Thanks to Airbnb, Craigslist, and time-share exchanges many Americans end up with money that is treated as rental income. Tax professionals have an opportunity here to advise clients regarding the right strategy to minimize their tax on such income. Small and easy changes can yield hundreds of dollars in savings.
Rental income is not limited to clients with investment properties. Many other situations can result in rental income. Examples include clients who rented or sub-let:
- a room in their home
- the entire home (e.g. when away on vacation)
- time share week(s)
- a vacation home used only for part of the year
- unused rented home (e.g. because the client had extra months before the lease was over)
- inherited property
- a previous unsold property after the client moved out
A client could even end up with rental income when purchasing a house. There have been cases where the seller could not move out before closing and ended up paying rent to the buyer for the time over-stayed.
The tax depends on whether the property that generated the rental income is classified as a home or an investment property. Even if it is not the only property owned by the client or their primary home, the rented property could still be classified as one of their homes, instead of a rental property. On the other hand, the only property they own may still classify as an investment property. Small changes in usage can change the classification and result big tax savings, just for a few weeks of renting.
The Correct Classification: Home or Investment Property?
The property is treated as a home for tax purposes if the client personally uses the property for greater than both of the following:
- 14 days
- 10% of the number of days for which the property was rented
Personal use includes the client living there, or someone paying less than fair-market rent living there. Personal use does not include the days the client lived at the property to perform repairs and maintenance (excluding improvement). An example of someone living there at less than fair-market rent could be a friend or family member they allowed. Or a colleague from work who they offered the place at a low rent just to cover the utilities. Or volunteers from a charitable organization that they rented to, at a significant discount over fair market rent.
Room in a home: If they rented out a room in their home during local events that attract many tourists but use that room for themselves, for greater than 14 days and at least as many as 10% of the days for which it is rented, then the room is treated as part of the home. On the other hand if the client never puts the room to personal use, then it becomes a rental property.
Vacation homes: Suppose the client owns a vacation home that is rented out only during the ski-season for about 60 days. If they themselves use the property for 2 weeks or more, then it is a home. On the other hand, if they stayed there for only 10 days over the year, it would be classified as a rental property.
Previous home: Suppose the client moved out from their last home in December of the previous year but did not want to sell it in the winters. So they rented it for 180 days from January through June. Their in-laws visited in July and they let them stay at this property for 20 days (more than 10% of 180 days and more than 14 days) without charging rent. They then sold the property. This property would be classified as a home.
Even an investment property that the client rented out for 8 months and then allowed their sister-in-law to use it for a month without rent, would be treated as a home.
Time-shares: If the client owns a timeshare week, and rents out that week to someone else, they cannot claim the timeshare property as a home since they cannot put the week to personal use for at least 14 days.
Which classification is better?
Since the client often controls the number of days they live at the property, number of days they spend doing maintenance, and the rent they charge relative to fair-market rent, their behavior can influence whether the property is classified as a home or investment property. Considering the tax calculations for the current year gives you a great opportunity to show them the potential to save next year.
Classifying it as an investment property can allow deducting property expenses such as maintenance and depreciation in addition to mortgage interest and property taxes, but deductions could be limited by the rental income due to passive loss rules.
Classifying the property as a home allows your client to pocket the rental income tax-free if the rental duration was less than 15 days. Classifying it as a home also allows deducting mortgage interest and property taxes from non-rental income if deductions are itemized.
The classification that yields the lowest tax depends on a few different factors such as whether the taxable income is less than $100,000, whether they are a real estate professional and meet IRS rules regarding material participation in the rental activity, and the amount of rental property related expenses (mortgage interest, property tax, depreciation and maintenance).
The following examples explain these situations.
Example 1: Suppose the client is married, filing jointly, and the combined taxable income is less than $100,000. Suppose they own a beach home that is in demand for 90 days in the summer. The total rent received is $15000 and the total annual expense for the property (mortgage interest, property taxes, maintenance, depreciation) is $30,000.
- Your client vacations at the beach home for 14 days: The home becomes a rental property. The property expense allocated to personal use is 14/(90+14) * 30,000 = $4,038. The rest, $30,000 - 4,038 = $25,962 can be allocated to the rental activity. Deductions are:
- The rental expense completely offsets the rental income. The remaining $25,962 - 15,000 = $10,962 is less than the $25,000 IRS limit for deductible passive losses (since client taxable income is below $100k). So if itemized deductions are used, then this can be deducted as well.
- The $4038 of expense allocated to personal use includes the mortgage interest and property taxes but mortgage interest cannot be deducted because the property is not a first or second home (even if the total loan amount for the primary home and the beach home combined is below $1.1 million) and property tax portion can be deducted because it is not a home.
