Many of our clients own and rent out homes they do not use full time as a residence, and even more are considering it based on the enticements of companies like Airbnb. Renting a property you use personally is somewhat different from renting a property that you do not live in at all.
Given that in 2022 any rental income received for a taxpayer totaling $600 or more may be reported to the taxpayer (and the IRS) on Form 1099, it is important to assess the impact of reporting net rental income on federal taxes.
When there is no personal use, the property is treated entirely as a rental property for tax purposes. Although passive activity rules generally apply, all income and expenses relating to that property are reported.
Even when there is some personal use, the income derived from renting a personal residence or vacation property is, in most instances, taxable to the recipient. Those taxes can be ordinary income tax, investment income tax, even self-employment income tax, depending on the facts and circumstances. The good news is that there is an exception to this income reporting when it relates to a casual rental, one totaling fewer than 15 days in a year. In this situation, income is not required to be reported.[1]
The tricky part comes with treatment of expenses. This treatment can vary for homes with rental and personal use.
Tax law imposes limitations on certain expenses when a rental property is classified as a dwelling unit used as a home. In general, the expenses of operating the home (other than the mortgage interest and real estate taxes that would be deducted as itemized deductions on schedule A even if the home were not rented out) cannot create a loss.
What is considered a dwelling unit used as a home? Any “dwelling unit” used by a taxpayer or a related party for personal purposes[2] for the greater of 14 days or 10% of the days it was rented at fair market value during the year. Clearly, taxpayers with more than one property can have more than one home by this definition.
Determining the tax treatment of expenses is complicated.
If the home was not used for personal use more than the greater of 14 days or 10% of the days rented AND the property was not rented or held out for rental, there is naturally no income to report and deductible mortgage interest and real estate taxes are reported by the taxpayer on Schedule A as itemized deductions. Alternatively, if the home was similarly not used for personal use more than the greater of 14 days or 10% of the days rented but the property or a portion of the property was rented, this is considered a rental property with personal use. All shared expenses are prorated between personal and rental use. Direct and prorated rental expenses along with prorated mortgage interest and real estate taxes are deducted against rental income on Schedule E. The prorated personal portion of real estate taxes is an itemized deduction reported on Schedule A. However, mortgage interest allocated to the personal use period is considered personal interest and is not deductible.
Many vacation homes are in the category of dwellings used for personal use more than 14 days or 10% of the days rented. For these properties allocable expenses are prorated between personal and rental use by the percentage of total days occupied. The allocated non-business mortgage and real estate tax expenses are deductible on Schedule A. Rental income is reported on Schedule E and reduced first by the prorated business portion of real estate taxes and mortgage interest. Other rental expenses will reduce any income remaining, but not below zero, since a “mixed-use” property can never have a loss for a year. Any expenses that are not deducted in the current year are carried forward.
The net rental income on Schedule E is taxable ordinary income for the year. Schedule E losses are an article unto themselves so you should discuss the treatment of any loss you expect with your tax preparer.
Rental income, unless derived from a trade or business, is considered investment income like interest and dividends for the purposes of computing the net investment income tax, a 3.8% surtax on net investment income applicable to individuals with incomes above the statutory threshold. Also, while rentals of real estate and personal property leased with real estate are usually exempt from self-employment tax, there are situations where, when additional services[3] are provided, the IRS has imposed self-employment taxes on rental income.
This is clearly a complicated area and we urge you to let us know if we can help you identify how you should document and report rental income and expenses.
[1] This exception might not apply in a self-rental arrangement where, for example, the rental is to the taxpayer’s business which then tries to deduct the rental expense.
[2] Personal use does not include days spent on maintenance. Days rented to family members are personal-use days unless fair rent is charged and the unit is the family member’s main home.
[3] In the IRS example, providing for a vacation rental things like daily maid service, toiletries, and ride-share vouchers.
This article submitted by Lois S. Fried, CPA, CFE, CVA, ABV.
