Key Federal Income Tax Issues Associated With Rentals of Residences and Vacation HomesNovember 9, 2017

By: Edward Rigby, CPA, The Curchin Group, LLC

This article highlights and explains the key, but somewhat complex, federal income tax rules associated with rentals of residences and vacation homes. The rules discussed include the definition of what constitutes a residence or dwelling, how personal use of the residence by the taxpayer affects the tax treatment, what expenses are deductible against rental income, and lastly, how dispositions of the property are taxed.

GENERAL/BACKGROUND
IRC Section 280A provides special tax rules for the tax treatment of certain expenses in connection with rentals of residences and vacation homes. Under the general rule stated in Section 280A(a), in the case of an individual taxpayer who uses a dwelling unit as a residence during the taxable year, deductions are not allowed for expenses other than mortgage interest, real estate taxes and casualty losses. The term dwelling unit includes a house, apartment, condominium, mobile home, boat, or similar property. In contrast, the term dwelling unit does not include any portion of a unit which is used exclusively as a hotel, motel, inn, or similar establishment.

USE OF DWELLING UNIT AS A RESIDENCE
IRC Section 280A(d) states that a taxpayer is treated as using a dwelling unit during the taxable year as a residence if he or she uses such unit for personal purposes for a number of days which exceeds the greater of: 14 days, or 10 percent of the number of days during such year for which the unit is rented at a fair market rate of rent. Although the tax law does not define the meaning of the term “fair rental”, the IRS’ position is that a rent is not considered a fair rental if it is substantially less than rents charged for similar properties in the same area. Personal use of the dwelling unit includes not only the use for personal purposes by the taxpayer, but also any person who has an ownership interest in the unit, or member of his or her family (i.e., brothers and sisters, spouses, ancestors, or lineal descendent). There is an exception to this rule for a rental at a fair market rental rate, to a family member who uses the dwelling unit as a principal residence.

PERSONAL RESIDENCE WITH LESS THAN 15 DAYS OF RENTAL USE
If the taxpayer’s personal use of the dwelling unit exceeds the greater of the 14 day or 10 percent of fair rental days test discussed in the above paragraph, and if the dwelling unit is rented for less than 15 days during the taxable year, then no deductions otherwise allowable (e.g., maintenance, utilities, depreciation) because of the rental use of the unit are allowed, and the income derived from such rental use is not included in the taxpayer’s gross income. Mortgage interest (i.e., to the extent the interest is “qualified residence interest”) and real estate taxes associated with the personal residence are deductible as itemized deductions. Thus, gross receipts for rental use are non-taxable in the case of less than 15 days of rental use.

SPECIAL DEDUCTION LIMITATION RULES FOR PERSONAL RESIDENCES  WITH RENTALS IN EXCESS OF 14 DAYS
In the case of a taxpayer that rents a dwelling unit for more than 14 days, and also uses the unit as a residence, there is a limitation and ordering rule that limits the amount of deductions associated with the rental use to the amount of gross income derived from the rental activity. According to the IRS’ regulations, gross receipts from the rental of the dwelling unit may be reduced by certain expenses to obtain tenants (e.g., realtor’s fees and advertising). Deductions for mortgage interest and real estate taxes allocable to the rental activity are allowable but only to the extent of gross rental income. Operating expenses except depreciation (such as maintenance, repairs, and utilities) are deductible only to the extent that the gross rental income exceeds the mortgage interest and real estate tax deductions. Finally, depreciation deductions are allowable but only to the extent of gross rental income in excess of mortgage interest, real estate taxes, and operating expenses. Operating expenses and depreciation amounts in excess of rental net income are not deductible in the current taxable year. However, such limited expenses are suspended and carried forward indefinitely to subsequent tax years until allowable as deductions against rental income. Although mortgage interest and real estate taxes may be limited by the gross rental income rule, taxpayers may be able to deduct mortgage interest and real estate taxes as itemized deductions to the extent such expenditures are associated with the personal use of the dwelling.

RENTAL ACTIVITY WITH PERSONAL USE THAT DOES NOT MEET  THE RESIDENCE TEST
If the dwelling unit is rented in excess of 14 days and personal use does not exceed the greater of 14 days or 10 percent of rental days, the dwelling is not considered a residence. This means that rental expenses are not limited to the gross rental income of the property. Expenses are required to be prorated between the rental activity and any personal use of the property. Although the expenses are not subject to a net income limitation as discussed above, rental activities are subject to the IRC Section 469 passive activity loss (PAL) rules and IRC Section 465 at-risk limitation rules. In general, the PAL rules limit the deduction for losses from a rental or other passive activity (a passive activity is generally a business activity in which the taxpayer does not materially participate, or a rental activity unless the taxpayer qualifies as a real estate professional). In general, passive losses are suspended until they are able to be offset against passive income, or the activity is disposed of in a taxable sale or disposition. The at-risk limitation rules suspend losses to the extent that the taxpayer does not have an “economic risk of loss”. Under a special rule for active participation in a rental activity, taxpayers can deduct up to $25,000 of losses from rental activities (subject to a phaseout rule based on the taxpayer’s income beginning at $100,000 of adjusted gross income). The PAL and at-risk limitation rules are complex and a detailed discussion of the rules are beyond the scope of this article.

DISPOSITIONS OF RENTAL PROPERTIES
As discussed above, losses limited by the PAL rules are deductible upon a taxable disposition of the property. In a taxable disposition, gain or loss is recognized and reported on Form 4797 by comparing the gross sales proceeds (less certain selling expenses) to the adjusted tax basis of the property. The adjusted tax basis is generally the original purchase price plus capital improvements, less depreciation deductions (property acquired by gift or inheritance have different basis amounts). Gain on the sale of the rental property is taxed at capital gains tax rates (a special capital gain tax rate of 25% applies to the extent of depreciation on the real estate). A loss on the sale of the real estate is taxed as an ordinary loss. There are limitations on loss recognition for certain related party transactions. Also, gain may be deferred under like-kind exchange and installment sale rules.

This article highlights and explains the key, but somewhat complex, federal income tax rules associated with rentals of residences and vacation homes. The rules discussed include the definition of what constitutes a residence or dwelling, how personal use of the residence by the taxpayer affects the tax treatment, what expenses are deductible against rental income, and lastly, how dispositions of the property are taxed.

CONCLUSION
The federal income tax rules associated with rental activities involving a dwelling unit depend on the number of personal use days. If the property is rented but personal use days exceed a certain threshold, there are limits that cap the amount of deductions that may be claimed, i.e., expenses are limited to the gross rental income associated with the rental activity. Rental activities with limited personal use below the residence thresholds are not subject to the income limitation rules. However, such activities are subject to passive loss and at-risk limitation rules.

If you have any questions regarding the information discussed in this article, please contact the author, Edward P. Rigby, CPA, The Curchin Group, LLC (732) 747-0500. Ed is a tax strategist and has extensive experience advising business owners and high wealth individuals on complex federal and multi-state tax issues.

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