Managing Second Homes and Taxes
The signs are we’re in or nearing a good time to look at a vacation home or second home, I wrote in our September 2012 visit. That turned out to be true. Prices have recovered in many popular vacation and second home areas, and forecasts are for reasonably steady demand as long as interest rates are low.
The tax rules, and how well you plan with them, can determine how affordable that second home is. Many people seek second homes or vacation homes because they want to visit an area regularly, but they don’t look into the tax rules before buying. Others decide they’d like to maximize the tax benefits, especially if they plan to rent the home full- or part-time. Still others want to move to that second home and rent their previous primary residence. Rents are rising in most areas as homeownership falls and people have a harder time qualifying for mortgages, so being a landlord can be profitable.
In this visit we take a close look at the tax rules and write offs for renting a property, especially when you also plan to make some personal use of it.
The first step is to get a valuation of the property and have the land and improvements separately valued. This is especially important when converting to rental use a property you’ve owned for a while and only used as a first or second residence. Ideally you pay for a professional appraisal. An alternative is to have real estate brokers develop valuations and hope that they’re in the same range and can be averaged.
After the appraisal, you look at the tax rules.
We start with the rules for property that will be rented full time. You won’t make any person-al use of the property.
In this case, you report the rental property as a separate business on Schedule E that is attached to your Form 1040. All the income and expenses related to the property are reported on there.
Deductible expenses on Schedule E include mortgage interest, property taxes, homeowners’ association fees, insurance, any property management fees, maintenance, and repairs. You also can deduct the cost of traveling to the property to examine or work on it when those costs are reasonable in relation to the value of the property and rental income.
You don’t deduct capital improvements that increase the value of the property or extend its useful life. These are added to the depreciation basis. This is an important point, and there are many court cases discussing whether an expenditure on a property qualifies as an expense or as a capital improvement. If you have any doubt about the classification of an expenditure, consult with a tax advisor or review the IRS publications cited at the end of this article.
Depreciation is a major deduction for rental properties. The tax code allows a residential rental building to be depreciated on a straight-line basis (equal annual deductions) over 27.5 years. Land is not depreciated; only the value of the building is depreciated. That’s why it is important to have that valuation done.
When a property is newly purchased for rental, the depreciation basis is the cost. When a property that was held for personal use is converted to a rental property, the depreciation basis is the lower of the current market value or the original cost plus the cost of any improvements.
When your rental property generates net taxable income, it’s taxed as ordinary income. When there’s a tax loss, you might be able to deduct that loss against other income. It’s likely that even in today’s hot rental market, you’ll have a tax loss each year after deducting depreciation and the other expenses.
Rental real estate losses are “passive losses” in the tax code. When your adjusted gross income is $100,000 or less (the limit is the same whether your are single or a married couple filing jointly), you can deduct up to $25,000 of rental real estate losses each year against other income. The $25,000 allowance is phased out as AGI rises until it is eliminated at AGIs of $150,000 and above.
When the loss isn’t deductible because of one of those limits, the passive loss can be deducted against any passive income you have. Passive income in this context doesn’t include income from portfolio investments, such as stocks, bonds, and mutual funds. Passive activities tend to be businesses and partnerships in real estate, oil and gas, and the like. They are considered passive activities because you aren’t helping to run them full time.
Any losses you can’t use in the current year are suspended and carried forward to the future. They can be deducted against any future passive income you earn. Suspended passive losses can be deducted from any income when you dispose of the property.
There’s an exception to the suspension of losses for real estate professionals. Professionals can deduct the real estate rental losses against other income each year in an unlimited amount. There are several ways to qualify as a real estate professional. The one people are most likely to qualify for is to spend at least 50% of your time working in one or more real estate businesses and spend at least 750 hours a year in the real estate businesses. The rules are detailed and complicated and require you to account for your hours. If you want to qualify as a real estate pro, be sure to work with a good tax advisor.
