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.

Any questions?

TTFN

GUIDANCE FOR TAXPAYERS WITH RENTAL PROPERTY

I expect that by now there is a website, and probably a blog, about every aspect of every subject imaginable.

This includes TAXES. There are all kinds of websites on income tax topics – from the dreaded Alternative Minimum Tax (AMT) to Volunteer Income Tax Assistance (VITA). And there are all kinds of general and specialized tax-related blogs, like THE WANDERING TAX PRO.

While there are a multitude of web pages and web articles devoted to the subject of reporting rental income and expenses on IRS Schedule E, and a Google search results in tons of links on the subject, I could not find a website or blog specifically devoted to this subject.

So here I have decided to fill the void with a new blog titled THE INTERNET GUIDE TO IRS SCHEDULE E – which is now “up and running”.

This new blog will deal with all aspects of reporting income and expenses from rental real estate on Schedule E of the federal Form 1040.

It will discuss in detail how and when to report rental income and what expenses are deductible and how to deduct them.

It will cover all kinds of rental real estate – from two-family owner-occupied properties to vacation rentals to apartment buildings to commercial property.

It will also include a regular BUZZ-like feature to provide links to and comments on other online resources - websites, web pages, online articles, and blog posts – on the subject.

Your comments on and suggestions for this new blog are certainly welcome. You can comment on a particular post or email me at rdftaxpro@mail.com. When emailing be sure to put INTERNET GUIDE TO IRS SCHEDULE E in the “Subject Line”. The rules for submitting comments and questions to TWTP will also apply to my new blog.

So before you do anything else please check out THE INTERNET GUIDE TO IRS SCHEDULE E!

TTFN

THIS WAS A REAL NICE CONFERENCE

So I got to the Woodbridge Hilton (in Iselin, not Woodbridge), signed in, found a spot at a table in the back with two empty seats, went through the continental breakfast buffet, and was back at the table just as the New Jersey chapter of the National Association of Tax Professionals Annual Conference got underway.

A few minutes into the introductory remarks someone sat in the empty seat next to me (which, the way we were seated in semicircle around a round table, was actually behind me), but I took no particular notice of the person.

About an hour into the presentation on the dreaded Alternative Minimum Tax there was a tap on my shoulder. I turned around and the person seated next to me said in a low voice, “Robert Flach?”. He took off his glasses and I looked at him closely to see if I recognized him. After a few seconds we both said, at the same time, “Jackie”, as his identity hit me.

Jack was one of the college students that worked with my mentor, James P Gill, during the tax filing season way back at the beginnings of my career. I began with Jim in February of 1972 and he joined “the firm” a couple of years later. He stayed with us for several seasons, and had come back on occasion to visit and help out after settling in to full time employment elsewhere.

The last time I had seen Jack was about 20 years ago when I ran into him and his then young (and now college graduate) son at the Hudson Mall.

He had recognized my neat handwriting, and the fact that I used a ruler to write straight, as I was making notes on the presentation!

Who would have thought!

This year’s conference consisted of a full day of presentations by one speaker, Alice Orzechowski, a CPA, CMA (Certified Management Account – not Country Music Award winner) and EA, with a brief annual meeting (and election of Board Members; I was running and lost – I knew I should have voted for myself) in between topics. Over the course of the day Alice covered the dreaded Alternative Minimum Tax, discussing case studies and tax planning strategies, the Minimum Tax Credit, Form 1041, Settlement (Closing) Statements, and real estate transactions.

I few items of note that deserve mentioning –

* Throughout her presentations Alice referred to specific applications that tax preparation software will do automatically and those that it will not do, requiring the user to enter some special information or make special calculations, and discussed the various problems she had encountered in the past with tax software and specific calculations, instances where the software did not produce the correct answer and in one situation actually made a math error.

All the more reason why the “uninformed” should not rely on tax software as a substitute for knowledge of the Tax Code or a tax professional, and why tax pros using software should not automatically accept what a program spits out as being correct without careful checking and verification.

* Under Internal Revenue Code Section 1.266-1(b)(1) a taxpayer can elect to “capitalize” (add to cost basis) real estate taxes paid on a vacant lot instead of claiming a deduction on Schedule A. This election can be made on an annual basis, capitalizing the expense one year and deducting it in another. In order to make the election the taxpayer must attach a statement to this effect to the appropriate Form 1040.

Taxes of any kind, state income or sales, personal property, and real estate, are not deductible under the dreaded Alternative Minimum Tax. A taxpayer with a vacant lot on which he/she pays real estate tax should elect to capitalize the tax in a year in which he/she falls victim to the dreaded AMT.

