What a dream scheme!
Last year, you bought a vacation home a stone’s throw from Taos, N.M., or Cape May, N.J., or Lake Wawasee, Ind. The kids had a super time, and you rented out the place for several weeks to help pay off the mortgage.
Now all you have to do is net the rental income and expenses on your tax return. Maybe the costs of mortgage interest, property tax and depreciation will blend into a “paper” loss deductible from your overtaxed salary income.
Would that it were so simple.
In reality, folks who look on residential property as a cool investment should first see whether they can plot a path through the convoluted tax treatment of rental income.
For one thing, a landlord is likely to tumble into what some accountants call “the abyss” of passive-activity rules, which severely restrict loss deductions.
For another, someone who rents out a second home part-time must skirt this trapdoor: If you overstay the limit on your own sojourns by just one day, you could wipe out hundreds or even thousands of dollars in expense deductions for the year.
“So much depends on how much you use the property yourself, on your adjusted gross income (the key figure on your federal 1040 tax return) and on how active you are in managing the property,” says Thomas Ochsenschlager, a partner in the Washington office of the accounting firm Grant Thornton.
Know the rules
Property use is considered “personal” or “rental,” depending on the number of days of each type, or “mixed.” You need to have documented the days carefully.
The simplest situation involves wholly personal use of a second home. You may take itemized deductions for the property tax and mortgage interest on Schedule A of your 1040. But get this: If you rent out your main or vacation home for no more than 14 days a year–during the Olympic Games across town, perhaps–you don’t report any income on your return or deduct any rental expenses.
If you both use and rent out your carefree condo, it’s classified as a rental property as long as your own use covers no more than the greater of 14 days or 10 percent of the number of days rented.
Personal use of 14 days a year and rental of 15 days makes it a rental property, subject to one set of mixed-use rules.
But if you use it for 15 days and rent it for 140 days, it remains a personal vacation home. Then it’s subject to different mixed-use complexities and the likely loss of expense deductions, notes Paul Vogel, a personal finance consultant at the accounting firm Price Waterhouse in St. Louis.
With such a mixed-use home, you allocate expenses between personal and rental days. You multiply each expense by a fraction to determine rental deductions. Relying on court rulings, Ochsenschlager figures the fraction as total days rented over total days in the year. The Internal Revenue Service, however, claims the proper fraction is days rented over days of use. Vogel follows that less favorable rule to avoid controversy. The choice is up to you and your tax adviser.
You report rental income and allocated expenses on Schedule E, Supplemental Income and Loss, of the 1040. However, if this produces a vacation-home loss, you can’t deduct it from any other income. And you must subtract expenses from rental income in this order: mortgage interest, property tax, advertising and commissions, operating expenses and depreciation (over 27.5 years).
Frequently, the interest and property tax will offset most or all of the income. Then the landlord gets little or no deduction for any loss stemming from operating expenses and depreciation. Still, these undeducted costs may be carried forward to offset future years’ income from the same property or to reduce your gain when you sell it.
Moreover, on Schedule A you may deduct the property tax and mortgage interest allocated to personal use.
Defining personal use
Personal use includes use by you, your family members, a co-owner, someone with whom you exchange use of homes or anyone who pays less than the fair-market rent.
What about a vacation home that you occupy for no more than 14 days, or use solely for rental? There you have a rental property and may be able to deduct an annual loss. But first you must grapple with the rules on passive activities, which include rentals and limited partnerships. A passive loss generally may offset only passive income. It can’t be deducted from other kinds of income, such as salary, interest and dividends.
If you’ve had some personal use of the property, you allocate a fraction of the expenses to rentals on Schedule E. Then you may deduct the rest of the property tax on Schedule A. But be aware, Vogel warns: You get no deduction anywhere for the personal balance of the mortgage interest.
Generally, if you have no passive income from which to deduct a passive loss, you carry the loss forward to future years. But there’s a special deal for folks who actively participate in managing their property and whose adjusted gross income, or AGI, is below $150,000. Taxpayers whose AGI is no more than $100,000 may deduct rental losses of up to $25,000 from salary or any other income. This benefit shrinks as AGI rises and disappears when AGI hits $150,000.
The IRS says active participation means making the decisions on such matters as new tenants and rents.
For broader details on the whole topic, get IRS Publication 527, “Residential Rental Property.”
