The summer season brings with it a considerable uptick in homeowners renting out their private residences. There are many rules to be cognizant of when it comes to renting out your home, especially when the residence is also used personally.
If the property was rented out for less than 15 days during the year, the rental income is not taxable. Likewise, rental expenses are not claimed aside from real estate taxes and mortgage interest that are claimed as itemized deductions. This tax break is often utilized when a major event comes to a geographic area, such as a political convention or the Olympics, where the number of available hotel rooms is insufficient and private residences are sought for lodging. Many homeowners in the New York metropolitan area thought they could score big by renting their homes for a week when the Super Bowl took place at MetLife Stadium in East Rutherford, New Jersey in early February 2014. From all indications, few homeowners actually were able to cash in on this situation, as demand from out-of-town fans did not materialize as anticipated.
Rental properties, whether a detached house, townhouse, condominium, or cooperative apartment, are subject to depreciation. After allocating a portion of the property cost to land (base allocation on assessed values), depreciation is computed using a prescribed tax life of 27.5 years for residential real estate. This works out to 3.636% annually for a full year. Partial depreciation is calculated in the year the rental property is placed in service.
Whenever there is personal use of a rental property, the expenses must be allocated proportionately between the personal and rental portions. On the face of Schedule E, the IRS has lines for entering both the Fair Rental Days and Personal Use Days. The personal use portions of real estate taxes and mortgage interest can be claimed as itemized deductions. The personal use share of all other expenses, such as advertising, repairs and maintenance, utilities, and depreciation cannot be deducted. If the residence is both rented and used personally, and personal use was more than the greater of 14 days or 10% of the total days rented, then the taxpayer is limited as far as claiming a deduction for expenses other than real estate taxes and mortgage interest to the remaining net rental income. Any excess rental expenses are carried over to the following year.
Where a residence is rented for the entire year with no personal use, any loss incurred is normally treated as a passive activity loss (PAL) unless the taxpayer meets the definition of a real estate professional – more than 750 hours devoted to real estate activities comprising more than 50% of total hours devoted to all business activities. The IRS frequently challenges taxpayers who claim to be real estate professionals. Normally, in order to deduct a PAL, the taxpayer needs to have passive income from other sources to absorb the rental loss(es).
A special rule allows a taxpayer to deduct up to $25,000 of their rental losses where the taxpayer owns at least 10% of the rental property and makes management decisions, such as approving new tenants or arranging for others to provide services (i.e. rental agent, building superintendent) in a significant and bona fide sense. The $25,000 loss allowance applies where modified adjusted gross income (MAGI) is below $100,000. The loss allowance is phased out $1 for every $2 of MAGI between $100,000 and $150,000. These amounts are cut in half for married individuals who file separately. When a rental property is sold, any suspended PALs are freed up and can be claimed in the year of sale.
For more information on this subject, please view IRS Publication 527.