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The chameleon character of interest expense during the rental of a residence.

A significant tax savings opportunity can arise if a taxpayer rents out his personal residence (e.g., due to acceptance of a temporary work assignment away from home) while making payments on a mortgage on the property. The tax savings hinge on the classification and deductibility of the mortgage interest. Generally under Sec. 163(h)(3), "qualified residence interest" (QRI) is an itemized deduction on Schedule A. However, taxpayers have deducted interest expense incurred during a rental period in at least three different ways:

* As passive activity interest (PAI) on Schedule E.

* As QRI on Schedule A.

* As QRI on Schedule E.(1)

Methods of Reporting

Under the first method, the interest is treated as PAI from a rental activity, subject to the Sec. 469 passive activity loss (PAL) rules. Thus, the expenses are reported on Form 8582, Passive Activity Loss Limitations, and are deducted on Schedule E to the extent allowed by Sec. 469.

Some taxpayers have taken the position that Sec. 469(j)(7) excludes QRI from the PAL rules; thus, they deduct QRI in full on Schedule A, while reporting other expenses and income attributable to the rental as from a passive activity. This position significantly decreases the amount of PAL (or may create passive activity income) for each tax year the residence is rented. Such a position may allow formerly limited PALs to be currently deductible. Nevertheless, the QRI may be subject to the Sec. 68(a) 3% phaseout of itemized deductions.

The third position is reporting all rental income and expenses (other than interest) on Form 8582, and deducting the interest as QRI on Schedule E.(2) This position also decreases the tax-payer's PAL and/or increases passive activity income; however, the deduction of the interest on Schedule E reduces the taxpayer's adjusted gross income (AGI) for the current year and is not limited by the 3% phaseout.(3)

Assuming that a taxpayer has other PALs and/or high AGI, the treatment of mortgage interest on the rental of one's residence can significantly affect tax liability. See the comprehensive example on pages 392-395.

Which of the three reporting methods is correct? Under a strict reading of the Code and regulations, there appears to be more than one way of reporting such interest.(4) Depending on the facts and circumstances, there may be substantial authority to support the third or the first position--both of which allow the interest deduction to be taken on Schedule E. The third position is the most favorable from a taxpayer standpoint, because the interest expense reduces AGI and is deductible without regard to the PAL rules.(5)

The Origin of the Problem

In general, Sec. 469(c)(2) subjects any rental activity to the PAL rules. However, Sec. 469(j)(10) provides that if Sec. 280A(c)(5) applies to the rental of the taxpayer's residence, Sec. 469 does not apply, and Sec. 280A controls the deduction of all related expenses.

Sec. 280A(c)(5) generally limits deductions attributable to rental use when a taxpayer uses a residence for personal use and rents it during the same tax year. Thus, if a taxpayer uses a dwelling unit as a residence during the tax year and Sec. 280A(c)(5) limits the deductions attributable to rental use, Sec. 469 will not apply. If Sec. 280A(c)(5) applies, an allocation of expenses between rental and personal use is required, and any loss attributable to the rental use is disallowed and carried over to the next year.

However, Sec. 280A(d)(4) provides that if the dwelling unit was used as a residence for any day during the tax year that occurs before or after a "qualified rental period" (QRP), Sec. 280A(c)(5) does not apply; thus, under Sec. 469(c)(2), rental of the principal residence will be subject to the PAL rules. Sec. 469(j)(7) provides that PALs are computed without regard to QRI.

Sec. 280A(d)(4)(B) defines a QRP as a consecutive period of (1) 12 or more months that begins or ends in such tax year, or (2) less than 12 months that begins in such tax year and ends with the sale or exchange of the residence, for which the unit is rented, or held for rental, at fair market value (FMV).

