By Audre Lukosevicius, WesierMazars LLP
Many people own rental property of some kind – whether they are renting out part of a primary residence or a vacation home. Regardless of the type of rental property, owners must make themselves acquainted with the various tax rules that apply to it, as these can differ significantly based on the degree to which the property is used for personal purposes.
The first step is to determine the status of the property – either dwelling or mixed-use. A dwelling unit used for personal purposes is not necessarily a main home – main home is defined as the location where a person lives most of the time. A mixed-use property is one that is used for both personal and rental purposes. A day of personal use of a dwelling unit would be any day that it is used by the owner or any other person who has an interest in it, such as a member of an owner’s family, anyone under an agreement that exchanges use of the unit in question for use of some other dwelling unit, or anyone who uses it at less than the fair rental price.
Once the type of rental property is determined, then its tax treatment is determined by personal usage. If you rent out a property that is also used for personal purposes for 15 or more days during the tax year , and total rental time is 14 days or less, you are not required to include the rent that you receive as income on Schedule E of your return. You are also not allowed to deduct expenses associated with the rental. However, you can deduct the mortgage interest, real estate tax and casualty and theft losses that are allowed for non-rental property as Itemized Deductions on Schedule A. This is a great benefit because the income is tax free.
If a dwelling unit is used for personal purposes for 14 or more days in the year or for at least 10% of the total number of days it is rented at a fair market rate during the year, it is considered a home and you must report the rental income. For example, Mary has a home and used it for personal purposes for 10 days during the year. Her home is rented out for 30 days during the year. 10% of 30 days is 3 days. She used it for personal purposes less than 15 days. However, because she used it for 10 days (which is more than the 3 days that are at least 10% of the total number of days it was rented out at fair market rate), the rental income would be reported and the rental expense deductions are limited to the amount of gross rental income.
If you do not use the property for personal use, then it is treated as a rental property and all income and expenses are reported on your return. In this case, deductions would not be limited to the gross rental income, but the deduction may be reduced since it is subject to the passive activity loss rules. Even with a rental property there may be some personal use. This is limited to no more than the greater of either 14 days or 10% of the number of days rented out at fair rental value. For example, John rents out his property for 200 days during the year. 10% of 200 days is 20 days. He used it for personal purposes for 18 days which is greater than 14 days but less than 20 days which is the greater of 14 days or 10% of the days rented out at the fair market rate. In this case, the portion of the expenses attributed to the rental would be reported on Schedule E. The personal-use portion would be allocated to the mortgage interest and property taxes and would be picked up on Schedule A. The personal-use portion of other rental expenses would not be deductible.
A special rule applies if you rent part of your home to your employer and provide services for your employer in that rented space. In this case, you would report the rental income and deduct rental expenses but should not deduct any business expenses.
Special rules apply if you rent a condominium to others. In addition to deducting rental expenses, you can deduct any dues or assessments paid for maintenance of the common elements. Special assessments paid to the condominium management corporation for improvements cannot be deducted but are added to the basis of the property and depreciated.
There is a special depreciation allowance for 2013 that residential rental property may qualify for. It applies to qualified disaster assistance property placed in service in those federally declared disaster areas in which the disaster occurred in 2009. The allowance only applies to the first year that an owner placed the property in service and it allows for a 50% special allowance. This is an additional deduction that you can take before your regular depreciation under MACRS. If you qualify for this special allowance but choose not to take it, then you must attach a statement to your return.
Even though a property may generate a loss for a taxpayer, rental real estate is generally classified as a passive activity unless the taxpayer is a real estate professional or if an exception to the rule applies. An example of such a situation would be if the rental averages seven days or less. A special passive loss rule for rental activities exists that allows up to $25,000 in passive losses from rental real estate to be deducted each year against non-passive income. To take advantage of this, the taxpayer or spouse must actively participate in the rental activity. In order to actively participate, the taxpayer and/or spouse must own at least 10% of the rental property and be actively involved in managing the rental. This would include approving new tenants, setting the terms of the lease, approving capital repairs and the like. There is an AGI phase-out of the $25,000 special allowance. It is reduced by 50% of the amount by which the taxpayer’s modified adjusted gross income exceeds $100,000. If your modified AGI is over $150,000 ($75,000 or more if you are married separately) then there is usually no special allowance. This special allowance is not available if you were married and lived with your spouse at any time during the year, but filed a separate return.
Given the complexity and nuance of the tax rules associated with renting property, you should consult with a tax professional when considering renting out your residence or vacation home.