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Vacation Home Rental Deductions: Example
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En provenance du cours de University of Illinois at Urbana-Champaign
Federal Taxation I: Individuals, Employees, and Sole Proprietors
115 notes
University of Illinois at Urbana-Champaign
115 notes
Cours 1 sur 5 dans Specialization U.S. Federal Taxation
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MODULE 5: DEDUCTIONS AND LOSSES: IN GENERAL
In this module, you will learn about deductions, which is the term used in tax to describe an expense that is allowed to reduce a taxpayer’s tax liability. You will discover what adjusted gross income is, why it is important, and how to calculate it. You will also learn the difference in tax treatments for special types of acitivites, such as hobbies and rentals.
Rencontrer les enseignants
Matthew HutchensLecturer of Accountancy
Department of Accountancy
Petro Lisowsky, PhD, CPAAssociate Professor of Accountancy
College of Business: Department of Accountancy
Welcome back as we continue discussing deductions.
In this video, we'll examine how to handle deductions related to vacation home rentals.
In general, recall the deductions are not allowed for personal expenditures.
In particular, personal expenses related to the home
are also not deductible, such as buying furniture,
paying for maintenance or insurance on your house.
That is, if you use a property for personal purposes,
the only personal types of expenses that are deductible are limited to what's
available on Schedule A related to
deducting home mortgage interest and real estate taxes.
Recall also that if you own a property and rented it out,
we will report the income and expenses on Schedule E. In this case,
the expenses related to maintaining the property would be deductible.
However, what if you run into the situation where it's a little bit of both?
What if, for example, you own a vacation home on the beach?
Perhaps you use it for two months during the summer,
but also rent it out for two months.
There are, of course, cost associated with maintaining the beach home.
You might pay for it to be professionally cleaned.
You might pay for lawn maintenance, insurance, and utilities.
How much of these costs are deductible for
tax purposes and how much of the costs are not deductible?
Well, generally speaking, there are
three possible tax treatments for expenses related to properties.
First, is if the property is primarily personal use.
A property is primarily personal use if it's rented out 14 days or less during the year.
Here, any rental income earned from the property is
actually entirely excluded from gross income.
But that also means that no rental expenses are deductible.
Here, the only expenses that are deductible are
the typical Schedule A expenses of home mortgage interest and property taxes.
For example, let's say,
the Olympics comes to your town and you rent
out your house for 10 days during the Olympics and charge $10,000.
The $10,000 rental income is entirely excluded from your gross income,
but if you incurred any expenses in renting out your home,
such as advertising expenses or you paid a lawyer to drop a rental contract,
those expenses are not deductible.
The only deductible expenses relate to your regular deductible expenses if you itemize.
So on the one side we had primarily personal property.
At the other extreme we have primarily rental property.
What does this mean if a property is primarily rental use?
Here it means that the property has been rented out for
more than 14 days during the year and it's not used for
personal purposes more than the greater of 14 days or 10% of the total days rented.
What happens here is the owner can deduct all expenses
allocated to the rental use of the property even if there is a loss.
As an aside, there may be some limits here, known as passive loss limitations,
but that's beyond the scope of this course.
But generally, the expenses associated with maintaining
the property, including cleaning, maintenance, supplies,
utilities, and depreciation, are deductible against the rental income and may
even generate a net rental loss and be
deductible against the property owner's other income.
Now what if it's a little bit of both?
There's some personal use of the property,
there's also some rental use.
Here it's considered mixed personal and rental use property.
If the property is rented more than 14 days and personal use
days exceed the greater of 14 days or 10% of days rented,
then the property owner has to allocate the rental expenses against
rental income and only deduct rental expenses to the extent of rental income.
Specifically, all expenses must first be classified into three tiers.
The first tier relates the expenses that would otherwise be
deductible, regardless of whether the activity was rental related.
This relates to items, for example,
like home mortgage interest or property taxes that are deductible on Schedule A,
regardless of how much the person's property is being used for rental activity.
The second tier relates to expenses incurred for
the rental activity that does not affect basis.
That is, expenses that don't relate to depreciation of
the property or equipment in the property, like refrigerators,
washing machines, and the like.
These are kind of like non-capital-based operating expenses.
