An overlooked aspect of vacation home rentals.
The Basic Rules
Under Section 280A, a taxpayer's dwelling unit(1) falls into one of three categories - a "residence" for personal use only, a "rental" property, or a "residence" which is also a "rental" property for part of the year. In essence, this characterization is determined by the number of days during the particular tax year which the taxpayer rents out the dwelling unit at a fair market rental and by the number of days during which the unit is used for personal purposes. As such, it is a year-by-year determination with the potential to change the tax treatment of a particular unit from one year to the next.
Residence (Personal Use Only)
If the property is rented out for less than 15 days during the year, both the income and expenses related to the rental are ignored.(2) The only tax consequences related to the ownership of such property are the itemized deductions for mortgage interest, real property taxes, and casualty losses which are available to all homeowners under Sections 163(h)(3), 164(a)(1), and 165(c) (3), respectively.(3)
Rental Property (Not a Residence)
If the property is personally used by the taxpayer for less than the greater of 15 days or 10% of the rental days, it is not considered to be a "residence" of the taxpayer;(4) instead, it is a "rental only" property. This means that the itemized deductions for mortgage interest and real property taxes will not be available, BUT the taxpayer will be able to deduct all expenses related to the rental of the property (including interest and taxes) - even if these expenses exceed the rental income from the unit. However, any rental "loss" will be subject to the passive activity rules of Section 469. These rules limit the deductibility of losses from passive activities (such as the rental of real estate(5)) to the extent of income the taxpayer has from passive activities.
There is an exception to the passive loss limitation available under Section 469(i). As long as the taxpayer-owner "actively participates" in the rental of the property (e.g. approves tenants, schedules maintenance, etc.(6)), rental losses of up to $25,000 can be deducted currently. The benefit of this exemption is phased out at the rate of 50% for each dollar of adjusted gross income (AGI) over $100,000.(7) Consequently, for taxpayers with AGIs in excess of $150,000, there is no relief from the passive loss limitations.
Any loss from a passive activity which is "suspended" (i.e., not currently deductible) can be carried over to the next taxable year, subject to the same passive loss/passive income limitations in that year.(8) Only when the taxpayer's entire interest in the passive activity (e.g. real estate rental) is disposed, will the passive loss carryovers be re-characterized as losses "not from a passive activity."(9) As will be discussed later, this is a key point to remember in tax planning for the year in which the property is disposed.
Another potential grounds for disallowance of the rental loss is if it is determined that the rental of the unit was an "activity not engaged in for profit." Under the "hobby loss rules" of Section 183, a refutable presumption arises that unless an activity produces a profit (i.e., gross income in excess of deductions) in three of the prior five taxable years, that activity is not "engaged in for profit."(10) If this is the case, the deduction of rental expenses will be limited to the gross income derived from the rental of the property.(11)
Residence AND Rental Property
If the property is rented for more than 14 days AND personally used by the taxpayer-owner for the greater of 14 days or 10% of the rental days, an allocation of expenses between rental and personal use days must be made.(12) Furthermore, the deduction of rental expenses is limited to the gross rental income - i.e., no rental losses are currently deductible.(13) While this rule is similar to that for "activities not engaged in for profit," Section 183 does not apply to the situation in which the unit is covered by Section 280A (i.e., a part-time residence/part-time rental use).(14) In short, there is the same tax result, only under a different Code provision.
In applying the gross rental [middle dot] income limitation, expenses are taken in a particular order - first, those items which would be deductible without regard to the rental (e.g. mortgage interest and real property taxes), followed by those items which do not result in basis adjustments (such as maintenance, insurance, repairs), and, finally, those items that will adjust the basis of the property (i.e., depreciation).(15) Any expense which is disallowed for the current year will be carried over to the succeeding taxable year.(16)
However, controversy exists over how expenses should be allocated between the rental and personal use. Section 280A(c)(4)(C) requires an allocation of expenses for any taxable year in which the property was not used exclusively for rental purposes. Accordingly, if the taxpayer/owner has even one day of personal use during the year, a proration is mandatory. That much is certain. The allocation controversy exists between the Tax Court (followed by the Ninth and Tenth Circuit)17 and the Internal Revenue Service over the proper denominator in the proration formula with respect to the interest and tax expenses.