Example: A's employer plans to transfer A to a new work location on Aug. 1, 1995, for 12 months. A rents out his principal residence under a one-year lease beginning Aug. 1, 1995. The rental period is a consecutive period of 12 or more months, so that it is a QRP under Sec. 280A(d)(4)(B)(i). Thus, A's personal use of the residence from Jan. 1-July 30, 1995 will not count as personal use under Sec. 280A(c)(5). Thus, Sec. 280A does not apply, and the rental income and expenses will be subject to Sec. 469.

QRI

The first issue, then, is whether interest paid on the rental is QRI. If QRI exists, the next issue is the proper reporting of the deduction (either on Schedule A as QRI, or on Schedule E as permitted by Sec. 62(a)(4)).

Sec. 163(h)(3) defines QRI as interest paid or accrued during the tax year on acquisition or home equity debt, with respect to any "qualified residence" of the taxpayer. Sec. 163(h)(4)(A)(i) defines a "qualified residence" as the principal residence (within the meaning of Sec. 1034) of the taxpayer and one other residence used by the taxpayer as a residence (as defined in Sec. 280A(d)(1)).

For this purpose, Temp. Regs. Sec. 1.163-10T(p)(2) provides that a taxpayer cannot have more than one principal residence at any one time. Sec. 163(h)(3)(A) provides that the determination of whether any property is the taxpayer's qualified residence is made at the time the interest is accrued. Thus, for the interest to be QRI, the taxpayer's residence must meet the "principal residence" definition of Sec. 1034 or the "second residence" definition of Secs. 163(h)(4)(A)(i)(II) and 280A(d)(1).

* Principal residence

Sec. 1034 allows a taxpayer to defer gain recognition on the sale of a principal residence by reinvesting, within a certain time, the proceeds in a new principal residence. Thus, one way to establish QRI is to rely on the Sec. 1034 principal residence definition. For rental periods of one year or less, it may be relatively easy to establish one's rented home as the principal residence; for extended rental periods, it may be more difficult. For extended rental periods, all of the Sec. 1034 requirements must be met to make the argument that the rented home is the principal residence.

Regs. Sec. 1.1034-1(c)(3)(i) provides that, in the case of a taxpayer using more than one property as a residence, the determination as to whether property is used by the taxpayer as his principal residence depends on the facts and circumstances, including the taxpayer's good faith. The mere fact that property is (or has been) rented is not determinative that such property is not used by the taxpayer as his principal residence. Further, the fact that he temporarily rents out the new residence during the period he vacates the old residence may not, in the light of all the facts and circumstances, prevent the new residence from being considered as the taxpayer's principal residence.

Thus, it is reasonably clear that a taxpayer who is temporarily away from his principal residence, but returns to his residence prior to its sale, would qualify for Sec. 1034 treatment. However, a taxpayer who is temporarily away from his principal residence and is considered to have abandoned it cannot use Sec. 1034, because the residence is no longer the taxpayer's principal residence.(6)

The taxpayer's chances of proving that the rented property has not been abandoned as his principal residence are improved if he vacates it with a manifest intent to return. This intent is not negated if the taxpayer's failure to return is due to factors beyond his control.(7) In addition, Regs. Sec. 1.1034-1(c)(3)(i) specifies that the fact that property is temporarily rented does not mean that it cannot be a principal residence. Rather, this depends on the facts; the argument is certainly stronger if the taxpayer's assignment is temporary (i.e., one to three years) and he actually moves back into the residence on completion of the temporary assignment.(8)

If the taxpayer moves back to the same general location, but not back into the claimed "principal residence," the IRS may argue that Sec. 1034 does not apply. Rather, the residence was converted to business use; thus, the associated interest may be properly includible under Sec. 469.

The courts have held that when a taxpayer vacates his residence and rents another (e.g., a house or apartment), his residence for Sec. 1034 purposes was the rented dwelling, not the owned one.(9) Thus, a taxpayer must argue against this position, the Temp. Regs. Sec. 1.163-10T(p)(2) requirement that the taxpayer can have only one principal residence at one time, and Sec. 163(h)(3)(A)'s requirement that interest is classified when accrued.

