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Generally, rental activities are considered a passive activity which is subject to loss limitations. Thus, rental losses you incur can only be deducted currently against passive income. However, if you 'actively participate' in the rental activity, you may be able to deduct a loss up to $25,000 against ordinary (non passive) income each tax year. Active participation does not require regular, continuous, substantial involvement with the property. You meet the test if you make key management decisions such as whom to rent to, the rental terms, approving capital expenditures, etc. You can also meet the test if you arrange for others to provide services. Additionally, you must own at least 10% of the rental property. Ownership as a limited partner does not count.
If you meet the above test, you can claim up to $25,000 in losses against non passive income. However, if your adjusted gross income (AGI) is above $100,000, the $25,000 loss allowance figure is reduced by one-half the excess over $100,000. If the AGI exceeds $150,000, the loss deductions phased out completely. Losses which are not allowed under the passive loss rules do not disappear. They are carried forward and used to offset future income from the rental, the sale of the rental activity or other passive income.
Example: Mr. Jones has adjusted gross income of $120,000. Thus, one-half of the $20,000 excess ($120,000 - $100,000) equals $10,000. The maximum rental loss Mr. Jones can take is $15,000 ($25,000 - $10,000).
Year End Planning: Prior to year end review your rental activities and projected income or loss in order to maximize the use of your $25,000 loss deduction. Make sure you can satisfy the active participation test by maintaining the management decisions. Watch the timing of year end expenditures. If possible, structure the timing of income to keep your modified AGI below $100,000.
Beware Commercial Rentals: Not all rental activities are considered a passive activity and meet the $25,000 loss deduction rules (IRC 469). Rentals averaging seven days or less, such as auto, hotels, and many resort condos, have an average period of customer use which is seven days or less. As a result, the activity is no longer a rental by definition and does not qualify for the $25,000 deduction. In Letter Ruling 9505002, the IRS concluded that taxpayers who owned and rented a condo in Ocean City did not have a rental activity for purposes of IRC 469 and were not eligible for the $25,000 loss deduction. IRS based their opinion on the fact that the average rental period was seven days or less. Therefore, it was classified as a business activity. Unless a taxpayer can prove that they materially participated in the business, the loss is classified as passive and could be only deducted against passive income.
Tax Tip: If you are renting on a month to month basis or any period greater than a week, you do not have a problem. The key is that the average rental period must be more than seven days. For example, during the busy summer months rent out by the week but then fill in during the off season for reduced rates with two weeks or month rentals to get your average rental period to be greater than seven days.
In many cases renting out a home or apartment will result in a loss even if the rental income is more than your operating expenses. This is due to the depreciation deduction allowed on the cost of the house or apartment. There are special rules and limitations if you rent to a related person. For this discussion a related person means your spouse, child or grandchild, parent or grandparent, and siblings.
If you rent a home to a relative who uses it as his/her principal residence and is paying a fair rental, then there are no limitations. You can deduct all the normal rental expenses even if they result in a rental loss for the year (under the passive loss rules). The problem arises if you set the rent below the fair rental value, that is, if you allow your relative a bargain rent. If this is the case, the use of the home by your relative will be treated as use of the home by you. The results will be a tax disaster. Since all of the rental days (at a bargain rate to a relative) are treated as personal days, the rental portion would be zero. Thus, you would have to report all of the rent received as income, but none of the operating expenses. The mortgage interest and real estate taxes would be deductible only on Schedule A as itemized deductions.
Therefore, it is extremely important to set the rent at a fair rate. Factors that the IRS considers are comparable rentals in the area and whether "side" gifts were made by you to your relative which could be reasonably interpreted to be the bargain element.
The cost of the building and all personal property is recovered ratably (depreciated) over an IRS defined life. Land is not a depreciable asset. The cost basis of the property must include acquisition costs and prorated between land and building. Acquisition costs may include construction period interest and taxes, transfer taxes and recordation fees. Points, loan origination fees, and loan commitment fees are not added to the basis of the property. Rather they are amortized over the term of the loan. With the real estate you may acquire personal property such as furniture and appliances. Part of the cost must be allocated to the personal property. These items can be written off over a shorter period of time.
Any residence that you own as an investment may fall within the definition of a vacation home. This is a generic term that is applied to property that an individual or members of the individual's family use personally to any extent. In addition to the traditional home, the term vacation home includes condos, apartments, boats, and mobile homes equipped with living accommodations. If there is any personal use of the home by the individual or by family members, write-offs with respect to that property are limited.
Vacation homes may be considered a residence if the unit is used for personal purposes for a number of days which exceeds the greater of: 14 days, or 10% of the number of days during the year for which the unit is rented at a fair rental, and not used for personal purposes.
Example: Sam owns a mobile home, which has basic living accommodations. Sam uses the mobile home for 16 days of the calendar year and rents the mobile home at fair rental for 173 days of the calendar year. Because Sam's usage is less than 10% of the rental usage, the mobile home qualifies as a rental property.
Personal usage includes all days that the dwelling unit is used by any of the following parties:
1. The taxpayer or any person who has an interest in the vacation home.
2. A member of any owner's family including brothers, sisters, half-brothers, half-sisters, spouses, ancestor and lineal descendants or any other person who has an interest in the unit.