In respect to all other expenses, the portion allocated to the rental is the amount of the expense times the number of rental days divided by the number of days the property was "used," with "use" being either rental or personal use. The IRS believes that this same ratio should be applied to the mortgage interest and tax expenses. As shown below, this application effectively limits the amount of rental income left-over to absorb the second and third tier of rental expenses. The Tax Court, reasoning that taxes and interest do not vary according to use but instead are incurred evenly throughout the year, holds that the denominator should be 365 - the total number of days in the tax year.
Example: To illustrate the tiering or ordering of deductions, as well as the conflicting views of allocation, assume the following: T, the taxpayer, owns a dwelling unit. During the current tax year, T personally uses the unit for 25 days and rents the property, at a fair market rate, for 75 days. Gross income from the rental of the unit totals $3,500. Expenses related to the property are for mortgage interest ($2,000), real estate taxes ($1,200), maintenance, insurance, and utilities ($2,500), and depreciation ($1,500).
Since the property was rented for more than 14 days during the year, T must include the rental income in her gross income. Because T personally uses the unit for more than greater of 14 days or 10% of the rental days (7.5 in this case), her deductions for rental expenses are limited by Section 280A to the gross rental income from the property. Also because of her personal use (more than the greater of 14 days or 10% of the rental days), this property qualifies as a "residence," allowing T itemized deductions for the mortgage interest and real property taxes that are allocated to the non-rental (personal) use of the unit.
Under the IRS approach, T would report net rental income of zero, would lose $775 of second tier expenses, and would not be able to take any of the depreciation deduction shown in exhibit ! below.
Under the Tax Court approach, T would still have no net rental income to include but would have been able to deduct the entire amount of maintenance, insurance, and utilities expenses, as well as a portion of the depreciation. In addition, T would have greater itemized deductions attributed to her personal use of the unit. As a result, the Tax Court approach yields total deductions of $6,042, or an increased deduction of $1,742 over the IRS method. (exhibit 2)
Exhibit 1 Gross rental income $3,500 First tier deductions: Interest (75/100 X 2,000) (1,500) Taxes (75/100 X 1,200) (900) (2,100) Subtotal $1,100 Second tier deductions: Maintenance, insurance, utilities (75/100 X 2,500 = 1,875 but limited to gross income after first tier) (1,100) Subtotal $0 Third tier deductions: Depreciation (1,500) disallowed) (0) Net Rental Income $0 Itemized deductions: Interest (25/100 X 2,000) $500 Taxes (25/100 X 1,200) 300
Since the characterization of the dwelling unit is made annually, planning opportunities exist if the taxpayer is able to control the number of days of rental and personal use. For example, for a taxpayer with an AGI under $100,000, the "best" tax treatment is often to have the unit characterized as a "rental only" property, with up to $25,000 of rental loss deductible against other income. Accordingly, the personal use of such a property should be limited to 14 days or less during the year.
Exhibit 2 Gross rental income $3,500 First tier deductions: Interest (75/365 X 2,000) (411) Taxes (75/365 X 1,200) (247) 658 Subtotal .$2,842 Second tier deductions: Maintenance, insurance, utilities (75/100 X 2,500) (1,875) Subtotal .$967 Third tier deductions: Depreciation (1,500 but limited to) (967) Net Rental Income .$0 Itemized deductions: Interest (2,000 - 411) $1,589 Taxes (1,200 - 247) 953
Alternatively, for taxpayers with AGIs over $150,000, the $25,000 exception to the passive loss limitation is unavailable. Therefore, no rental loss would be deductible in the current year. The "rental property" characterization would be undesirable unless the taxpayer has other rental income to offset. Instead, these taxpayers would do well to make sure that they personally use the unit for at least the greater of 14 days or 10% of the rental days in order to preserve their itemized deduction for qualified residential interest.(18) Failing that, the mortgage interest is considered to be nondeductible "personal interest."
Example: T owns a dwelling unit which he rents out at a fair market rate of $15,000 during the current year. Expenses related to the unit are mortgage interest ($10,000), real estate taxes ($4,000), utilities, maintenance, insurance ($16,000), and depreciation ($5,000). While T is not "in the real estate business" within the meaning of Section 469(c)(7), he does approve tenants and oversees the maintenance of the unit. T's AGI is $85,000.
