Rental Property:
Proper Classification and Reporting
Summer 2014
Developed by Timothy Dilworth EA, CPA
Presented by XXXX
Table of Contents
Table of Contents 1
Tax Rules for Mixed-Use Property 1
Tax Court Method and Exceptions 3
Rental Real Estate with Active Participation 3
Modified adjusted gross income (MAGI) 4
Basis Limitation example: 5
At-Risk Rules 5
Real estate professionals: 5
Real property trades or businesses 6
Material Participation 6
Material participation tests 6
Proof of participation 7
Rental Activities not automatically treated as Passive: 8
Participation Rules 9
Work not usually performed by owners 9
Participation as an investor 9
Spouse's participation 10
Definition of a qualified joint venture 10
Self Rental activity: 10
Sources: 11
Tax Rules for Mixed-Use Property
Classification / Personal-UseProperty / Rental Property / Vacation Home
Days of
Personal use / 15 days or more of personal use and rented fewer than15 days. / No more than the greater of (1) 14 days or (2) 10% of the number of days rented at fair rental value. / More than the greater of (1) 14 days or (2) 10% of the number of days rented at fair rental value.
Rental
Income / Not reported. / Report on Schedule E, line 3. / Report on Schedule E, line 3.
Mortgage
Interest / Report on
Schedule A, line
10, if qualified home or second home. / Amount allocated to rental, report on Schedule E, line 12. Personal-use amount nondeductible. / Amount allocated to rental, report on Schedule E, line 12.
Personal-use amount report on Schedule A, line 10, if qualified second home.
Property
Taxes / Report on Schedule A, line 6. / Amount allocated to rental, report on Schedule E, line 16.
Personal-use amount report on Schedule A, line 6. / Amount allocated to rental, report on Schedule E, line 16. Personal-use amount report on Schedule A, line 6.
Casualty / Theft Losses / Personal use subject to limitations, report on Schedule A, line 20. / Amount allocated to rental report on Schedule E. Personal-use report on Schedule A, line 20. / Amount allocated to rental, report on Schedule E. Personal-use amount report on Schedule A, line 20.
Direct
Expenses / Nondeductible. / Report on Schedule E, lines 5 -19. / Report on Schedule E, lines 5 -19.
Other Operating Expenses / Nondeductible. / Amount allocated to rental, report on Schedule E. Personal-use amount nondeductible. / Amount allocated to rental, report on Schedule E, but limited to gross rental income, less the expense items in the preceding rows. Personal-use amount nondeductible.
Tax Court Method and Exceptions
280A(e) Expenses attributable to rental
(1) In general
In any case where a taxpayer who is an individual or an S corporation uses a dwelling unit for personal purposes on any day during the taxable year (whether or not he is treated under this section as using such unit as a residence), the amount deductible under this chapter with respect to expenses attributable to the rental of the unit (or portion thereof) for the taxable year shall not exceed an amount which bears the same relationship to such expenses as the number of days during each year that the unit (or portion thereof) is rented at a fair rental bears to the total number of days during such year that the unit (or portion thereof) is used.*
(2) Exception for deductions otherwise allowable
This subsection shall not apply with respect to deductions which would be allowable under this chapter for the taxable year whether or not such unit (or portion thereof) was rented.
*Tax Court method allows allocation of taxes and interest based on entire year.
Rental Real Estate with Active Participation
Example. Mike is single and had the following income and losses during the tax year:
Salary ...... $42,300
Dividends ...... 300
Interest ...... 1,400
Rental loss ...... (4,000)
The rental loss was from the rental of a house Mike owned. Mike had advertised and rented the house to the current tenant himself. He also collected the rents, which usually came by mail. All repairs were either made or contracted out by Mike. Although the rental loss is from a passive activity, because Mike actively participated in the rental property management he can use the entire $4,000 loss to offset his other income.
Modified adjusted gross income (MAGI)
This is your adjusted gross income from Form 1040, U.S. Individual Income Tax Return, line 38, or Form 1040NR, U.S. Nonresident Alien Income Tax Return, line 37, figured without taking into account:
1. The taxable amount of social security or equivalent tier 1 railroad retirement benefits,
2. The deductible contributions to traditional individual retirement accounts (IRAs) and section 501(c)(18) pension plans,
3. The exclusion from income of interest from Series EE and I U.S. savings bonds used to pay higher educational expenses,
4. The exclusion of amounts received under an employer's adoption assistance program,
5. Any passive activity income or loss included on Form 8582,
6. Any rental real estate loss allowed to real estate professionals,
7. Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships (PTPs) in the Instructions for Form 8582),
8. The deduction allowed for a portion of self-employment tax,
9. The deduction allowed for interest paid on student loans,
10. The deduction for qualified tuition and related fees, and
11. The domestic production activities deduction (see the Instructions for Form 8903).
Basis Limitation example:
Doug buys a rental home with his daughter Kay. Doug supplies 70% of the capital and Kay supplies 30%, but Kay is interviewing and approving the renters (with Doug’s final approval), and doing the maintenance and paying the utilities (which are included in the rent). Doug and Kay split the profits and losses 50/50. They advertised the rental for sale in January, but didn’t acquire a renter until October. The utilities, repairs, advertising expenses, mortgage interest, property taxes, snowplowing (in northern Montana!) and other expenses created a loss of $35,000 the first year. Kay’s investment was only $15,000. Her share of the loss of $17,500 is limited to her basis of 15,000. The remainder will carry over until her basis increases either by her share of future profits or if she contributes more capital to the venture.