If the taxpayer cannot meet the Sec. 1034 test and the "one principal residence at a time" rule, perhaps the Sec. 163(h)(4)(A)(i)(II) "second residence" test can be met.

* Second residence

"Second residence" is defined in Sec. 163(h)(4)(A)(i)(II) and Temp. Regs. Sec. 1.163-10T(p)(3). As previously noted, a residence rented by the taxpayer will be a "second residence" only if it used by the taxpayer during the tax year as a residence within the meaning of Sec. 280A(d)(1). Under that section, a taxpayer uses a dwelling as a residence if he or a related party uses it for personal purposes for more than the greater of (1) 14 days or (2) 10% of the number of days during such year for which the residence is rented at FMV.

If the residence is rented for a QRP and the taxpayer lives in it least 34 days (e.e., more than 10% x 331) during both the first and last years of the temporary assignment, the interest paid in both years will be QRI, and will not have to be allocated between rental and nonrental use.

For intervening tax years in which the taxpayer does not personally use the residence, the residence will not be a second residence; thus, unless the taxpayer can successfully argue that the dwelling is a Sec. 1034 principal residence, the interest will not be QRI, and most likely will be PAI under Sec. 469.

* Deducting interest in the absence of a QRP

If the taxpayer rents out his dwelling for a period that is not a QRP, the treatment of the interest depends on the taxpayer's personal use of the dwelling. If the Sec. 280A(d)(1) personal use test is met during a tax year, Sec. 280A(c)(5) would apply to disallow and postpone any loss from the rental period, while the interest expense allocable to the personal use period would be QRI. If the personal use test is not met, the rental would likely be a passive activity and the interest expense allocated to the rental period would be PAI; the portion (if any) of the interest allocated to personal use might be investment interest deductible to the extent of net investment income.(10)

* Deducting QRI on Schedule E

Under the "second residence" test, the character of interest expense may change annually, depending on whether the taxpayer personally uses the residence during the tax year. This determination appears to be supported by the legislative histories of Secs. 280A(d)(4) and 469. The General Explanation of the Revenue Act of 1978,(11) which enacted Sec. 280A(d)(4), stated that Congress did not believe that the personal use of a principal residence for a portion of the tax year should result in the disallowance of deductions for the period when the residence has been converted to rental property; the Senate Finance Committee Report(12) provided that the determination of whether a unit is a principal residence (within the meaning of Sec. 1034) depends on the facts and circumstances of each particular case. The Joint Committee Report on the Black Lung Benefits Revenue Act of 1981,(13) which amended Sec. 280A(d)(4), stated that under prior law, Sec. 280A did not apply in the year a taxpayer converted a personal residence into a rental unit (or a rental unit into a personal residence), unless the dwelling unit was rented to a family member.

Moreover, explaining the active participation standard required to obtain the $25,000 offset for rental real estate activities, the General Explanation of the Tax Reform Act of 1986(14) (the "Blue Book") stated that in some cases, an individual could hold for rental a residence that he used part time, or that previously was and at some future time might be his primary residence.

Thus, it appears that taxpayers are required to determine, on an annual basis, whether they have converted their residence to a rental activity, or whether they hold the rented property solely as a principal residence.

Sec. 62(a)(4) allows a deduction for expenses attributable to property held for the production of rents. The legislative history referred to above and Sec. 62(a)(4) provide substantial authority to deduct the interest expense on Schedule E, regardless of whether the interest is QRI. If the interest is not QRI, it is PAI reported on Schedule E to the extent allowed by Sec. 469. If the interest is QRI, it will not be subject to the PAL rules, and can be deducted in full on Schedule E.

This result is achieved by a literal reading of the Code and regulations. In addition, the Blue Book also provides support for this position,(15) but it was written prior to the enactment of Sec. 469(j)(10) by Section 1005(a)(9) of the Technical and Miscellaneous Revenue Act of 1988. As previously noted, Sec. 469(j)(10) provides that Sec. 280A and Sec. 469 are mutually exclusive.