If T personally uses the property for less than the greater of 15 days or 10% of the rental days, he can deduct the entire rental loss in the current year - $20,000 less any allocation of expenses to the personal use of the property. This is because he "actively participates" in the rental real estate activity and, thus, qualifies for the exception to the passive activity rules provided by Section 469(i). Furthermore, since his AGI is less than $100,000, T is not subject to any phase-out of the exemption. However, he will not have any itemized deductions for the interest or taxes - even for the portion prorated to his personal use since the property does not qualify as his "residence."
If T personally uses the property for more than the greater of 14 days or 10% of the rental days, he falls into the gross income limitation under Section 280A. Consequently, T can only offset rental expenses to the extent that he has rental income. The disallowed rental expenses will carry over to succeeding years. T will have itemized deductions for the interest and taxes which are allocated to his personal use of the unit.
Example: Same facts as above but T's AGI is $130,000. If T's personal use is limited so as to qualify the property as for "rental only," he will be able to deduct only $10,000 of the rental loss during the current year due to phasing out of the Section 469(i) exemption by $15,000 (50% X the $30,000 of AGI in excess of $100,000). The remaining "passive" rental loss is carried over to succeeding years. T would still not receive any itemized deductions for interest or taxes.
Had T, by his personal use days, qualified the unit as a "residence," he would have the same results as in the previous example (i.e., subject to the Section 280A gross income limitation).
Example: T's AGI for the year is $200,000. If this is a "rental only" property, T will have no current deduction for the rental loss since the Section 469(i) exemption has been completely phased out because of his AGI. The "passive" loss ($20,000 less any expenses allocated to the personal use of the unit) will carry over to succeeding years, available to offset "passive" rental income in those future years. Still no itemized deductions are available.
If the unit was characterized as a "residence/rental" property, T would have the same results as in the previous examples - i.e., limited deductions of rental expenses to offset rental income and itemized deductions for the interest and taxes allocated to his personal use of the unit.
In analyzing the personal residence or rental property classification, several issues must be resolved before making the final determination. Considerations include the size of the interest payments, the amount of rental income received from the property, the availability of other passive activity income, and, of course, the taxpayer's AGI. Assuming vacation homeowners can control their personal use of the property, there is no simple answer. Moreover, what is the "best" tax treatment can change on an annual basis.
In planning the annual classification of the property as personal or rental, taxpayers often overlook the nature of their loss carryovers. Given the potential for differing characterizations for different taxable years, a taxpayer may have two different types of loss carryovers relating to the same property. The first is the loss carryover resulting from the passive activity rules of Section 469; the second is the loss carryover from the gross income limitation of Section 280A. These carryovers are not combined and will retain their character regardless of the characterization of the property itself in future years.(19) In other words, the passive loss carryover can only be utilized in years in which the unit is a "rental only" property; the Section 280A loss carryover can only be utilized in years in which the unit is a "residence/rental" property.
Given the time value of the potential tax benefits, a taxpayer would like to use up these loss carryovers as quickly as possible. However, the amount and character of the loss carryforwards increase in significance when the taxpayer is planning to dispose of the property. Ideally, one would like to utilize all loss carryovers before this happens, perhaps by planning "personal use" in the years leading up to the sale so as to achieve the desired characterization as a "rental only" or "residence/rental" property so that the appropriate carryover can be utilized. Even if this is not possible, a final planning opportunity exists - viz. the characterization of the property in the year of disposition.
Loss Carryover in the Final Year
Assuming the taxpayer has both a passive loss (Section 469) and a gross income limitation (Section 280A) carryover coming into the year of disposition, which is the best characterization of the property for this final year of ownership?
If the property is considered "for rental only," the passive loss carryover will be freed up, i.e., considered no longer from a passive activity, by the "disposition of the entire interest in the passive activity."(20) Given that these losses could then be used to offset other non-passive income while the benefits of the Section 280A carryover would be lost forever, it makes sense for the taxpayer to limit his personal use of the unit in order to achieve the desired result.
