RENTAL ACTIVITY FOR PROFIT: WHAT SHOULD A REAL ESTATE INVESTOR KNOW?
Taxpayer Use of a Rental Property
These circumstances typically occur when a taxpayer owns a vacation home, or when a taxpayer has two homes in different geographical regions. The most important rule for a taxpayer in these types of situations is to split expenses between rental use of a property and personal use of the property.
In order to correctly figure a deduction for the rental expenses on a property that is also used for the landlord’s personal purposes, it must be determined whether or not the dwelling unit is considered a home, because the amount of rental expenses that will be deductible may be limited in cases where the dwelling unit is considered a home. Whether or not a dwelling unit is also considered a home for tax purposes generally depends upon how many days during a given tax year are considered days of personal use for the homeowner.
In most situations, a taxpayer’s rental expenses will not exceed his or her total expenses multiplied by a specific fraction. The numerator of the fraction is total number of days in the year that the property was rented to tenants at a fair market price, the denominator of the fraction is the total number of days that the dwelling unit was used by the taxpayer
Dividing Expenses
A taxpayer who uses the same dwelling unit for both rental and personal purposes must divide expenses between rental use and personal use, based upon the number of days in the year used for each purpose.
In order to correctly figured the day of personal use versus days of rental use, a taxpayer must determine the fair rental price of the dwelling unit. The fair rental price of a dwelling unit will generally be considered the amount of rent that a tenant who is a stranger to the landlord would be willing to pay for use of the unit. If the rental price for a dwelling unit is substantially less than rents charged for similar properties in the same geographic area, the price will not be considered a fair rental price. When comparing his/her property to similar properties in the area in order to determine a fair rental price, a taxpayer is advised to ask five specific comparative questions: Are both properties used for the same purpose? Are both properties of approximately the same size? Are both properties in approximately the same condition? Are both properties located in a similar location? For tax purposes, if the answer to any of the five questions is ‘no’, then the properties are probably not similar enough to compare for the purposes of determining a fair rental price. Even between two very similar properties, one difference may be significant enough to make the rental prices incomparable. Any day that the dwelling was rented, at less than a fair market price, will not be considered a day of rental use.
To separate rental expenses related to a property from personal expenses, a taxpayer must gather several pieces of information. The total number of days during the year that the property was used for rental purposes; the number of days the dwelling was available for rent but not rented; and the total number of days the dwelling was used for personal purposes. Next, the taxpayer adds the days that the dwelling was rented to the number of days that the dwelling was used for personal purposes, in order to determine the total number of days that the dwelling was in use during the year.
Once a taxpayer has determined the total number of days that his/her dwelling was used, the percentage of expenses that were for rental purpose can be calculated. To find the percentage, the taxpayer must divide the number of days that the dwelling was used for rental purposes by the number of days that the dwelling was in use.
Dwelling Unit Used as a Home
When a taxpayer uses a dwelling unit for both rental and personal purposes, the tax treatment of rental expenses and income will depend upon whether the landlord is considered to be using the dwelling unit as a home. For tax purposes, a dwelling unit will be considered to bused as a home during the tax year if the owner uses the property for personal purposes more than the greater of two amounts of time: Either fourteen days out of the tax year, or 10% of the total days the property was rented to others at a fair rental price. Any day upon which the dwelling unit was rented at a fair rental price and used for personal purposes is counted as a day of personal use, but not a day of rental use.
A day of personal use is not limited to use of a dwelling unit by the property owner. For tax purposes, a dwelling will be considered to be used for personal purposes if; it is used by the property owner for personal purposes, it is used by another person who has some ownership interest in the dwelling unit , it is used by a member of the property owner’s family or the family of another person who has ownership interest in the home, except when the family member is paying a fair rental price for use of the home, it is used by someone under an arrangement that allows the property owner to make use of some other dwelling unit; or the dwelling unit is used by any person at less than a fair rental price.
When determining whether a dwelling unit was used as a home, a taxpayer must also consider the number of days that the dwelling was used as a main home before (or after) the dwelling was rented. A Taxpayer will not have to count days that he/she used a dwelling unit as a main home before (or after) renting it (or offering it for rent) if either of two conditions are met: Either the property owner rented or attempted to rent the property for twelve or more consecutive months; or the property owner rented or attempted to rent the property for a period of less than twelve consecutive months, but the period of rental or attempted rental ended due to the owner selling or exchanging the property.
In cases where a property owner uses a dwelling unit as a home and rents the unit for less than fifteen days during a tax year, the rental period is not treated as rental activity. For tax purposes, such activity is considered ‘minimal rental use’ which does not require that taxpayer to calculated days of rental activity. In such situations, the property owner is not required to report the income from minimal rental use, and may not deduct expenses in the way that owners with rental activities might.
For tax purposes, it is not considered a passive activity when a property owner rents a dwelling unit that is considered a home. Excess expenses in this case that cannot be used to offset other income are carried forward to the next year, and treated as rental expenses for the same property. Carryover expenses are subject to limits that apply to the year to which they are carried forward.