Eventually you’ll sell the property. If it was a rental property and you sell at a loss, you can deduct that as a capital loss. But if it was a personal use property that you converted to a rental property, only declines in value after the conversion are deductible capital losses. Declines in value before that are personal and not deductible.
When you sell at a gain, it’s possible you’ll be able to exclude the gain from income. You can exclude the gain when you owned the home for at least two of the five consecutive years before the sale and it was used as your principal residence for at least two years in the last five consecutive years before the sale. Then, you can exclude up to $500,000 of gains if you’re a married couple filing jointly and $250,000 for single taxpayers. The ownership and residence periods don’t need to be the same years.
For example, if you lived in the home as your principal residence for at least the last two years, you can rent it to others for the next three years, sell it, and exclude gain. Or you can rent it for a while. Then re-establish it as your principal residence for at least two years, and then sell it and exclude the gain.
Whether you can exclude the gain or not, you’ll owe taxes on the amount you deducted as depreciation. It doesn’t qualify for the exclusion and might not qualify for long-term capital gains. This is known as recapturing depreciation and is complicated.
There are non-tax aspects to being a landlord to consider. The home is likely to have times when it’s empty between tenants and you don’t earn any rent. You have to find good tenants who’ll take care of the property and pay the rent promptly. You also have to manage the property, which means taking care of repairs and upkeep, and that periodically means late night or weekend phone calls regarding some kind of quickly-needed repair. When you can’t or don’t want to handle these yourself, you need to hire a property manager or contractor who will charge a fee for the service.
When you rent a property some of the time and make personal use of it other times, the tax treatment is different. The exact treatment depends on how much personal use you make of the property.
When you plan to both rent a property and make personal use, it is important to keep a calendar or log of how the property was used each day of the year. Rental days are days when the property was rented to others for fair market rent. Days when you spend the majority of the day repairing or maintaining the property also are rental days. Personal use days are when you, friends, or relatives use the property without paying full fair market rent.
There’s a special rule when a property is rented no more than 14 days during the year. In that case, you exclude the rental income from gross income and don’t report any rental expenses.
When a property is rented more than 14 days and you make personal use of the property, the expenses might have to be divided between personal and rental use. The division is required if your personal use exceeds the greater of 14 days and 10% of the days it is rented to others at fair market rent. When your personal use is less than the threshold, you can treat the property solely as a rental property as discussed earlier.
When a property is both rental and personal, then the expenses of the home are divided between personal and rental use. The ratio to use to determine the rental portion of expenses is the number of days rented to the number of days the property was used for any purpose. Notice that the denominator is not the total days in the year. Excluded are days when the property neither is rented nor used for personal purposes.
All the rental income is included in gross income and reported on Schedule E. The rental portion of expenses is reported on Schedule E using the formula to determine the rental portion.
On your schedule A for itemized deductions you still deduct the personal use portion of mortgage interest, real estate taxes, and any casualty losses. The personal use portion of other expenses, such as repairs, insurance, utilities, and depreciation, isn’t deductible.
You can deduct the rental expenses up to the rental income for the year. When the rental expenses exceed the income, the excess amount of the expenses can be carried forward to future years.
When you own a business through a separate entity (not as a proprietor) you might consider having the business own the property. That way the property is on the business’s tax returns and you don’t have to bother with Schedule E or dividing the expenses. If you have the business own the property, remember that any personal use of the home is included in your gross income at the fair rental value. The business should report this on your W-2 or a 1099. Personal use includes any time the property is used by you, friends or relatives and they don’t pay fair market rent to the business.
When you have questions about the details of these issues, go first to the free publications on the IRS web site at www.irs.gov or that can be obtained by calling 800-TAX-FORM. You can find the basics in Publication 17, Your Federal Income Tax. Publication 527 covers Residential Rental Property and has useful examples and worksheets to determine the limits on deductions and how to count personal use days. Publication 925 details Passive Activity and At-Risk Rules while Publication 946 explains How to Depreciate Property. Also read the instructions for Schedule E and Forms 4562 and 8582.
RW June 2015.
