RENTAL ACTIVITY FOR PROFIT: WHAT SHOULD A REAL ESTATE INVESTOR KNOW?
Condominiums and Cooperatives
Although most condominiums are dwelling units inside a larger, multi-unit building, condos can take other forms such as townhouses or garden apartments. Although most condominiums share walls with other condominiums, each dwelling unit is separately owned. When a taxpayer owns a condominium, he or she also typically owns a share of one or more common elements of the larger property; such as the land, lobbies, service areas, pool and so forth. A condominium owner will typically pay regular dues or assessments to a special corporation that is organized specifically to take care of the commonly-owned elements of the property.
Property Converted to Rental Use
Unless a taxpayer converts a property from personal to rental use at the beginning of the tax year, expenses for the year must be divided between personal and rental costs. In other words, deductible rental expenses may only be claimed for the part of the year that the property was used for rental purposes. A property’s basis for depreciation as a rental property will be either the property’s fair market value on the day its use was changed from personal to rental, or the taxpayer’s adjusted basis in the property on the day its use was changed, whichever amount is less.
Renting Part of a Property
A taxpayer is only permitted to deduct expenses related to the part of the property used for rental purposes as rental expenses on his or her schedule E (Form 1040). Expenses that are for both rental and personal use of a home must be divided between rental use and personal use. Commonly-accepted methods of dividing expenses include dividing an expense by the number of people living in a home, the number of rooms in the home, or the square footage of the home. Any expense incurred solely for the part of the home being used in rental activities will not have to be divided, because no part of the expense was incurred for personal purposes.
Property Not Rented for Profit
In a situation where the property is not rented for profit, three main rules apply. First, a taxpayer who does not rent his or her property for profit may only deduct rental expenses up to the amount of his or her rental income. Second, a taxpayer who does not rent for profit is not permitted to deduct a loss related to the rental. Third, a taxpayer who does not rent for profit may not carry forward any rental expenses that exceed rental income to the next year. If a taxpayer’s rental income exceeds his or her rental expenses for at least three years out of any consecutive five-year period, the taxpayer will be presumed (for tax purposes) to be renting the property to make profit. The IRS refers to this as a “presumption of profit”. A taxpayer must report not-for-profit rental income using line 21 of IRS From 1040 or 1040 NR If a taxpayer files 1040 and also itemizes deductions, certain amounts (such as mortgage interest, real estate taxes, casualty losses, and qualified mortgage insurance premiums) may be entered into the appropriate lines of Schedule A (Form 1040). Other rental expenses may be claimed as miscellaneous itemized deductions on line 23 of Schedule A (Form 1040) or line 9 of Schedule A (Form 1040NR). However, a taxpayer may deduct these expenses only if the total more than 2% of his or her adjusted gross income.
Casualties and Thefts
As defined by IRS, a casualty is damage, destruction, or loss of property resulting from and identifiable event that is sudden, unexpected or unusual. To be sudden, and event must occur swiftly, not gradually or progressively. To be unusual, an event must be one that is not an everyday occurrence, and one that is not typically encountered during the activity in which a taxpayer is engaged. The IRS has defined ‘Theft’ as the unlawful taking and removing of money or property with the intent to deprive some other person of the money or property.
Some taxpayers may realize a gain after a casualty or theft event. Gain occurs when a taxpayer receives money (such as and insurance payout) in an amount that is greater than his or her adjusted basis in the property. In most circumstances, a taxpayer must report gain realized after a casualty or theft. However, some taxpayers may be able to defer paying taxes on the gain by choosing to postpone reporting the gain. To postpose reporting gain, a taxpayer must generally buy replacement property within two years after the close of the first tax year in which any part of the taxpayer’s gain is realized. However, in some cases, the replacement period may be greater than two years. To postpone reporting gain, the cost of the replacement property must be equal to or greater than the money received by the taxpayer.
AS established by the IRS, the basic form used to report residential rental income and expenses is Schedule E (Form 1040). However, there are several situations in which a taxpayer may not use Schedule E, because those situations include rental activities that do not qualify to use Schedule E. For example, a taxpayer who engages in not-for-profit rental activity may not use Schedule E to report rental activities. Similarly, a taxpayer who provides “substantial services” to tenants as part of rental activities will not be able to use Schedule E. Additionally, casualties and thefts related to rental activities are considered separately from the income and expenses reported on Schedule E.
A taxpayer will generally use Schedule E to report rental income and expenses if two conditions are met: First, the taxpayer must rent out buildings, rooms or apartments. Second, the taxpayer must provide basic services as part of rental activities; such as utilities, trash collection, and property maintenance. For these taxpayers, the total income, expenses, and depreciation for each rental property must be listed on line 2 of Schedule E. If a taxpayer using Schedule E has more than three rental (royalty) properties, additional Schedules E may need to be completed and attached. Depreciations is claimed on page 1, line 18 of Schedule E.