If the tax were claimed as an itemized deduction it would provide absolutely no tax benefit, as it would not be deductible under AMT – the deduction would be totally lost. By capitalizing the payment the expense can be claimed and a tax benefit realized when the lot is eventually sold.

As with any option in such a situation you should calculate the regular and AMT federal income tax and the state (and local if applicable) income tax both ways, with and without the current deduction, and compare the net combined federal, state and local tax liabilities.

* Alice reminded us that taxpayers should take into consideration the AMT when determining who gets to claim a dependent child in negotiating a divorce settlement – as personal exemptions are not allowed under the dreaded AMT.

Often times divorced parents will alternate claiming a dependent, the custodial parent claiming the exemption one year, and the non-custodial claiming the exemption the next. If one parent is a victim of AMT one year but not the next this should be taken into consideration when deciding who will get the exemption for a particular year.

This just goes to point up that it is very important when negotiating a divorce agreement that you choose an attorney who is well versed in tax law as well as divorce law, or have a tax professional consult with you and your attorney as part of the ongoing process. Using a well-qualified and experienced divorce attorney who knows everything there is to know about divorce law but diddly-squat about tax law, and not also using the services of a tax professional, could end up being very expensive.

* Certain closing costs paid on the purchase of a rental property that are deemed to be “expenses in obtaining a mortgage” can be amortized over the life of the original mortgage. These expenses are generally listed under Section 800 on the Closing/Settlement Statement and can include lender’s title insurance reported on Line 1101 of the Statement.

Just like with points paid on the purchase of such a property, any “unamortized” closing costs can be deducted in full on Schedule E in the year that you refinance the mortgage with a new lender.

You have $1,500 in qualifying “expenses in obtaining a mortgage” on the purchase of a rental property that you have been deducting over the 30-year term of the mortgage at $50 per year. Four years down the road you refinance the mortgage. The original mortgage was with Wachovia and you refinance with Chase. You had previously deducted $150 in amortization on Schedule E. In the year you refinance you can deduct the remaining $1,350 on Schedule E, plus the applicable amortization of the costs of obtaining the refinanced mortgage.

As usual the NJ-NATP conference was well done. I especially look forward to the chapter’s annual New Jersey State Seminar in January.

TTFN

PS – To any tax professionals out there who are reading this, if you are not already a member of the National Association of Tax Professionals you should be! If you decide to join please mention my name as a “referral” and I will get a gift from NATP.

RENTAL OF A MIXED-USE VACATION HOME

I just emailed a client with the answer to a question about deducting expenses for a “mixed use” vacation property, and thought it would be a good idea to post my answer here, considering we are in the height of the summer rental season:

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“Here is the word -

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In general expenses for a "mixed-use" property - i.e. both personal use and rental - are allocated based on the number of days used for each activity.

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You take the number of days rented and divide this by the total number of rental and personal use days. For 2007 your property was rented for one week and had two weeks of personal use. So 1/3 of the operating expenses (7 days / 21 days) were deducted against the rental income.

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An alternative method is used for deducting real estate taxes and mortgage interest. Since real estate taxes and mortgage interest "accrues" continuously throughout the year these expenses are deducted based on actual rental use as a factor of the entire 365 day year. Since you rented the property for only one week in 2007 we deducted 1/52 (1 week divided by 52 weeks) of the real estate taxes and mortgage interest against the rental income. The remaining 51/52 of real estate taxes and mortgage interest was deducted on your Schedule A.

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Of course expenses directly related to the rental use - such as commissions paid to rental agencies, any "merchant" license or registration fees, advertising, cleaning and maintenance before, after or between rentals and additional special "renter's" insurance - are 100% deductible.

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When the personal use of a "mixed-use" vacation property exceeds the greater of 14 days or 10% of the days rented the property is considered to be primarily a "home" and deductible expenses are limited to rental income received. If you collect $1,000 in gross rent for the year your deductions are limited to $1,000. Unused expenses can be "carried over" to future years.

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Rental expenses for a property considered to be primarily a home are deducted in the following order -

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First you deduct the allocated real estate taxes, mortgage interest, and casualty loss and direct expenses.

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If the total of these deductions equals or exceeds the gross rental income then you must stop here. No other deductions are allowed.

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If the total of these deductions is less than the gross rental income you next deduct allocated "operating expenses", such as insurance and utilities - up to the remaining amount of gross rental income.

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If there is any gross rental income remaining after deducting these two types of expenses then, and only then, can you deduct depreciation.

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In other words - while allocated real estate taxes, mortgage interest, and casualty loss and direct expenses can create a rental loss, allocated operating expenses and depreciation cannot create or increase a rental loss.