This would even be an advantageous strategy for a high AGI taxpayer who had no previous passive losses related to this property. For example, as was previously illustrated, where the property is generating a rental loss, a taxpayer with AGI in excess of $150,000, would be better off qualifying the property as a "residence/rental" unit. This classification preserves his itemized deductions since the rental loss would not be currently deductible. Meanwhile, the expenses which are disallowed due to the Section 280A gross income limitation will continue to carry-over just as the passive losses from "rental only" would have.
Assuming the losses continue into this final year, there would no longer be any opportunity to utilize the carry-over of previously disallowed "residence/rental" expenses. Consequently, there is no further advantage to be gained from having the unit characterized as a "residence." On the other hand, if the taxpayer were to limit his personal use in order to qualify this as "rental only" property during this last year of ownership, the resulting "non-passive" rental loss would be available to offset other income.
Example: T's AGI is $200,000. His "rental loss" is $20,000. The amount of mortgage interest and taxes allocated to his personal use of the property is $1,600.
Until T's final year of ownership, it would be more advantageous from a tax perspective to qualify the unit as a "residence" by personally using it for the greater of 14 days or 10% of the rental days during the year. While the rental loss would not be deductible due to the Section 280A gross income limitation, T would at least get $1,600 in itemized deductions. In contrast, if the unit is characterized as a "rental only" property, not only would the $20,000 rental loss not be deductible (Section 469(i) exemption having been phased out by T's AGI), but the itemized deductions of $1,600 would be lost.
In the year in which T disposes of the property, a "rental only" characterization is preferable. T loses the itemized deductions ($1,600) but gets a $20,000 loss which can be used to offset other income.
Any tax planning decision is extremely fact sensitive. This is especially true with the ownership of a second or vacation home. Before any decision is made regarding the most advantageous characterization of the property as a "residence" or "rental only" unit, careful consideration must be given to amount and character of income, expenses, losses, and loss carryovers. Regardless of the decisions reached during the on-going ownership of the unit, these factors must be reconsidered in detail for the year during which the property is being disposed. As this article has shown, what is best for one year may not be best for another. Fortunately for the taxpayer, since each year stands on its own, there is a golden opportunity for planning for the most tax advantageous result.
1. Code Sec. 280A(f)(1)(A) defines "dwelling unit" to include a house, apartment, condominium, mobile home, boat, or similar property, and all structures or other property appurtenant to such dwelling unit.
2. Section 280A(g).
3. This assumes all other requirements for deductibility of these items is met (e.g. the limitations on qualified residential indebtedness or $100 per casualty and the AGI limits on casualty losses).
4. Section 280A(d)(1).
5. Rental activities are always passive under Section 469(c)(2). However, there is an exception to this if the taxpayer is in the real property business. See Section 469(c)(7) for these special rules.
6. S. Rept. No. 99-313, 99th Cong., 2d Sess., pp. 737-738 (1986).
7. Section 469(i)(3).
8. Section 469(b).
9. Section 469(g).
10. Section 183(d).
11. Section 183(b)(2).
12. Actually, if a rental property is used for even one "personal" day, an allocation of expenses must be made. Section 280A(e)(1).
13. Section 280A(c)(5).
14. Section 280A(f)(3).
15. Section 280A(c)(5); Prop. Reg. Sec. 1.280A-3(d)(3).
16. Section 280A(c)(5).
17. Bolton v. Commissioner, 51 AFTR2d 83-305,694 F2d 556, affg 77 TC 104 (9th Cir, 1982); McKinney v. Commissioner, 52 AFTR 2d 83-6281, 732 F2d 414 (10th Cir, 1983).
18. Section 163, using the definition of "residence" from Section 280A(d)(1), limits the deduction of mortgage interest to indebtedness on properties personally used by the owner for the greater of 14 days or 10% of the rental days during the year.
19. As Section 280A(c)(5) states, the carryover of the loss disallowed due to the gross income limitation is subject to this same limitation in the succeeding tax year "whether or not the dwelling unit is used as a residence during such year."
20. Section 469(g).
W. Richard Sherman, J.D., LL.M., C.P.A., associate professor of accounting, St. Joseph's University and Thomas M. Brinker, Jr., J.D., M.S., C.P.A. of Brinker, Simpson, Nicastro & Volk.
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|Author:||Sherman, W. Richard; Brinker, Thomas M., Jr.|
|Publication:||The National Public Accountant|
|Date:||Nov 1, 1997|
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