This post is lengthy. But it contains important information that you need. Doing things wrong in that first year of dealing with a rental is not an option. Perfection is a must. Even the tiniest of mistakes can (and will) grow exponentially over time. Then when you catch the error years down the road (usually in the tax year you sell the property) the cost of fixing it will be expensive. So a bit of work on your part now, will save you a massive headache, as well as your wallet, later.
Example. You are renting out two bedrooms in your house to two completely different and unrelated persons. Each bedroom occupies 10% of your total floor space. So together they occupy 20% of your total floor space. You will have "ONE" rental on the SCH E for this, and "TWO" assets for that one rental, with each asset being one of the bedrooms. There is a reason I am recommending this method, that I will cover later.
Start working through the Rental & Royalty Income (SCH E) section of the program. Below, I am only addressing those screens that matter.
- On screen, "What type of rental is this?" select single family home.
- On screen, "Do any of these situations apply to this property?" you will select three items.
- 2021 was the first year I rented this property
- I rent out part of my home
- I converted this property from personal use to a rental in 2021
- On screen, "Was this property rented for all of 2021?" if you started renting the rooms at any time in 2021 (doesn't matter if you started on Dec 30, 2020) and the rooms were still classified as rental space on Dec 31 of 2021, select YES for both questions. The program will base your allowed deductions starting on the date you placed the asset "in service" as rental property, and you will enter that date later, and you will enter that date more than once.
- On screen, "do you have an office in your home?" Be aware that a home office is not allowed for residential rental real estate. So you'll select NO on this screen. However, if you have a SCH C business and claim a home office on that SCH C, then (and only then) would you select YES. I am going to assume you select NO.
- On screen, "Let us calculate your expenses for you." select NO. The problem with selecting yes, is that the program does not calculate everything "correctly", and there are still some things it still flat out can not calculate at all. You want to do this manually, because perfection on the SCH E in your first year is not an option.... it's a must. Even the tiniest of mistake can (and will) grow exponentially over time. Then when it's caught years down the road, the cost of fixing it will be expensive. So do a bit of your own brain work now, to avoid being forced to deal with it (and the IRS) later. It's a one time process, and you're done.
- On screen, "Tell us about the property" where it asks if the property was your residence in the past, select yes.
- On screen, "Enter purchase price" enter what you paid for the property in full, when you "originally" purchased the home all those years ago. In this figure, you should also include the cost of any property improvements that you paid for before you converted the rooms to rental. For the available date, enter the date you converted the rooms to rental. Typically, this will be the first day that a renter "could" have moved in. The purchase date will be the date you closed on the original loan when you originally purchased the property.
- On screen, "Enter Fair Market Value" enter the FMV of your house on the date you converted the rooms to rental. Typically, this value will be "HIGHER" than the original price you paid for it. So I fully expect (and will assume) that the value you enter on this screen, will be higher than the value you entered on the screen for "Enter purchase price".
- On screen "enter escrow fees", enter these numbers from the HUD-1 Settlement Statement or the ALTA settlement statement you were given at the closing when you originally purchased the property.
- On screen, "Any seller paid points?", if the seller paid any points "for you", that will be on the line item for points, under the "paid by seller" column. This is not common, but not unheard of either.
- On screen, "Any property improvements made?" I would fully expect you already included the cost of any property improvements, in the purchase price you entered on the screen for "Enter Purchase Price". If you did, then leave this blank. If you did not, then enter the cost of any property improvements here.
- On screen, "Enter property tax values", get these values from the most current property tax bill you have in your possession. I would expect that to be your 2021 property tax bill.
- On screen, "Depreciation Results" these numbers are flat out wrong. But don't worry, we'll correct it later in the assets/depreciation section. When you click the continue button on this screen, you are returned to the "Review your [propertyname] Rental Summary" screen.
- In the rental income section enter the total rental income received from all sources for the two rooms rented in 2021.
- In the rental expenses section you will enter your costs directly related to the rented rooms. Some things have to be pro-rated and I'll cover that now.
- Insurance - you can enter the percentage of property insurance you paid, that is equal to the percentage of floor space rented. For example, if you are renting out 20% of your floor space and you paid $1000 for property insurance in 2021, then you can claim $200 for insurance, since $200 is 20% of the $1000 you paid. The remaining $800 of your insurance payment is not deductible anywhere on your tax return.
- Repairs: You can claim 100% of repair costs provided the repair expense incurred related to something that was 100% rental use. For example, if the $25 door handle broke on the bedroom door, that would be 100% deductible as a rental expense, since that door is used exclusively by the paying renter. You can claim a percentage of the repair expense for repairs that affect the renter, but are not exclusive to the renter. For example, if the $25 door lock on the front door broke and was replaced, you can claim as a rental expenses a percentage of that cost that is equal to the percentage of floor space being rented by the tenant. In my scenaro that would be 20%, or $5.
- Real Estate Taxes: You can claim a portion of your real estate taxes that is equal to the percentage of floor space rented out, further reduced by the period of time the room was classified as a rental. For example, say I paid $1000 in property taxes in 2021. With 20% of my floor space rented out that would be $200 I can claim on property taxes. The room was converted to a rental on 7/1/2021, so it was only classified as a rental for 6 months. $200 divided by 12 gives me $16,66 a month. Multiply that by the number of months rented which is 6 months in my scenario, and I can claim $100 for my property taxes on SCH E. The remaining amount is deductible later on SCH A as an itemized deduction.