At-Risk Rules
You may be subject to the at-risk rules if you have:
1. A loss from an activity carried on as a trade or business or for the production of income, and
2. Amounts invested in the activity for which you are not fully at risk.
Losses from holding real property (other than mineral property) placed in service before 1987 are not subject to the at-risk rules.
In most cases, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year. You are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity. Any loss that is disallowed because of the at-risk limits is treated as a deduction from the same activity in the next tax year. See IRC Section 465 and Publication 925 for a discussion of the at-risk rules.
Form 6198: If you are subject to the at-risk rules, file Form 6198, At-Risk Limitations, with your tax return.
Real estate professionals:
If you are a real estate professional, complete line 43 of Schedule E.
You qualify as a real estate professional for the tax year if you meet both of the following requirements.
1. More than half of the personal services you perform in all trades or businesses during the tax year are performed in real property trades or businesses in which you materially participate.
2. You perform more than 750 hours of services during the tax year in real property trades or businesses in which you materially participate.
If you qualify as a real estate professional, rental real estate activities in which you materially participated are not passive activities. For purposes of determining whether you materially participated in your rental real estate activities, each interest in rental real estate is a separate activity unless you elect to treat all your interests in rental real estate as one activity.
Do not count personal services you perform as an employee in real property trades or businesses unless you are a 5% owner of your employer. You are a 5% owner if you own (or are considered to own) more than 5% of your employer's outstanding stock, or capital or profits interest.
Do not count your spouse's personal services to determine whether you met the requirements in bullet points 1 and 2. However, you can count your spouse's participation in an activity in determining if you materially participated.
Real property trades or businesses: A real property trade or business is a trade or business that does any of the following with real property.
· Develops or redevelops it.
· Constructs or reconstructs it.
· Acquires it.
· Converts it.
· Rents or leases it.
· Operates or manages it.
· Brokers it.
Material Participation: A trade or business activity is not a passive activity if you materially participated in the activity.
Material participation tests. You materially participated in a trade or business activity for a tax year if you satisfy any of the following tests:
· You participated in the activity for more than 500 hours.
· Your participation was substantially all the participation in the activity of all individuals for the tax year, including the participation of individuals who did not own any interest in the activity.
· You participated in the activity for more than 100 hours during the tax year, and you participated at least as much as any other individual (including individuals who did not own any interest in the activity) for the year.
· The activity is a significant participation activity, and you participated in all significant participation activities for more than 500 hours. A significant participation activity is any trade or business activity in which you participated for more than 100 hours during the year and in which you did not materially participate under any of the material participation tests, other than this test.
· You materially participated in the activity for any 5 (whether or not consecutive) of the 10 immediately preceding tax years.
· The activity is a personal service activity in which you materially participated for any 3 (whether or not consecutive) preceding tax years. An activity is a personal service activity if it involves the performance of personal services in the fields of health (including veterinary services), law, engineering, architecture, accounting, actuarial science, performing arts, consulting, or any other trade or business in which capital is not a material income-producing factor.
· Based on all the facts and circumstances, you participated in the activity on a regular, continuous, and substantial basis during the year.
You did not materially participate in the activity under the last test if you participated in the activity for 100 hours or less during the year. Your participation in managing the activity does not count in determining whether you materially participated under this test if:
· Any person other than you received compensation for managing the activity, or
· Any individual spent more hours during the tax year managing the activity than you did (regardless of whether the individual was compensated for the management services).
Proof of participation: You can use any reasonable method to prove your participation in an activity for the year. You do not have to keep contemporaneous daily time reports, logs, or similar documents if you can establish your participation in some other way. For example, you can show the services you performed and the approximate number of hours spent by using an appointment book, calendar, or narrative summary.
Rental Activities not automatically treated as Passive:
· The average period of customer use of the property is 7 days or less. You figure the average period of customer use by dividing the total number of days in all rental periods by the number of rentals during the tax year. If the activity involves renting more than one class of property, multiply the average period of customer use of each class by a fraction. The numerator of the fraction is the gross rental income from that class of property and the denominator is the activity's total gross rental income. The activity's average period of customer use will equal the sum of the amounts for each class.
· The average period of customer use of the property, as figured above, is 30 days or less and you provide significant personal services with the rentals. Significant personal services include only services performed by individuals. To determine if personal services are significant, all relevant facts and circumstances are taken into consideration, including the frequency of the services, the type and amount of labor required to perform the services, and the value of the services relative to the amount charged for use of the property. Significant personal services do not include the following:
· Services needed to permit the lawful use of the property,
· Services to repair or improve property that would extend its useful life for a period substantially longer than the average rental, and
· Services that are similar to those commonly provided with long-term rentals of real estate, such as cleaning and maintenance of common areas or routine repairs
· You provide extraordinary personal services in making the rental property available for customer use. Services are extraordinary personal services if they are per-formed by individuals and the customers' use of the property is incidental to their receipt of the services.
· The rental is incidental to a non-rental activity. The rental of property is incidental to an activity of holding property for investment if the main purpose of holding the property is to realize a gain from its appreciation and the gross rental income from the property is less than 2% of the smaller of the property's unadjusted basis or fair market value. The unadjusted basis of property is its cost not reduced by depreciation or any other basis adjustment. The rental of property is incidental to a trade or business activity if all of the following apply: