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Chapter 9
Rental income and expenses

Introduction

Rent is the income received for allowing another person to use property that you own. This income is customarily received in cash. If, in lieu of paying all or part of the rent in cash, a tenant provides you with certain services, the value of those services is rental income to you.

You may deduct expenses incurred to repair or to maintain your rental property. However, certain other expenses may not be deducted in the year in which you pay for them; rather, they must be capitalized and deducted over a period of years. You may also deduct any depreciation taken on your rental property. Depreciation is a noncash expense claimed in order to deduct each year a small part of what you originally paid for the property. There are a variety of methods by which you may depreciate property and calculate your tax deduction. These methods are explained in this chapter.

Rental real estate activities are generally considered passive activities, and the amount of any loss you can deduct is limited unless you have income from other passive activities or you “materially” or “actively” participate in your rental activity. This chapter explains the rules for figuring rental income, expenses, depreciation, and allowable losses.

In addition to paying regular income tax or alternative minimum tax on rental income, a 3.8% Net Investment Income Tax (NIIT) is assessed on unearned Net Investment Income (NII). For individuals, the NIIT is 3.8% of the lesser of: (1) NII or (2) the excess of modified adjusted gross income (MAGI) over $200,000 ($250,000 if married filing jointly; $125,000 if married filing separately). Net investment income includes income from passive activities. For most taxpayers, rental activities are treated as passive, and any net rental income is subject to the NIIT. On the other hand, rental income derived in the ordinary course of a trade or business by certain real estate professionals is considered to be nonpassive, and therefore is not subject to the NIIT. For more information, see Passive Activity Limits, later in this chapter. A detailed overview of the NIIT can be found in chapter 49, Net Investment Income Tax.

Introduction

This chapter discusses rental income and expenses. It also covers the following topics.

Personal use of dwelling unit (including vacation home).
Depreciation.
Limits on rental losses.
How to report your rental income and expenses.

Tax Breaks and Deductions You Can Use Checklist

Rental expenses. You can deduct the cost of rental expenses from your rental income. Expenses include advertising, cleaning and maintenance services, utilities, property insurance, taxes, interest on a loan taken out to buy or improve the rental property, commissions paid to collect rent, management fees, legal and other professional fees, ordinary and necessary travel and transportation, repairs, depreciation on amounts paid to acquire the property and to make subsequent improvements, and amortization of points paid to acquire a mortgage on the rental property. For more details, see Rental Expenses and Other Expenses, later.

Rental expenses of vacant rental property. You can deduct the expenses of managing and maintaining a rental property during the time it is being marketed for rent for the first time and in between rentals, as long as it is actively being held out for rent. For more details, see Rental Expenses, later.

Deducting repairs and capitalizing improvements. You can deduct the full amount of the cost of repairs made to your rental property in the year paid (for a cash-basis taxpayer). On the other hand, the cost of improvements cannot be deducted currently but rather must be capitalized and then recovered over time by taking depreciation. An expense can be considered a repair if it keeps the property in good working condition but does not increase its value nor its useful life. An improvement adds to the value of property, prolongs its useful life, or adapts the property to new uses. For more details, see Repairs and Improvements, later.

Exclusion of rental income from a home rented for less than 15 days during the year. If a dwelling unit is used as a personal home and you rent it for less than 15 days during the year, you can exclude all of the rental income received from your taxable income. You are also not permitted to deduct any rental expenses paid. Note, however, that you can continue to deduct qualified residence interest, real estate taxes, and casualty and theft losses if you itemize deductions. For details, see Exception for Minimal Rental Use, later.

Passive rental losses allowed as a deduction. There is an exception to the general rule that disallows a deduction for passive rental losses. If you actively participate in a passive rental real estate activity (you actively participate if you and your spouse owned at least 10% of the rental property and you made significant management decisions, such as approving new tenants, deciding on rental terms, and approving expenditures for the property), you can deduct up to $25,000 of your losses from the activity from your nonpassive income. However, if your modified adjusted gross income is $150,000 or more ($75,000 or more if you are married filing separately), this exception to the passive loss deduction rules is not available. For more details, see Losses From Rental Real Estate Activities, later.

If you sell or otherwise dispose of your rental property, see Pub. 544, Sales and Other Dispositions of Assets.

If you have a loss from damage to, or theft of, rental property, see Pub. 547, Casualties, Disasters, and Thefts.

If you rent a condominium or a cooperative apartment, some special rules apply to you even though you receive the same tax treatment as other owners of rental property. See Pub. 527, Residential Rental Property, for more information.

Useful Items

You may want to see:

Publication

527 Residential Rental Property
534 Depreciating Property Placed in Service Before 1987
535 Business Expenses
925 Passive Activity and At-Risk Rules
946 How To Depreciate Property

Form (and Instructions)

4562 Depreciation and Amortization
6251 Alternative Minimum Tax—Individuals
8582 Passive Activity Loss Limitations
Schedule E (Form 1040) Supplemental Income and Loss

Rental Income

In most cases, you must include in your gross income all amounts you receive as rent. Rental income is any payment you receive for the use or occupation of property. In addition to amounts you receive as normal rent payments, there are other amounts that may be rental income.

