The IRS allows you to use either the cash or accrual accounting methods to report the income and deductions for a rental property you own. Although both methods apply the same tax rules, the years in which you report income and deductions will be different. Once you choose an accounting method to use, the IRS expects you to stick with that method.
The cash method of accounting for income taxes on a rental property is the most common since it makes record-keeping much simpler. This is because the method simply requires you to report the rental income in the year you receive payment, regardless of which year the rental payment covers. Similarly, the rental expenses you deduct are taken in the year you pay the expense, even if it you make the payment early.
The accrual method of accounting for your rental property utilizes timing principles opposite from the cash method. Under this method, you only report rental income to the IRS that is for rental periods within the tax year. Therefore, if your tenant prepays rent for January in November, you don't report that income until the following tax year, provided you use the calendar year as your tax year. Additionally, the expenses that relate to the rental property are not deductible until the period that the expense covers. So if you are responsible for paying electric bills on the rental property and make an advance payment in December for the month of January of the following tax year, you must wait until the next tax year to claim the deduction.
Comparison of Methods
To illustrate how each method results in different amount of taxable income at the end of the year, suppose your tenant pays $1,000 per month to rent your property, and after paying for the current tax year, decides to make an advance rent payment of $6,000 in December for the following six months. Furthermore, assume you are responsible for paying $100 each month towards the electricity bill, and for convenience, you prepay the electric bill in December for those same six months the tenant prepays the rent. Under the cash method, you report total rental income of $18,000 and rental deductions of $1,800 resulting in taxable income of $16,200. However, under the accrual method, you only report $12,000 of rental income and $1,000 of deductible expenses for total taxable rental income of $11,000. You then include the prepaid rent and expenses on your return in the following year.
How to Report
Regardless of which method you choose, the forms you report rental income and deductions on depend solely on your level of participation in the rentals. If the renting of your property doesn't require much of your time, you can report all income and deductions on a Schedule E. However, if you actively participate in the rentals by providing significant management services throughout the year, you report everything on a Schedule C.
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