Wednesday, July 16, 2014
DEDUCTING RENTAL EXPENSES FOR A “MIXED USE” PROPERTY
As promised in last Friday’s BUZZ installment, I will share with you information on deducting expenses of a “mixed-use”, or dual purpose, vacation property.
What prompted this was an email from clients whose GD extension I had recently finished, which began, in effect, saying –
“We took a look at our return before tucking it in the mail and it appears that most of our 2013 expenses relating to our vacation home are not set forth on Schedule E of the return.”
When you rent a vacation home and your personal use of the property is more than 14 days, or more than 10% of the number of days it is rented at fair market value, whichever is greater, the property is treated as a "dwelling unit used as a home" for income tax purposes. In 2013 my clients used the property for “personal use” a total of 55 days, which is more than 14 days. The property was rented for a total of 35 days.
Expenses directly related to the rental of the home are 100% deductible on Schedule E. These are expenses that would not have been incurred if the property was not being rented. They can include advertising for tenants, commissions and fees paid to real estate and property management agencies, local business registration fees, cleaning the property and laundering of bed sheets and towels after the end of one rental period and before the beginning of another, and consumable supplies.
You can also deduct in full maintenance, repair and replacement costs resulting from damage done by the tenants, less the amount of any security deposit you have withheld to cover the damage.
"Indirect" expenses - expenses that apply to the house in general and apply to both the rental and personal use - are only partially deducted on Schedule E. Th3 amount you can deduct is based on the number of days rented at fair market value (35 in this case) divided by the total number of days the property is occupied (90 days in this case – the 35 days rented plus the 55 days of personal use).
Any day you spend working “substantially full time” on cleaning, painting, repairing, or maintaining the property is not counted as a “personal use”. But days that the property is rented to family and friends at less than the “fair-market” rent are considered “personal use” days. You normally rent the home for $1,000 per week during the summer, which is in line with what other similar properties in the area charge. But your brother and his family stay for a week and you only charge them $500. That week is considered to be personal use.
35 days divided by 90 days = 39%. So only 39% of 2013 payments for real estate taxes, mortgage interest on acquisition debt, insurance, utilities, general maintenance, garbage collection, security and alarm systems, cable television and telephone service (if available to tenants), etc is deductible on Schedule E. If the homeowners’ insurance premium for the year is $1,000 only $390 could be deducted on Schedule E. A deduction is also allowed for depreciation, based on the rental use percentage.
If the property owners itemize they could claim 61% of the real estate taxes and mortgage interest on Schedule A.
The rental of a “dwelling unit used as a home” cannot generate a deductible tax loss in excess of the amount of direct expenses plus the pro-rated share of indirect costs that would be fully deductible regardless of whether or not the property was rented, such as real estate tax, mortgage interest and casualty losses. This is similar to the tax deduction allowed for business use of your home.
As with the home office deduction, there is a three-tiered “hierarchy” of deductible expenses for rental expenses.
First to be applied against rental income are direct expenses and pro-rated indirect expenses for real estate taxes, mortgage interest on acquisition debt, and casualty losses.
If there is rental income left after claiming these deductions you next can deduct the pro-rated share of all other “operating” expenses – insurance, utilities, general maintenance and repairs, etc.
If rental income still remains you can deduct pro-rated depreciation, but only up to the extent of the remaining rental income.
Any unused expenses are “suspended” and can be carried forward to be deducted in subsequent years, subject each year to the net income limitation.
Let us say the total rental income for the year for your “mixed-use” property is $5,000. If the total of your “tier 1” expenses (direct expenses and pro-rated real estate taxes, mortgage interest on acquisition debt, and casualty and theft losses) are $5,200 you cannot deduct any other expenses and your Schedule E will show a net rental loss of $200.
If the total rent received was $10,000 you would deduct the $5,200 in “tier 1” expenses and could deduct a total of $4,800 in “tier 2” and “tier 3” expenses. Your Schedule E would show “0” for net rental income. If “tier 2” expenses totaled $5,000, you could deduct only $4,800 and would not be able to deduct any depreciation. If “tier 2” expenses were $4,000 you could deduct up to $800 in depreciation.