See these topics for information on Schedule E. If you need help filling in Schedule E, we suggest you go through the Interview topic, Rentals and Royalties in the Income section.
Many taxpayers get into the landlord business by deciding to hold on to their house when they move to a new home. That may sound like an easy way to do it; after all, you know the property and the neighborhood and probably have a good idea of what would be a reasonable rent. If you can afford it, why not turn the old homestead into a rental property? That way you could enjoy the rental income and tax benefits, not to mention the continued appreciation on the place.
Uncle Sam has a few special twists for homeowners-turned-landlords. For one thing, the conversion of a principal residence to a rental belies the notion that the new rules that make most home sale profits tax free mean you no longer need to keep records to track the tax basis of your home. If you convert it to a rental, you must know its basis to figure your depreciation deductions and the ultimate taxable profit when you sell the rental.
If you convert your home to a rental, you do qualify to write off all the basic rental expenses, and if those expenses exceed your rental income, you may qualify to deduct up to $25,000 of losses if you actively participate in the rental of the property and your adjusted gross income is under $150,000. But you fall under a unique rule when it comes to figuring depreciation and calculating the gain or loss when you sell the property.
Although your home probably appreciated—perhaps quite significantly—while you lived in it, you don't get to use the higher value for depreciation purposes. Your tax basis in such a converted residence is the lower of the house's value when you convert it to rental property or your adjusted basis. That means you're usually stuck with adjusted basis, which is generally what you originally paid for the place, plus the cost of improvements. If you rolled over the profit from a previous home, your basis is reduced by the amount of the profit on which you deferred the tax. The higher you can show the basis to be, the better for your tax picture.
This rule can make a big difference in your depreciation write-offs. Say you bought your home several years ago for $100,000, $85,000 of which was the value of the building. Although you've made no improvements, it's now worth $300,000, $250,000 of which is the value of the building. If you convert it to rental use, your depreciation is based on the $85,000 basis.
Back in the days when the congressional penchant was to liberalize deprecation rules—that is, change the law to permit quicker write-offs—there was another rule to hold down depreciation on residences transformed to rentals. Basically, you had to use the depreciation rules in effect when you bought the property, not the possibly more liberal method in force when you converted.
Now that Congress has slowed down depreciation schedules, there's a new rule. If the depreciation method in effect when you bought the property would deliver bigger annual deductions—as it certainly would if you bought the house while ACRS was in effect from 1981 through 1986—you can't use it. Instead, you're stuck with the new law's 27.5-year depreciation period. Heads you lose, tails the IRS wins.
Special vacation-home tax rules apply to a property you rent part-time and use personally. Also note this: Converting a home to a rental property means forfeiting the right to claim up to $500,000 of profit tax-free on a joint return or $250,000 on an individual return. That tax break applies only when the home sold is your principal residence. Of course, you could always reconvert the place to a principal residence and, if you live in it for two years before selling, you'd reclaim your right to tax-free profit.
When you use a vacation home strictly for personal purposes, the tax situation is pretty straightforward: Mortgage interest on a second home is fully deductible, unless the combined debt on your first and second homes (and any home equity loans on either of them) exceeds $1.1 million. Your property taxes are also fully deductible as an itemized deduction on Schedule A. It's when you start renting the vacation home—as many owners do to help pay the freight—that things get tricky.
In an uncharacteristic display of generosity, the IRS does not care about any rental income you receive if you rent the place for 14 or fewer days during the year. That nugget in the tax law has prompted some homeowners who find themselves in a temporarily hot rental market—in New Orleans during Mardi Gras, say, or near the U.S. Open—to rent their homes briefly when they can command especially high rents. The rule offers the opportunity for tax-free income from a principal residence as well as a second home. Congress often threatens to put an end to this source of tax-free cash but, so far, has resisted the impulse.
There is no limit on how much you can charge for the use of your home. As long as your temporary tenants stay no more than two weeks during the year, the rent you receive is tax-free. Rent for more than 14 days and you become a landlord in the eyes of the IRS. You have to report rental income and you qualify to deduct rental expenses.
If your personal use accounts for more than 14 days during the year or more than 10% of the number of days the place is rented (26 or more personal days compared to 250 rental days, for example), the house is considered a personal residence. Hold personal use below the 14-day/10% threshold, however, and the house is considered a rental property.
Because the tax consequences turn on the amount of personal use, it's important to know that the IRS takes a broad view of what counts. It includes:
Note that time you spend at the place doing repairs or general maintenance does not count as personal use. As long as that is the primary purpose of staying at the vacation home, the day is not counted as personal use. You must keep detailed records showing the dates of personal use, rental use and repair and maintenance days.
The breakdown between personal and rental days is crucial because it controls whether or not the property can produce tax losses. Such losses—available only if personal use is limited so the property qualifies as a rental rather than a residence—can often be used to trim your tax bill by sheltering other income, such as your salary.
These days, however, even limiting personal use no longer automatically opens the door to big tax losses. The law now limits the deduction of losses from "passive" activities, a category that includes all losses on rental property. There is an important exception, though, that protects many vacation homeowners. If your adjusted gross income is less than $100,000, you can deduct up to $25,000 of rental losses each year. The $25,000 allowance is gradually phased out as AGI rises to $150,000. To sidestep the passive-loss rules, you must "actively" manage the property, a requirement you can probably meet as long as you're involved in such decisions as approving tenants, rental terms and repairs. You also need to be certain that the average rental of the place is longer than seven days, which should also be relatively simple.
Expenses you can't deduct because of the passive-loss rules aren't lost forever. Unused losses are held over to future years when they can be used to offset income from the vacation home or other passive investments. Also, any passive losses unused when you sell the property can be deducted against the profit on the sale or any other income.
