Personal Use of Rental Properties
11 May 2012 / Uncategorized / Comments Off on Personal Use of Rental Properties
Personal Use of Rental Properties
When the IRS issued the latest version of Form 8825, Rental Real Estate Income and Expenses, it added three new columns to the revised form, one to enter a code for the type of property being rented and two columns of significance: fair rental days and personal use days. Now that reporting the number of days each rental property is rented at fair rental value and the number days the property is used for personal purposes is required on Form 8825, properly apportioning the expenses between personal and rental use presents several challenges.
Determining Personal Use Days
Once the total income and expenses have been calculated for a property, the next consideration is how to determine the number of personal use days. This can be challenging when there are multiple unrelated partners. Even in a close family relationship, obtaining data and tracking usage of “vacation” property can be hard to obtain. Basically, a “day” is counted when overnight accommodations are provided.
“Personal use days” as defined in Sec. 280A(d)(2) include:
- Use by “the taxpayer or any other person who has an interest in the property, or by any member of the family (as defined by section 267(c)(4)) of the taxpayer or such other person.” The attribution rules referred to in Sec. 267(c)(4) include siblings, spouse, ancestors, and lineal descendants. Even if the property is rented to a relative at fair rent, if the owner retains free access to the unit, those days will be considered personal use days.
- Use under house-swapping arrangements, whether or not fair rental is charged.
- Use by any individual who does not pay fair market rent.
Since personal use days do not include days when repairs and maintenance are performed on a substantially full-time basis by the owner, even if other individuals are present who are not repairing or maintaining the property, it will be important to determine if any days of occupancy were maintenance days rather than personal use days.
Allocation of Expenses to Personal Use Days
The second challenge is calculating the amount of deductible rental expenses. Under Sec. 280A(e)(1), the number of personal use and fair rental days is used to determine the tax treatment of expenses incurred and the amount of depreciation allowed as a deduction. Sec. 280A(e)(2) carves out an exception for “deductions which would be allowable under this chapter for the taxable year whether or not such unit (or portion thereof) was rented.” Despite the seemingly clear language of Sec. 280A(e)(2), the IRS interprets Sec. 280A(e) to mean that all deductible expenses related to a property are allocated between fair rental and personal use days based on the ratio of fair rental days to the total number of days used, not just to those expenses that are deductible only in relation to the rental of the property.
The deductibility of real estate taxes and mortgage interest (which are generally deductible by individual taxpayers whether or not the property is rented out as a vacation property) was challenged, the Ninth and Tenth Circuit courts have disagreed with the IRS’s calculation of the ratio using the total number of days used and supported using 365/366 days in the denominator of the ratio. Obviously, the personal use percentage is decreased when a full year is used as the denominator. Taxpayers' should consult with their CPAs regarding which position to follow when deducting items such as real estate taxes and mortgage interest.
Limitation on Deductions If Unit Is Considered a Personal Residence
If a taxpayer uses a property for personal purposes for the greater of 14 days or 10% of the days during the tax year it is rented at a fair rental, the property is treated as a personal residence. If a property that qualifies as a personal residence is rented for more than 15 days, the deduction of expenses related to the property is limited to the amount of rental income received during the tax year, and there is an ordering of the allowable deductions. Excess rental losses are carried over to the next tax year. The personal use portion of mortgage interest and property taxes can be deducted as itemized deductions on Schedule A.
If the property qualifies as a residence and is rented for less than 15 days during the year, the rental income is not taxable. Nor are any expenses deductible, other than property taxes and mortgage interest.
Limitations on Deductions If Unit Is Rental Property
If the personal use days do not exceed the limits described above and the property is rented for more than 15 days, the unit is considered a rental property. In general, the rental of real property is considered a passive activity, and, as such, gains or losses from the activity can only be offset against gains or losses from other passive activities. However, if a taxpayer actively participates in a rental activity, losses of up to $25,000 from the activity may be used to offset nonpassive income.
An individual meets the active participation rules by:
- Owning at least a 10% interest in the activity; and
- Having significant participation in the activity, such as making management decisions regarding tenants or policies, and arranging for repairs or capital improvements.
Both conditions must be met for active participation. Hence, a determination of participation by each partner or shareholder owning more than 10% is required. The $25,000 offset is phased out by 50% of the amount by which the taxpayer’s adjusted gross income for the tax year exceeds $100,000.
Rental activities where the average rental period of the property is seven days or less are not considered a rental activity under the passive loss rules and thus do not qualify for the active participation exception. Many vacation-type of properties have average use periods of seven days or less, so the period of use must be determined.
If the taxpayer is a real estate professional who meets the tests of material participation in partnership activities, any losses from the partnership’s rental property will be nonpassive to that partner.11 A taxpayer is a real estate professional for a tax year if:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.