By Matthew S Hewes, CPA
520 Old Stoney Rd, Corolla, NC 27927
Each year tens of thousands of families flock to the Outer Banks for a week of sun and sand, long days and warm water. While owning a vacation home is a dream come true for many people, few people are aware of the tax benefits and pitfalls related to rental property ownership. In this article related to the taxation of rental property, we will explore the good, the bad, and the downright ugly of the Internal Revenue Code, and how to maximize the good. To say that the taxation of rental property is complex is an extreme understatement. Personal use, extent of participation, grouping elections, and special deductions, are but some of the terms of which the savvy real estate investor will need to become conversant. The first step in navigating these waters is determining the extent of the owner’s use of the property.
In response to concerns that personal motives rather than profit predominates the rental of vacation homes, Congress in 1976 enacted Internal Revenue Code section 280A. By this enactment, Congress sought to limit the deductibility of vacation home expenses when a vacation home is used for both rental and personal purposes. If there is too much personal use of the vacation home during the year, then the expenses associated with the activity must be allocated between personal and rental use.
The tax treatment of rental property expenses depends on whether the taxpayer also used the property as a home during the year. A vacation rental property is considered a home of the taxpayer if the property is used for personal purposes during the year for more than the greater of 1) 14 days or 2) 10% of the total number of days the property was rented at fair value. Count family members and friends that you let use the property, as well as charitable donation use of the property, as days of personal use. Do not count days used primarily for repairs and maintenance as personal use.
Now for some good news. If you rent any dwelling unit that you also use as a home for less than 15 days during the year, it’s not considered income under the tax code. The dollar amount is irrelevant; you aren’t required to report the income on your tax return. Certain expenses, like mortgage interest, real estate taxes, and casualty losses may be deductible as itemized deductions.
Renting vacation property that is also used as a home of the taxpayer isn’t a passive activity under the tax law. Instead, you must first allocate your expenses between rental and personal use. Expenses allocated to personal use are generally not deductible. In addition, rental expenses in excess of your rental income can’t be used to offset income from other sources. The special deduction for active participation does not apply in this case.
In light of the rules for using a vacation rental property as a home, owners should keep careful records of their personal use throughout the year. Avoiding the home designation will ultimately result in increased rental deductions and therefore the greatest tax benefits.
It’s a new year and that means it is tax time in America!
In this, the second part in a series of articles related to the taxation of rental property, we will delve deeper into the rules and strategies that will maximize the tax benefits and avoid the pitfalls of the Internal Revenue Code. In the first installment, we discussed owners’ personal use of rental property; that property owners should avoid the home designation and the limiting rules of Internal Revenue Code section 280A. Let’s now continue with this discussion under the assumption that the rental property does not qualify as a home of the taxpayer.
For many clients, rental real estate is a viable investment choice because of its potential for capital appreciation, regular and predictable cash flows, and its inherent qualities as a tax shelter. In many cases the rental activity will generate positive cash flow while at the same time creating a non-cash loss for tax purposes mainly through depreciation deductions. However, the timing of the losses and to what extent the losses are allowed to reduce other non-passive sources of income are determined by the passive activity rules contained in Internal Revenue Code section 469.
Most of the time a rental activity is considered a passive activity. Losses from passive activities can only be deducted against passive income. There are many exceptions to the previous two statements and this is precisely where tax planning can pay huge dividends.
The first step in applying the passive activity rules is to determine if the rental activity meets any of the 6 exceptions to the definition of a rental activity. That’s right, a rental activity many not even be a rental activity for purposes of the passive activity rules. One exception is when the average period of customer use of the property is seven days or less. Another exception is when the average period of customer use is 30 days or less and is accompanied by significant personal services such as cleaning. If one of these exceptions apply, then the only hurdle remaining in deducting losses without any limitation is meeting the material participation standard with respect to the activity. Without material participation, losses are considered passive with no special allowance and may only be deducted against passive income.
Material participation is a measure of the taxpayer’s involvement in the activity. It’s determined on an annual basis and satisfying any one of the seven tests will result in the activity being treated as non-passive and thus deductible against all sources of income without limitation. Spouses may combine their participation for this purpose even when filing separate returns. For example, a taxpayer is considered to materially participate in an activity if they work more than 500 hours during the year. Another test is when the taxpayer’s participation constitutes substantially of the participation by all individuals including non-owners. Taxpayers can elect to group multiple activities together and thus aggregate their participation for purposes of the tests. There are more tests, however, in the case where an outside property manager is involved, meeting the material participation standard is highly unlikely.
If you’ve stuck with me so far, then you might be a person that gets excited about really dull things. The lesson for taxpayers is that under the right set of circumstances, and with careful records documenting participation, rental losses can flow freely through the tax return and without limitation. This is akin to the classic tax shelter, and it’s good to know that it still exists