Whether you're a seasoned real estate professional, an accidental landlord, or someone venturing into the rental property market to earn extra income, understanding the tax implications of your rental activity is crucial.
One large part of this is understanding the required tax forms and the differences between Schedule C and Schedule E for reporting the tax on your rental income. In this article, we take a closer look at both Schedule C and Schedule E (which are part of Form 1040), to help you determine which one you need for your situation.
Understanding Passive and Non-Passive Income
Before delving into the specifics of Schedule C and Schedule E, it's essential to grasp the concepts of passive and non-passive income as related to rental property income.
Generally speaking and for most investors, rental property income is deemed by the IRS to be passive income. Passive income in this context encompasses earnings from dividends, interest, appreciation, and rent collected from rental properties. This is a slight misnomer, as any real estate investor will tell you, running rentals requires a lot of work.
Non-passive income, on the other hand, relates to income received as salary, in exchange for substantial services or from commission. For rental property income to be deemed non-passive you generally need to qualify for the real estate professional status (REPS) and be materially participant in the day-to-day management and operation of your rental business.
The IRS has strict rules around qualifying for the REPS which you can review here.
For short-term rentals, the distinction between active and passive income can be complex. Hospitality services provided to guests might constitute active income, while simultaneously acting as a residential landlord by investing in properties and collecting rent constitutes passive income. This ambiguity highlights the importance of having a quality CPA on your team and choosing the correct tax schedule.
About Schedule C
Schedule C is used by individuals running businesses or operating as sole proprietors.
To qualify for Schedule C reporting, your business activity must meet two criteria:
- Profitability: Your business activity's primary purpose should be to earn a profit.
- Consistent Involvement: You must be consistently and regularly engaged in your business activity.
About Schedule E
Schedule E is used to report passive income, which includes self-charged interest, rental property income, royalties, and business activities generating income without requiring material participation.
Passive income, such as rent collected from tenants, is generally reported on a Schedule E.
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What’s The Difference? - Schedule C vs Schedule E
Now let us look at how using Schedule C for rental property is different from Schedule E.
Schedule C
- It is used for reporting business revenue and losses.
- The income you report on Schedule C is subject to self-employment tax.
- You are allowed to deduct any business expenses on Schedule C that are ordinary and necessary in running your operations to lower your taxable income.
- Because you materially engage in your business you are not subject to passive activity rules and your losses are not capped.
Schedule E
- It is used to report rental earnings and losses.
- The income you report on Schedule E is not subject to self-employment tax.
- Deductions declared on your Schedule E can only be deducted against passive income.
- You are subject to passive activity rules which limit the losses you are allowed to deduct.
Schedule C vs Schedule E: Which to use for your rental properties
The choice between Schedule C and Schedule E for reporting rental income is not a one-size-fits-all decision; it depends on several factors. Here's a breakdown to help you make an informed choice.
When to Use Schedule C for Rental Property
For investors with multiple rental properties Schedule C might be the right choice if you qualify for the real estate professional status. To qualify as a real estate professional you need to materially participate in rental real estate activities.
Real Estate Professional Status (REPS) is a designation recognized by the IRS for individuals who spend more than 50% of their time working in real estate trades or businesses and perform at least 750 hours of service per year.
Learn more about the seven IRS REPS tests here.
If material participation is established, real estate losses become non-passive and fully deductible.
Choosing real estate professional status lets you combine all activities, unlocking previously restricted passive losses.
When to Use Schedule E for Rental Property
Most real estate investors don’t qualify for the real estate professional status and as such the Schedule E is the most commonly used form by landlords.
The majority of real estate investors and landlords declare their rental property income and expenses at tax time on the IRS form 1040 Schedule E.
The Schedule E form has 15 distinct expense categories that you need to understand so that you can accurately categorize your rental property expenses and maximize your end-of-year deductions.
Note: Landlord Studio default expense categories are in line with the IRS requirements, but can also easily be adjusted to your specific needs.
If your losses exceed your passive income or the $25,000 passive loss limitation, then the additional losses are carried forward into future tax years until the losses are fully offset.
If you engage in vacation or short-term rentals, your classification depends on the level of service provided. Offering substantial services categorizes it as a business, reportable on Schedule C. Conversely, minimal participation with no substantial services means reporting on Schedule E.
Final words: Schedule C vs Schedule E
While Schedule E is most common for landlords and real estate investors it’s not always the right schedule. Determining whether you need to file a Schedule C vs Schedule E depends on a variety of factors including your material participation and rental duration.
Because of this, it’s always recommended that you consult with a licensed tax professional to ensure you’re filing your taxes correctly and accurately. They can provide insights into which tax schedule you need as well as how you can maximize your tax savings.
Whichever form you are required to file you will need to ensure you employ bookkeeping best practices throughout the tax year to accurately capture all of your deductible expenses.
The easiest way to do this is with purpose-built property management and accounting software like Landlord Studio.
Landlord Studio is a free cloud software that pairs powerful accounting and automation with a full suite of property management tools.
Plus, instantly generate any of over 15 reports including our specifically designed Schedule E report and profit and loss report. Make tax season easy and maximize your return on investment.
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