The Blue Book stated that interest on debt secured by the taxpayer's residence or a second residence is not subject to limit under the PAL rules if the interest meets the definition of QRI. Thus, if a taxpayer rents out his vacation home (that qualifies as a second residence) and a portion of the mortgage interest (that meets the definition of QRI) is allocable to rental use of the home and would otherwise be treated as PAI, the interest expense is not subject to disallowance under the passive activity rules.

Thus, under the current Code and regulations, there appears to be substantial authority to report QRI on Schedule E without limitation by either Sec. 469 or 280A.

Deducting QRI on Schedule A

An alternative argument supporting a deduction of QRI on Schedule A is that the taxpayer's property is simultaneously a principal residence and a rental activity. In Bolaris,(16) a 1985 (i.e., pre-PAL rules) decision, the taxpayers tried to sell their residence, then moved to a new residence, tried again to sell the old residence, rented it out, then sold it. Reversing the Tax Court, the Ninth Circuit permitted the taxpayers to defer the gain on sale under Sec. 1034, while also allowing depreciation and other rental expenses incurred during the rental period.(17) The IRS did not contest the taxpayers' deduction of interest expense on Schedule A; at that time, the interest was deductible under Sec. 163, regardless of whether the residence was held for the production of income.(18) However, the result would likely differ today, after enactment of the PAL and QRI rules.

The Tax Court's opinion in Bolaris had been grounded on the legislative history of Sec. 1034, which provided that the term "residence" is used to distinguish between property used in a trade or business and property held for the production of income.(19) The Tax Court had held that the taxpayer lacked a profit motive, so that rental deductions in excess of rental income were nondeductible.

Finally, it may be possible to have a QRP, and have two principal residences under Sec. 1034. This will be the case if a taxpayer rents out an old principal residence prior to its sale, and has also acquired a new principal residence. Temp. Regs. Sec. 1.163-10T(p)(2)'s requirement that the taxpayer have only one principal residence at a time would bar the interest on the old residence from being QRI, unless during the year of sale the taxpayer lived in the old residence long enough to satisfy the "second residence" requirement.

Conclusion

The characterization of interest expense attributable to a rented residence is a complex task. Depending on the facts and circumstances, the interest can be classified as QRI, PAI or perhaps even investment interest. While the mechanical rules defining second residences provide some certainty for the QRI classification and a deduction on Schedule E (without limitation under the PAL rules) for years in which the rental period begins and ends, taking this position in the intervening years (if any) of the rental period may be more difficult to substantiate. To prevail in the intervening years, the taxpayer must meet the principal residence test and have only one principal residence at a time. If these requirements can be met, the taxpayer should benefit each year by taking advantage of the best reporting position available.

RELATED ARTICLE: Comprehensive Example

Taxpayer T owns a home he purchased a few years ago with a $300,000, 8.5% mortgage. During 1995, T earns wages of $140,000, has $10,000 each of taxable interest income and dividends, has one child and files a joint return. T also holds 25% ownership interests in several apartment buildings that he treats as one passive activity, which produce $20,000 of PALs annually. T has a suspended PAL carryover of $60,000. Other items of income and deduction are set forth in the examples below.

T works at his company's corporate headquarters, but has been temporarily assigned to a job location 1,000 miles away for 13 months (encompassing an entire calendar year); his preassignment residence is treated as his principal residence.

[TABULAR DATA OMITTED]

(1)See Bomyea and Marucheck, "Rental of Residences," 21 The Tax Adviser 533 (Sept. 1990), at 548; and Outslay and Weber, "Characterizing a Taxpayer's Living Situation," 20 The Tax Adviser 552' (Aug. 1989), at 559.

(2)To the extent that interest expense attributable to the residence exceeds the Sec. 163(h)(3)(B) $1 million acquisition debt or 163(h)(3)(C) $100,000 home equity debt limit, it should be reported on Form 8582 as PAI. See Secs. 62, 469(c) and (j)(7).

