjusted cost basis, you are required to use the fair market value for deprecation calculations.
- You cannot depreciate land value. If your home was a single-family home, for example, built on a valuable plot of land, you can only depreciate the cost of the building, not the value of the land. You need to segregate the value of the land and exclude from the amount that is used for the depreciation calculation. This segregation can sometimes be tricky, especially in areas where land is extremely valuable, such as certain cities and coastal areas, and may require obtaining an appraisal.
- TIME: Recovery periods, or number of years over which you are required to depreciate the property, vary depending on the type of property you are renting, the location of the property and the year it was placed in service:
- Residential property, such as a family home, located in the USA is depreciated over a 27.5 year period.
- Residential property placed in service after January 1st, 2018 and located outside the USA, is depreciated over a 30 year period.
- Residential property placed in service before January 1st 2018 and located outside the USA, is depreciated over a 40 year period.
- Nonresidential property (for example, an office building) located in the USA is depreciated over a 39 year period.
- Nonresidential property located outside the USA, no matter when it was placed in service, is depreciated over a 40 year period.
Let’s do a simple calculation to illustrate the depreciation calculation: assume you purchased a home in Indiana for $260,000 and paid $15,000 in closing costs. You decide to start renting the home in January 2021.
Value: $260,000+$15,000 = $275,000
Time: 27.5 years, since the property is located in the USA, in Indiana
Annual Depreciation: $275,000/27.5 years = $10,000.00/year
Now imagine the property is located in France. In that case the calculation would be:
Annual Depreciation: $275,000/30 years = $9,166.67/year
If you make, or realize you have made, mistakes in your depreciation deduction, either because you didn’t take any depreciation at all, or because you calculated it incorrectly, you can correct those errors by using Form 3115. Form 3115 may look a little daunting, but the instructions are surprisingly helpful.
What else is important to understand regarding Schedule E Rentals?
- If your income is high enough, your rental loss may be suspended. For more information about suspended rental losses, check the IRS website here.
- If your rental activity is a short term rental, and you provide substantial services, such as linens, housekeeping, paper products, etc., your rental activity may need to be reported on Schedule C instead of Schedule E.
- If your rental property is mixed use between personal vacation use and rental, your deductions may be limited, and some of the expenses may be deductible on your Schedule A – itemized deductions instead.
Once again, we covered a lot ground, so I will let you go until next week. Stay healthy and take good care. Un abrazo y buena onda, and much love to all,