Rental of residences.

Traditionally, taxpayers who own rental property have been able to take advantage of several tax breaks. While having to recognize rental income, they also have been able to take certain business deductions (such as depreciation and insurance); as a result, rental activities often generate tax losses that can be used against other income.

However, these rules have been revised recently and the advantages have been cut back and subject to more restrictions.

PRIMARY CONSIDERATIONS

Use as a residence. The first step in determining which deductions are available is to calculate how many days the taxpayer uses the residence during the year. A dwelling is used as a residence if the taxpayer's personal used exceeds the greater of 14 days or 10% of the days it is rented at a fair price.

Principal residence. The next steps is to determine if te residence was the taxpayer's principal residence. This determination is based on the facts of the situation and is usually an issue only when the taxpayer has more than one residence.

Passive activity rules. If the taxpayer does not live in the house, its rental may be subject to the passive activity rules. These rules apply if renting the property is considered a rental activity or if it is considered a trade or business in which the owner does not materially participate.

TAX CONSEQUENCES

The tax consequences of renting are varied, depending on how frequently and for what purposes a residence is being used.

Rental use of fewer than 15 days. If a dwelling is used as a residence and rented for fewer than 15 days, the owner may receive the rental income tax-free. However, he or she may deduct only those rental expenses otherwise allowable (qualified mortgage interest, property taxes and casualty losses); depreciation and insurance are not deductible.

A rental that is also used as a residence. In this situation, a taxpayer may deduct whatever expenses are attributable to renting the dwelling. However, since the dwelling is for both personal and business use, these expenses must be apportioned; only the portion attributable to rental use may be deducted against the rental income.

A dwelling not used as a residence. If the house is not used as a residence, the passive loss rules may apply. If renting the dwelling generates a loss, the net passive loss is combined with other passive losses and can offset only passive income. If the total net passive loss exceeds net passive income, the excess loss is carried forward and may offset passive income in succeeding years.

Three exceptions. There are three exceptions to this general rule:

1. Suspended losses can offset other income when the property is sold to an unrelated party in a taxable transaction.

2. An individual who actively participates in the rental of real estate can deduct up to $25,000 of net passive losses from rental real estate activities. (This $25,000 limit is phased out for individuals with adjusted gross incomes between $100,000 and $150,000.)

3. Losses from interests in passive activities acquired before October 23, 1986 (the enactment date of the Tax Reform Act of 1986), can be phased in. For 1990, 10% of these preenactment losses can be deducted. (After 1990, none of these losses will be deductible.)

The rental of a dwelling as a trade or business. If the dwelling is not used as a residence but for a trade or a business in which the taxpayer materially participates, the losses from the activity are not limited by the passive loss rules or the residence rules. However, if a portion of the dwelling is used for personal purposes, the expenses attributable to that personal use are not deductible (unless otherwise allowable).

A nonresidence that is not used in trade or business. Even if the rental unit is not used as a residence or for a trade or business, the property might still be considered as used for the production or collection of income or the activity may be considered as engaged in for profit. However, the deductions available for such activities are limited, and attributable expenses can be deducted only as miscellaneous itemized deductions to the extent they exceed 2% of the taxpayer's adjusted gross income.

For a detailed discussion of these rules and planning hints for using the available deductions most effectively, see "Rental of Residences," by Annette Bomyea and Kris Marucheck, in the September 1990 issue of The Tax Adviser.