(3)A decrease in AGI will have a beneficial impact on the exemption and itemized deduction phaseouts, and may increase the allowable medical and miscellaneous itemized deductions. See Secs. 151(d)(3), 68, 213(a), 67 and 165(h)(2)(a)(ii).

(4)If there is substantial personal use of the residence, Sec. 280A might control; if not, Sec. 469 appears to control.

(5)See Temp. Regs. Sec. 1.469-2T(d)(3)(ii)(A).

(6)See, e.g., William G. Stolk, 40 TC 345 (1963), aff'd per curiam, 326 F2d 760 (2d Cir. 1964) (13 AFTR2d 535, 64-1 USTC [paragraph]9928); Rene A. Stiegler, Jr., TC Memo 1964-57; and Ann K. Demeter, TC Memo 1971-209.

(7)See, e.g., Ralph L. Trisko, 29 TC 515 (1957), acq. 1959-1 CB 5.

(8)Facts that will be considered include (1) the length of the taxpayer's assignment (see Trisko, id.); (2) the length of the lease; (3) whether the house was rented furnished (perhaps indicating an intent to return); and (d) whether the house was listed for sale with local brokers (indicating no intent to return). See Handler, "Acquisition, Financing, Refinancing and Sale or Exchange of Residence," 179-4th T.M.

(9)Richard T. Houlette, 48 TC 350 (1967). See also Stolk, note 6, 40 TC at 353, in which the Tax Court, citing Dwyer v. Matson, 163 F2d 299, 302 (10th Cir. 1947) stated: "[Residence] does not mean ...on'es permanent place of abode, where he intends to live all his days, or for an indefinite or unlimited time; nor does it mean ...one's residence for a temporary purpose, with the intention of returning to his former residence when that purpose has been accomplished, but means ... one's actual home ... whether he intends to reside there permanently, or for a definite or indefinite length of time."

(10)The argument is that the taxpayer is not personally using the dwelling unit, but is holding it as an investment; thus, the Temp. Regs. Sec. 1.163-8T interest tracing rules would classify the interest expense as investment interest. See Sec. 163(d)(3) and (5).

(11)Staff of the Joint Committee on Taxation, General Explanation of the Revenue Act of 1978, 95th Cong., 2d Sess. 346 (1978).

(12)Senate Finance Committee Report on H.R. 6715, 95th Cong., 2d Sess. 20 (1978).

(13)Summary Proposal by the Joint Committee on Taxation (12/21/81).

(14)Staff of the Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986, 99th Cong., 2d Sess. 243 (1986).

(15)Id., at 218.

(16)Stephen Bolaris, 776 F2d 1428 (9th Cir. 1985) (56 AFTR2d 85-6472', 85-2 USTC [paragraph]9822), aff'g, rev'g and rem'g 81 TC 840 (1983).

(17)The Ninth Circuit's opinion in Bolaris, id., has been cited with approval in subsequent cases. See, e.g., David boyd, E.D. Pa., 1993 (71 AFTR2d 93-1695, 93-1 USTC [paragraph]50,240); Gary Antonides, 893 F2d 656 (4th Cir. 1990) (65 AFTR2d 90-521, 90-1 USTC [paragraph]50,029); Independent Electric Supply Inc., 781 F2d 724 (9th Cir. 1986) (57 AFTR2d 86-665, 86-1 USTC [paragraph]9192); Curtis B. Perry, TC Memo 1994-247; Henry E. Walshe, TC Memo 1994-46; Stephen J. Coffey, TC Memo 1991-516; Ralph D. Kellogg, TC Memo 1986-549.

(18)See Bolaris, note 16, at 85-2 USTC 90,267, n. 1.

(19)S. Rep. No. 82-781, 82d Cong., 1st Sess. 32 (1951), 1951-2 CB 566.
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Author:Tripp, John C.
Publication:The Tax Adviser
Date:Jul 1, 1995
Words:3727
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