- The total deduction is $25962.
- Your client vacations at the beach home for 3 weeks: The property becomes a home. The portion of expense allocated to personal use is 21/(90+21)*30,000 = $5,675. The remaining expense is rental related: $30,000-5,675= $24,325.
- The rental allocated expenses ($24,325) can only be deducted up to the amount of total rental income, implying a deduction of $15,000.
- Of the $5675 personal use portion of the expense, the interest and taxes, say $4000, can be deducted as well.
- Total deduction is $19,000.
By spending one extra week at the property, the client loses $6962 in deductions. This can amount to $1740 in additional taxes if their marginal tax rate is 25%, as expected for someone who is married, filing jointly (MFJ), and has near $100,000 in taxable income.
Example 2: Suppose in the above example their taxable income is more than $150,000. As before they rent the beach property for 90 days.
- They vacation for 14 days: The deductions are:
- The rental expense is $25,962 as before but at incomes of $150,000 or higher the passive rental loss can no longer be deducted from salary or investment income. So the deduction is only $15000.
- The interest and tax from personal use portion is not deductible since the property is an investment property.
- Total deduction $15,000.
- They vacation for 3 weeks: The property becomes a home. Deductions are:
- The rental expense can be deducted up to the rental income amount: $15,000.
- The interest and property tax portion of the personal use related expense, $4000 can also be deducted.
- Total deduction: $19,000.
Vacationing for one extra week yields $4000 more in deductions and will likely save $1120 in taxes, assuming the 28% tax bracket expected for a client who is married, filing jointly, and has $15000 in taxable income. (If the client is too busy to vacation for an extra week, they could offer you to vacation at their beach property at significantly less than fair market rent and still accumulate the personal use days needed.)
No Mortgage: If they do not have a mortgage, classifying it as a home helps deduct property taxes but only if itemized deductions can be used. If the property taxes and other itemized deductions without the mortgage interest do not exceed the standard deduction (as could be expected in 2018, with the greatly increased standard deduction), then the only deduction from the rental activity is the rental expense on Schedule E. If the expense is greater than the rental income, changing the vacation days does not matter. If the rental income is greater than the expense, then the 14 day threshold is not significant but vacationing for a shorter duration would cause more of the expenses to be allocated to the rental activity and become deductible.
Example 3: Suppose, as in example 2 above, the income is above $150,000 but your client qualifies as a real estate professional, or their income is primarily from passive real estate investments.
- Suppose they vacation for 14 days: The property is an investment property. You can deduct the entire loss of $25,962 on their Schedule E (the same way as in example 1).
- Suppose they vacation for 3 weeks: The deduction is $19000 as discussed before.
The extra $6,962 in deductions can save $1949 in taxes using the 28% marginal tax bracket expected for MFJ at $150,000 of taxable income.
Example 4: Suppose the client only has one home. They are away from home for a month and decide to rent it out during that time. They live there the remaining 11 months. The property is classified as a home. Suppose they found a renter for 16 days of the month at the fair market price of $150/day. Suppose the total annual expense for the home is $40,000 including interest, taxes, maintenance and depreciation, of which the mortgage interest and taxes are $35,000.
Suppose they charge rent for 14 days and let the tenant stay free for 2 days: At $150/day rent collected is $2,100. You need not report this income on the client's return since the home was rented for less than 15 days. The deduction related to the primary home is $30,000 (if itemizing deductions). In short:
Additional income to report: $0
Decutions from home: $35000.
Suppose they charge rent for the entire 16 days: At $150/day, they collect $2400 in rental income. You must report this rental income since the rental exceeded 15 days. The portion of the expense allocated to the rental is 16/(335+16)*$40,000=$1,823. In short:
Income to report: $2400
Deductions, for expense related to rental period: 1823
Interest and tax related to personal use period: 335/(335+16)*35000=$33,404
Total deduction: $35,227
So deductions increase by $227 but there is an extra $2400 in income to report. Meaning, they pay tax on an additional $2400-227=$2173.00. In the 25% tax bracket, this means they pay $543 extra in taxes and receive $300 in extra rental income. They lose $243 by charging rent for two extra days.
The discussion above is based on the details in IRS Publication 527, Chapter 5.
Disclaimer: The information in this article is not intended as tax advice or financial advice. It is only intended for your education and awareness, such as to help you consider the issues raised. Please consult relevant professionals or other sources for advice when making decisions or taking actions related to this information.
Question. I purchased a home and the seller stayed in that home for one month after closing. They paid me rent for that month. I had to pay rent on a different home for that time because the seller had not moved out. I do have to report the rental income since I had rented out my purchased for more than 15 days. Can I deduct the cost of the rent I paid on the different home during that time as an expense related to rental income?
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