Question

Your firm has a client who has been a management accountant for many years and is now also teaching part-time at TAFE and has recently acquired a rental property. We prepared his Tax Return, sent it out for signature. He has sent the Tax Return back to us unsigned, saying that we had made an error in claiming a tax deduction for the interest and expenses for the first four months that he owned the rental property, as it was not earning income at the time, as it runs counter to the matching principle. Required: Your manager has asked you to prepare an essay exploring this issue. Explaining to the client diplomatically that he is in error

Answer 1

Dear Sir, thanks for raising this query with us. Given below are our observations on the issue:

“When we own a rental real estate, we have some responsibilities towards disbursement of federal tax with the Government. Any rental income is required to be disclosed in the tax return and in general, the associated expenses are allowed as deduction from your rental income. Under the accrual method of accounting, we report income when it is earned (irrespective of when it is received). Similarly, we deduct expenses when we incur them, rather than we pay them.

Under the accounting system, all the amounts received as rental income (for e.g., payment for cancellation of lease, forfeiture of security deposit, etc.) must be included in the gross income. Also expenses paid by tenant such as water or sewage bill must be included in the rental income.

Further, the federal government allows taxpayers to deduct expenses incurred in relation to rental income. For example, if you receive rental income from the rental of a dwelling unit, there are certain rental expenses you may deduct on your tax return. These expenses may include mortgage interest, property tax, operating expenses, depreciation, and repairs.

You can deduct the ordinary and necessary expenses for managing, conserving and maintaining your rental property. Ordinary expenses are those that are common and generally accepted in the business. Necessary expenses are those that are deemed appropriate, such as interest, taxes, advertising, maintenance, utilities and insurance.

Under the accrual system of accounting, you can deduct the costs of certain materials, supplies, repairs, and maintenance that you make to your rental property to keep your property in good operating condition. Provisions of the tax system nowhere casts a condition that these expenses should be incurred during the period income is accrued.

Further, matching principle becomes purposeless here as these expenses are incurred for purchase, repair, maintenance of property that are relevant for its existence.

Maintenance of good records for both rental income and rental expenses would be essential for claiming deductions and preparation of tax returns."