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Days you spend at the property that are "substantially" used to clean, paint, or repair the property are not considered to be "personal days" for purposes of either the allocation percentages or determining if the property is primarily a home.

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Days used by or rented to family and friends are considered to be personal days, unless the rent paid is considered to be a "fair market" rent. This fair market rent can be less than the actual rent charged to "strangers", as the Tax Court has accepted that family and friends are expected to take "exceptionally good care" of the property and there are no commissions paid on the gross rent. A good number to use is 80% of what you would charge the "great unwashed masses".

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Got it?”

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TTFN

1040 FYI: REAL ESTATE PROFESSIONAL

This 1040 FYI was “inspired” by a GD extension I completed this past week-end.

Rental real estate activities are considered to be “passive” activities even if the owner “actively” participates in the activity. Generally losses from passive activities can only be applied against “passive income”. You cannot use a passive loss to offset W-2 income or interest and dividends. As accountants love acronyms, the rule is that you need a PIG (positive income generator) to offset a PAL (passive activity loss).

There is a special exception to the rule for rental real estate activities in which you “actively” participate – i.e. you own more than 10% of the property and are substantially involved in its management. Up to $25,000 in rental real estate losses can be used to offset other income, such as wages and interest and dividends.

This special $25,000 allowance is “phased-out” as your “modified” Adjusted Gross Income (AGI) goes from $100,000 to $150,000. To calculate “modified” AGI you start with “regular” AGI, subtract any taxable Social Security or Railroad Retirement benefits, and add back –

· net passive losses (including rental losses),
· excluded US Savings Bond interest used for higher education expenses,
· excluded employer adoption assistance payments,
· the deduction for contributions to IRAs and other qualified retirement plans,
· the deduction for ½ of self-employment tax,
· the deduction for student loan interest,
· the deduction for qualified tuition and fees, and
· the deduction for “Section 199” domestic production expenses.

Taxpayers who are considered to be a qualified “real estate professional” do not have to treat their rental real estate activities as passive activities and can deduct all rental losses in full.

Internal Revenue Code Section 469(c)(7)(B) defines a real estate professional as a taxpayer who (1) spends more than 750 hours and (2) performs more than one-half of his or her personal services during the tax year in real property trades or businesses in which he or she materially participates.

A real estate professional is generally considered to be a real estate agent or broker, a landlord, a professional property manager, a developer or in the construction business.

Under Internal Revenue Code Section 469(c)(7)(D)(ii) time worked as a real estate professional does not count unless taxpayer owns 5 percent or more of the activity. According to the IRS, “If, for example, the taxpayer works full-time for a construction company, but does not own any of the company, he is not a real estate professional”.

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It is important to properly document time spent in rental activities if you’re claiming to be a real estate professional. Taxpayers ideally should keep contemporaneous daily time reports, logs, or similar documents. If the taxpayer uses appointment books, calendars, or narrative summaries to identify services performed over a period of time that estimate time spent on real estate property trades or businesses the time estimated must be reasonable.

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This issue arose when a client whose return was extended (waiting for a Form K-1) informed me that for 2007 he was a general partner, one of three, in a partnership that owned and managed rental real estate. The partnership generated a substantial net loss. My client’s “modified” AGI was well over $150,000 for 2007, so none of the real estate loss was deductible on the 2007 return. The 2007 loss will be “suspended” until a year when his MAGI is less than $150,000 or until he terminates his interest in the partnership.

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My client told me that his partners’ accountant said that they qualified as real estate professionals and were therefore exempt from the $150,000 income threshold.

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One partner worked for a hedge fund that invested in commercial real estate. Another partner monitored the risks of an insurance company's investments in securities backed by residential and commercial mortgages. The third, my client, worked with mortgages for a bank.

If they did not each own more than 5% of the hedge fund, insurance company or bank, which they obviously did not, then the time they spent working in these positions does not count toward qualifying for real estate professional status. It is as if they were bus drivers. The only time that counts toward the one-half of all work is time spent working on real estate investments in which they have a material ownership. The time involved in running the real estate partnership would count - but because the partners are all employees each would have to spend over 2000 hours per year on this activity.

A Real Estate Professional is one who is self-employed in the real estate field managing properties that he/she has a substantial ownership interest in. If in 2008 the three partners do not have "day jobs" and spent their entire time (at least 750 hours each) actively managing the real estate properties held by the partnership then they could each be a real estate professional. Working as an employee in an industry that is somewhat tied to real estate investment and management does not cut it unless you have a 5% or more ownership in the firm for which you work.

TTFN

PS – Don’t forget to visit ASK THE TAX PRO. Today is Twofer Tuesday!