- Utilities: To start, understand that if you have one landline telephone in your home, you are not allowed to claim any amount of your phone bill on SCH E. Not a single penny. The IRS says so. But if you have two land lines "and" one of them is exclusive to the renter, then you can claim 100% of the cost of that line only, as a SCH E rental expense. Now utilities includes the cost of LP Gas, electricity, water, cable/satellite TV and Internet. There are two ways you are allowed to figure the SCH E portion of these expenses. But for now I"m only going to cover what I consider the simpler way, which is based on percentage of floor space you have rented. SO if you're renting 20% of your floor space, only 20% of those bills are deductible on SCH E, starting on the date the room was converted to a rental. So it may not be 20% of your utility costs for the entire tax year. Additionally, to claim the utility expenses on SCH E for cable/satellite and Internet, it must be available for "exclusive use" of the tenant. So if you have a cable drop and/or satellite box in the tenant's room, that's exclusive to the tenant. If you do not have a cable drop/satellite box in the tenant's room, it's not exclusive to the tenant. If you are providing wireless internet access to your tenant, then that's considered to be exclusive to the tenant regardless of where the access point is in your house. Otherwise, if only hard wired internet access is available, then you must have a physical RJ-45 drop in the tenant's room for the tenant to plug into, and obviously it has to work. 🙂 So you'll total up your utility bills from the date the room was converted to a rental, and then claim a percentage of that total on SCH E, that is equal to the percentage of floor space rented out.
- On screen, "Report Mortgage Interest" start with the amount in box 1 of the 1098-Mortgage Interest Statement you received from your mortgage lender. Multiply that amount by the percentage of floor space you are renting to the tenant. Now divide that by 12 to get the mortgage interest for each month. Now multiply that figure by the number of months the room was classified as a rental. This gives you the total amount of mortgage interest you can claim on the SCH E. The remaining amount is claimed later in the program as a SCH A itemized deduction. So write that amount down so you have it when you need it later in the program.
- On screen, "Any miscellaneous expenses?" If you pay HOA dues, then you can claim a percentage of that equal to the percentage of floor space rented to the tenant, further reduced by the number of months the room was classified as a rental. This completes the expenses section. Now move on to the Assets/Depreciation section.
- If prompted to go directly to your asset summary, select yes and continue.
- On the "Your property assets" screen you see your property itself listed there, with a depreciation amount. That depreciation amount is wrong, and is way to high. (Don't worry, I'll prove it's wrong as we work this through)
- Elect to edit that entry.
*- On screen "Describe this asset" select Rental real estate property, and continue.
- On screen "Tell us a little more about your rental asset" select Residential Rental Real Estate, and continue.
- On screen, "Tell us about this rental asset?" The numbers you see there should all be correct, as you entered them when you started the SCH E data entry process. No need to change them. Just continue.
- On screen "Tell us more about this rental asset" select that you purchased this asset. Then below that select "No, I have not always used this item 100% of the time for this business. Then below that select "I used this item for personal purposes before I started using it in this business" Then below that, "Date I started using it in this business" should already be filled in with the date you converted the room to rental use.
Below that it reads, "Percentage of time I used this item for this business in 2021 (e.g., 80%)" THIS IS THE WRONG QUESTION, AND IF ANSWERED AS IT READS YOUR DEPRECIATION WILL BE WRONG!
The question is wrong only for your specific and explicit situation, because your entire house is not 100% business use. What this question should be asking you is, "percentage of floor space that is exclusive to the renter".
Now you said that you wanted to claim each room separately. You can do that here. As I understand it, each room is 10% of your floor space. So with two rooms, that's 20%. We'll make this asset entry for only one of the rooms. So just enter 10% here, then continue.
On screen, "Asset Summary" you need the amount of depreciation deductible for this one room, which is 10% of your structure value pro-rated for the number of months it was classified as a rental. You can click the details checkbox if you like, to see the details. I recommend you print this screen, as you are going to need this data for entering another asset, which will be the other bedroom you are renting out. Once done viewing this screen, click continue. This returns you to the 'Your property assets" screen.
- On screen, "Your property assets" click the Add an Asset button.
Now go back up in this post to the line that starts "*- On screen "Describe this asset" select Rental real estate property, and continue." Note that there is an asterisks (*) at the start of the line above where you need to start from, and enter the same information again as another new asset. The only thing that will be different is the third screen in called "Describe this asset". Your description for the 2nd room can not be identical to the description in the first asset. So call it something like "Bedroom 2" or whatever. Just work it through and all of the data entered will be identical to all the data in the first asset listed.
When done, you'll be back to the "Your property assets" screen, and you should see two entries on that screen now, and assuming the percentage of floos space is the same for both rooms, the depreciation shown for each should be identical. If we're good, click the DONE button. This returns you to the "Review Your [propertyname] Rental Summary" screen.
ON that screen next to Assets/depreciation, you see the total depreciation amount based on your total percentage of floor space that is classified as rental. Now lets confirm beyond a doubt that amount is correct.
Go to IRS Publication 946 at https://www.irs.gov/pub/irs-pdf/p946.pdf Use the worksheet that starts on page 37 of that document to manually figure the depreciation. For line 4 of that worksheet, it's 27.5 years. For line 6 of that worksheet use table A-6 on page 72.
If your figure is off by a buck or two, that's fine. You manually figured using exact numbers. The program incorporates the IRS requirement to "round to the nearest dollar". So if there's a buck or two difference, that's perfectly fine. Just leave it alone and you're good to go.
One advantage you have by splitting the two rooms into physically separate assets, is that if later down the road you need to convert one of the rooms back to personal use, you can do so quite easily without having to jump through hoops of fire over a burning lava pit.