3. Any individual who uses the unit under an arrangement which enables the taxpayer to use some other dwelling unit for any period of time.
4. Anyone who uses the unit at less than fair market rental for the unit unless this individual is an employee and the furnished lodging is furnished for the convenience of the employer. (IRC 119)
Exception: Any days used by any of the above persons to perform repair and maintenance work on the dwelling are not considered personal days.
If a vacation home is rented for 14 days, or less during the year and there is any personal use, the individual gets to pocket the rental income. (Code Sec. 280A(g)) The taxpayer does not have to report the income; however, the taxpayer is permitted to claim no expenses other than mortgage interest and property taxes. Keep in mind to deduct the mortgage interest and property taxes the home must be classified as a second home.
If rented more than 14 days then all rental income must be reported along with deductions for the rent-related portions of expenses such as utilities, maintenance, and upkeep, mortgage interest, real estate taxes and insurance. A depreciation deduction may also be claimed against the rental income. Expenses will be both personal and business and must be prorated based on the number of rental days and the number of personal days. However, Code Sec. 280(A)(c)(5), deductions can not exceed rental income less:
Deductions related to the rental activity itself, such as advertising and broker's commissions and
Deductions allocable to the rental use, which would be deductible whether or not, the property was rented out.
Example: Real estate taxes and mortgage interest.
Excess expenses may be carried forward and may be used in the future years. When owner's rental deductions for the year are limited, the passive loss rules for that year do not apply to this rental property. In regard to the personal use aspects, property taxes and mortgage interest may be claimed as an itemized deduction if the property is a second residence.
Prorating expenses on a vacation home has been a controversy over the years. The IRS takes the position that mortgage interest and property taxes are prorated between the rental activities and personal activities based on the number of days of each use. However, the courts have rejected the IRS approach, instead prorating just these two expenses based on the number of rental days and the number of other days in the year (reasoning that interest and property taxes accrue even when the property sits vacant). The effect is to increase the interest and property taxes allocable to the personal days and to decrease the interest and taxes chargeable to the rental days.
Example: I own a beach house and rented it 160 days during the year. My family and I used the house for 20 days; it is vacant the remainder of the year. I received $16,000 in rent. The mortgage interest was $5,000, I paid $3,000 in property taxes, and my insurance and repair costs totaled $4,000. My depreciation allowance for the year based on the total cost of the structure itself (ignoring the land) would be $8,000. How is all of this handled on my tax return?
Solution: Since your personal use of the property (20 days) exceeds the ten percent of the number of days that the house is rented, you will not be able to claim a tax loss on the property. First, however, determine whether the position of the courts or the IRS position gives you a better result. Using the favored allocation method of the courts, limit your deductions chargeable to the rental activity by applying a fraction (160/365 to interest and property taxes and 160/180 to other expenses) to the whole amounts of the expenses as shown below:
|Mortgage Interest||$ 2,192||$ 2,808|
|Insurance & Repairs||3,556||N/D|
|$ 14,174||$ 4,493|
Because the portion of the expenses attributable to the rental period is less than the $16,000 of rental income, all of the $14,174 in expenses will be deductible. The remaining property taxes and mortgage interest (if the interest is treated as qualified residence interest on a second home) will be used as itemized deductions.
Using the IRS method of allocating interest and taxes between rental portion and personal portion, interest and taxes charged to the rental days would be $4,444 and $2,667, respectively. Rental expenses would total $17,779; thus $1,779 of expenses would be disallowed with the depreciation deduction for the year reduced by that amount.
Tax tips for vacation home owners. The "right" pattern of usage depends largely on non-tax considerations, such as the owner's vacation schedule, how much he can make by renting the unit to others, and how much he can net after expenses. However, to the extent that it's possible to do so, the owner should arrange his usage, and his financing, with the following factors in mind:
• If the passive loss rules would bar current deductions, and there's little chance that the owner would be able to utilize the losses in the near future, it usually won't pay to restrict personal use to the point where the vacation home is considered rental property. If the property is treated as a residence for tax purposes, the owner will at least keep a full deduction for the mortgage interest allocable to personal use of the home.
• If the passive loss rules won't bar deductions (e.g., the owner can use the special $25,000 loss allowance for active participation rental real estate), it may pay from the tax viewpoint to restrict personal use so that the home is considered rental property. However, the interest allocable to personal use will be nondeductible.
• If rental income from the vacation home significantly exceeds rent-related deductions, and the owner has passive losses from elsewhere, it may pay to restrict personal use to the point where the home is considered rental property. That way, the losses can be used currently to offset the passive vacation home rental income. If the owner does not have offsetting passive losses from other activities, then it may pay to increase.
• Individuals with homes in seasonably desirable locations (such as Louisville during Derby Week or New Orleans during Mardi Gras) should consider taking advantage of the tax-free windfall of legally putting cash in their pockets for up to 14 days rent. Owners of each home or ski resort properties may fare best by renting their units for seven weekends and keeping the cash, especially in light of the IRS position that short-term rentals do not qualify for the $25,000/$12,500 exception to the passive loss rule for rental real estate. Congress has periodically considered legislation which, if enacted, would end the 14-day rule, requiring the property owners to account for income and expenses of all rentals regardless of duration.