Giovetti and Giovetti, Certified Public Accountants
Generally, rental activities are considered a passive activity which is subject to loss limitations. Thus, rental losses you incur can only be deducted currently against passive income. However, if you ‘actively participate’ in the rental activity, you may be able to deduct a loss up to $25,000 against ordinary (non passive) income each tax year. Active participation does not require regular, continuous, substantial involvement with the property. You meet the test if you make key management decisions such as whom to rent to, the rental terms, approving capital expenditures, etc. You can also meet the test if you arrange for others to provide services. Additionally, you must own at least 10% of the rental property. Ownership as a limited partner does not count.
If you meet the above test, you can claim up to $25,000 in losses against non passive income. However, if your adjusted gross income (AGI) is above $100,000, the $25,000 loss allowance figure is reduced by one-half the excess over $100,000. If the AGI exceeds $150,000, the loss deductions phased out completely. Losses which are not allowed under the passive loss rules do not disappear. They are carried forward and used to offset future income from the rental, the sale of the rental activity or other passive income.
Example: Mr. Jones has adjusted gross income of $120,000. Thus, one-half of the $20,000 excess ($120,000 – $100,000) equals $10,000. The maximum rental loss Mr. Jones can take is $15,000 ($25,000 – $10,000).
Year End Planning . Prior to year end review your rental activities and projected income or loss in order to maximize the use of your $25,000 loss deduction. Make sure you can satisfy the active participation test by maintaining the management decisions. Watch the timing of year end expenditures. If possible, structure the timing of income to keep your modified AGI below $100,000.
Beware Commercial Rentals: Not all rental activities are considered a passive activity and meet the $25,000 loss deduction rules (IRC 469). Rentals averaging seven days or less, such as auto, hotels, and many resort condos, have an average period of customer use which is seven days or less. As a result, the activity is no longer a rental by definition and does not qualify for the $25,000 deduction. In Letter Ruling 9505002, the IRS concluded that taxpayers who owned and rented a condo in Ocean City did not have a rental activity for purposes of IRC 469 and were not eligible for the $25,000 loss deduction. IRS based their opinion on the fact that the average rental period was seven days or less. Therefore, it was classified as a business activity. Unless a taxpayer can prove that they materially participated in the business, the loss is classified as passive and could be only deducted against passive income.
Tax Tip. If you are renting on a month to month basis or any period greater than a week, you do not have a problem. The key is that the average rental period must be more than seven days. For example. during the busy summer months rent out by the week but then fill in during the off season for reduced rates with two weeks or month rentals to get your average rental period to be greater than seven days.
In many cases renting out a home or apartment will result in a loss even if the rental income is more than your operating expenses. This is due to the depreciation deduction allowed on the cost of the house or apartment. There are special rules and limitations if you rent to a related person. For this discussion a related person means your spouse, child or grandchild, parent or grandparent, and siblings.
If you rent a home to a relative who uses it as his/her principal residence and is paying a fair rental, then there are no limitations. You can deduct all the normal rental expenses even if they result in a rental loss for the year (under the passive loss rules). The problem arises if you set the rent below the fair rental value, that is, if you allow your relative a bargain rent. If this is the case, the use of the home by your relative will be treated as use of the home by you. The results will be a tax disaster. Since all of the rental days (at a bargain rate to a relative) are treated as personal days, the rental portion would be zero. Thus, you would have to report all of the rent received as income, but none of the operating expenses. The mortgage interest and real estate taxes would be deductible only on Schedule A as itemized deductions.
Therefore, it is extremely important to set the rent at a fair rate. Factors that the IRS considers are comparable rentals in the area and whether “side” gifts were made by you to your relative which could be reasonably interpreted to be the bargain element.
The cost of the building and all personal property is recovered ratably (depreciated) over an IRS defined life. Land is not a depreciable asset. The cost basis of the property must include acquisition costs and prorated between land and building. Acquisition costs may include construction period interest and taxes, transfer taxes and recordation fees. Points, loan origination fees, and loan commitment fees are not added to the basis of the property. Rather they are amortized over the term of the loan. With the real estate you may acquire personal property such as furniture and appliances. Part of the cost must be allocated to the personal property. These items can be written off over a shorter period of time.