So any expenses incurred for property insurance, supplies, advertising,
maintenance, cleaning, or real estate broker fees would all fit into tier two expenses.
Finally, we have tier three expenses.
These are expenses that do affect basis. Namely, depreciation expense.
So to the extent you have property or equipment that's subject to depreciation,
these expenses would be considered last.
The tiers one, two , and three expenses related to
the rental activity are deductible for AGI.
The personal portion of tier 1 expenses that do
not pertain to the rental activity are still deductible,
but as from AGI deductions if the taxpayer itemizes.
Importantly, unlike hobbies, the tiers two and three expenses are
not potentially disallowed if they do not exceed 2% of the taxpayer's AGI.
Here, the rental-related expenses are deductible for AGI against rental income.
Note that you can only deduct expenses for AGI that
are related to the rental portion of the property's activity.
So the big question now is, how does the taxpayer
allocate the costs between rental and personal days?
Here, for tier one expenses only,
that is, think mortgage interest and property taxes,
two methods are allowed.
The first is the IRS's method, where
expenses are allocated on the basis of total days used.
So here, the taxpayer has to take the number of days
rented divided by the number of days used, for
either rental or personal use, to figure out
the percentage of tier one expenses that are deductible for AGI.
The second method was approved by the courts in Bolton vs. Commissioner in
1982 by the Ninth Circuit Court of Appeals,
after the case was heard and decided in the Tax Court.
This is referred to as the Bolton method.
Here, the tier one expenses are allocated over the number of days
in the year rather than in the number of days used.
So here, the taxpayer would take the number of days
rented divided by the number of days in the year,
or 365, to figure out the percentage of tier one expenses that are deductible for AGI.
For tiers two and three expenses,
the taxpayer can only allocate the cost using the IRS method.
Again, number of days rented divided by the number of days
the property is used for both rental and personal use.
In terms of process, the rationale follows just like for hobbies.
When a taxpayer goes through this calculation,
the taxpayer will start with gross income from the rental activity.
Then, the taxpayer will subtract tier one expenses.
If the net rental income amount remains positive,
then the taxpayer can go on and subtract tier two expenses.
If the net rental income amount remains
positive after having subtracted tier two expenses,
then the taxpayer can go on and subtract tier three expenses.
If at any point the expenses exceed the remaining income,
the most in expenses that can be used in
the current year is how much net rental income is left.
Therefore, rental expenses cannot create
net rental losses for mixed, personal, and rental use properties.
Any losses in excess of rental income are disallowed.
That is, they cannot be claimed against other income of the taxpayer.
Let's turn back and look at this Bolton method a little bit more closely.
What usually happens when a taxpayer chooses
the Bolton method over the IRS method is that the share of
tier one expenses deductible for AGI will be
smaller under the Bolton method than under the IRS method.
Yes, smaller deductions for AGI.
So a smaller deduction is allocated to rental income
from tier one expenses under the Bolton than IRS method.
So why would a taxpayer want do that?
To choose to minimize their for AGI deductions for tier one expenses.
Well, if a taxpayer knows that he or she will be itemizing expenses,
then, in effect, the taxpayer might be indifferent whether
the tier one expenses are allocated for or from AGI.
The deduction will reduce gross income one way or another.
Where this does matter is that if
the net rental income that is left over after having deducted
tier one expenses is now relatively higher, because
the Bolton method did not allocate very many expenses to tier one,
then there's more net rental income against which to
claim tiers two and three expenses against.
So here, tiers two and three expenses can only be allocated using the IRS method.
Recall if these expenses are greater than
the net rental income after having subtracted out tier one expenses,
then they're disallowed for the current year, although they aren't
carried forward indefinitely to offset future rental income.
So, in the end, what can happen is that under the Bolton method there will
be more deductions claimed in total in the current year.
That is, expenses in all three tiers plus the
larger personal from AGI deductions using the Bolton method
compared to the total deductions claimed using the IRS method for
all three tiers plus the lower personal from AGI deductions.
To recap, in this video,
we looked at how to differentiate rental activity between primarily personal,
primarily rental, and mixed personal and rental use,
and how rental expenses and losses are treated and allocated for tax purposes.
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