Even if the $25,000 exception will protect your rental write-offs, there's another potential trap. Limiting personal use of your vacation home may mean giving up the right to some mortgage interest deductions.
Remember that the law permits mortgage-interest deductions for loans secured by your first and second residence. If your vacation place is a business property, however, the mortgage isn't covered. Part of the interest would still be deductible—the portion attributable to the business use of the property—but the remainder falls in the category of personal interest and therefore is nondeductible.
That rule has led some tax advisers to recommend that taxpayers intentionally flunk the 14-day/10% test by increasing personal use of vacation property. That way, you preserve the full interest write-off. Part of the interest would be deducted as a rental expense and the rest as mortgage interest. What you give up, of course, is the opportunity to claim a tax loss.
If you are in a situation to choose whether to pass or flunk the 14-day/10% test, you'll have to do a lot of number crunching to figure out which one will produce the best overall result.
To figure your vacation-home deductions you have to allocate expenses between personal and rental use. There are two ways to do this—the IRS method and another approach that has been approved in court cases—and the one that's best for you depends on your circumstances.
According to the IRS, you begin by adding up the total number of days the house was used for personal and business purposes. Your deductible rental expenses are the same proportion of the total as the number of rental days is to the total number of days the place was used.
For example, assume you have a cabin in the mountains that you use for 30 days during the year and rent out for 100 days. The 100 days of rental use equals 77% of the total 130 days the cabin was used during the year. Using the IRS formula, 77% of your expenses—including interest, taxes, insurance, utilities, repairs and depreciation—would be rental expenses.
The IRS is also particular about the order in which you deduct those expenses against your rental income. You deduct interest and taxes first, then expenses other than depreciation, and then depreciation. The sequence is important, and detrimental, because of the rule that limits rental deductions to the amount of rental income when personal use exceeds 14 days or 10% of total use.
Remember that property taxes not assigned to rental use could be claimed as a regular itemized deduction instead. But by requiring you to deduct those expenses against rental income—that might otherwise be offset by depreciation you won't get to claim—the law can reduce your total write-offs.
By using a different allocation formula, though, you can limit the interest and tax expenses used to offset rental income and thereby boost the write-off of other rental costs. Courts have allowed taxpayers to allocate taxes and interest over the entire year rather than over just the number of days a property is used.
In the example above of 100 days of rental use, that method would allocate just 27% (100 divided by 365) of the taxes and interest to rental income. That would leave more rental income against which other expenses can be deducted. The extra taxes and interest can be deducted as a regular itemized deduction.
Although the court-approved formula can pay off when the 14-day/10% test makes the property a personal residence, the IRS version can be more appealing if the place qualifies as a business property. You need to look at the specifics of your situation to determine the best method for you. And, realize that if you go with the court-okayed method, you might have to go to court if the IRS audits our return and challenges you.
The sweet, new rules that grant tax-free status to most home-sale profit only apply to your principal residence. But there's a way to stretch the tax shelter around a vacation home. Simply move into the place after you sell your main home and live in it for at least two years before you sell. After two years, the house becomes your home in the eyes of the IRS and you get a second bite at the tax-free apple. Any profit attributable to depreciation taken after May 6, 1997, however, would be taxed at 25%. And note this, if the vacation home is one you acquired in a like-kind exchange, you have to wait at least five years after converting it to a personal residence before selling in order to claim the tax-free profit. That rule applies to sales after October 22, 2004.
When it comes to adding up the deductible expenses tied to renting a vacation home, be sure to count the cost of newspaper ads advertising the availability of the property as a deductible rental expense.
The cost of travel to look after your properties counts as a deductible expense, too. This can include the cost of driving across town to repair a leaky faucet or the expenses—including travel, lodging and 50% of the cost of your meals—of visiting out-of-town rental property. (Mileage rate for 2006 is 44.5 cents per mile.)
The key to including such costs is that the principal purpose of the trip be to inspect or work on your property. Taking a two-week vacation to Florida and spending an afternoon checking on a rental condo won't qualify. A week-long visit, five days of which are spent on painting and repairs to prepare the place for a new tenant, would qualify.
For more information on Automobile Expenses, see Car and truck expenses in Help for Schedule C.
You can still deduct the costs of producing rental income. Uncle Sam demands a share only of your net income, so it's clearly in your best interest to tote up all the tax-saving expenses that can trim that figure. Be sure to count the following:
Here's a tip: Put your children on the payroll, working in the evenings and on weekends during the school year and during the summer. What you pay them is a business deduction for you and earned income for them. That shifts income out of your tax bracket and into the child's. Because it is earned income, the kiddie tax doesn't come into play.
For more information on Hiring the Family, see Hiring the Family in Tax Tips and Advice.
Other deductible expenses include:
This form is filled out automatically, from the rentals and royalties worksheet which, in turn, is filled out automatically if you go through the Interview for Schedule E. We suggest you go through the Interview topic, Rental/Royalty Property.
For information on this tax subject, see Rents and Royalties.
This form, for income or loss from a partnership or S-corporation, is filled out automatically from the K-1 worksheet which, in turn, is filled out automatically if you go through the interview for Schedule K-1 Partnerships and S-Corporations. We suggest you go through the interview topic, Partnerships and S-Corporations (K1)
For information on this tax subject, see Partnerships and S-Corporations.
This worksheet shows the beneficiary's share of income and deductions from an estate or trust. It is filled out automatically from the K-1 worksheet for estates and trusts.
For information on this tax subject, see Estates and Trusts.