When to report. If you are a cash-basis taxpayer, you report rental income on your return for the year you actually or constructively receive it. You are a cash-basis taxpayer if you report income in the year you receive it, regardless of when it was earned. You constructively receive income when it is made available to you, for example, by being credited to your bank account.

If you are an accrual basis taxpayer, you generally report income when you earn it, rather than when you receive it. You generally deduct your expenses when you incur them, rather than when you pay them. See Pub. 538, Accounting Periods and Methods, for more information.

For more information about when you constructively receive income, see Accounting Methods in chapter 1.

Advance rent. Advance rent is any amount you receive before the period that it covers. Include advance rent in your rental income in the year you receive it regardless of the period covered or the method of accounting you use.

Example. You sign a 10-year lease to rent your property. In the first year, you receive $5,000 for the first year’s rent and $5,000 as rent for the last year of the lease. You must include $10,000 in your income in the first year.

EXPLANATION

Some taxpayers have attempted to circumvent the rule requiring advance rent to be included in current income by structuring the payment as a “loan.” The courts have generally disallowed this technique and examine this type of transaction with close scrutiny. As a general rule, if such a loan is to be repaid out of future rental proceeds, the loan will probably be considered advance rent.

However, the courts have held that an up-front payment for an option to purchase the property is not considered advance rent and, as such, does not have to be included in income where the agreement provides no provision for returning the money to the renter or applying it to the rent.

Even if a promissory note is written to support the “loan,” the courts will look to the parties’ intent, as well as to other factors such as interest charged, whether the loan is secured, and whether the loan payment and rental dates are identified.

Canceling a lease. If your tenant pays you to cancel a lease, the amount you receive is rent. Include the payment in your income in the year you receive it regardless of your method of accounting.

Expenses paid by tenant. If your tenant pays any of your expenses, the payments are rental income. Because you must include this amount in income, you can deduct the expenses if they are deductible rental expenses. See Rental Expenses, later, for more information.

Example 1

Your tenant pays the water and sewage bill for your rental property and deducts the amount from the normal rent payment. Under the terms of the lease, your tenant does not have to pay this bill. Include the utility bill paid by the tenant and any amount received as a rent payment in your rental income. You can deduct the utility payment made by your tenant as a rental expense.

Example 2

While you are out of town, the furnace in your rental property stops working. Your tenant pays for the necessary repairs and deducts the repair bill from the rent payment. Include the repair bill paid by the tenant and any amount received as a rent payment in your rental income. You can deduct the repair payment made by your tenant as a rental expense.

EXPLANATION

When a tenant pays to have capital improvements constructed on the landlord’s property and these improvements are not made in lieu of rent or other required payments, the value of these improvements is not income to the landlord, either when made or on termination of the lease, even though the landlord keeps the improvements at the end of the lease. However, the landlord will have no basis in the improvements and, therefore, cannot depreciate the improvements.

Example 1

Susan rents an apartment to Pam. Pam, at her own expense, constructs a wall to separate the dining area from the living room. At the end of the lease, Pam vacates the apartment, leaving the wall. Susan does not record income at any time, even though she may benefit from the capital improvement. Susan may not depreciate the value of the wall because she has no basis in the wall.

If Susan must incur an expense to remove the wall and restore the property, it is either deducted from income or capitalized, depending on factors discussed later in this chapter.

Example 2

Ken rents an apartment to Anthony for $550. Anthony pays for plumbing repairs of $150, which he in turn deducts from his current month’s rent. Although Ken has received only $400 from Anthony, he must report the entire rent amount of $550 as income. Ken may also be able to report the $150 for plumbing repairs as a deductible expense.

Other examples of landlord expenses paid by a tenant that would be considered rental income include a tenant’s payment of a landlord’s real estate taxes, mortgage payments, or income taxes.

TAXPLANNER

It would be unusual for an expense that is the responsibility of the landlord not to be deductible by the landlord when the tenant pays the expense. But such expenses do exist. Consider, for example, a building code violation fine incurred for some change made in the tenant’s space by the tenant without the landlord’s consent. The fine is imposed on the landlord, but the violation is the tenant’s fault. The tenant pays the penalty, but the landlord still has to declare that amount as income. Since most penalties are not deductible, the landlord probably will not be able to deduct the amount of the fine as an expense. If this is a possibility, a clause in the lease making the payment of such a penalty the responsibility of the tenant when the tenant is at fault would probably keep the payment by the tenant from being income to the landlord.

Property or services. If you receive property or services, instead of money, as rent, include the fair market value of the property or services in your rental income.

If the services are provided at an agreed upon or specified price, that price is the fair market value unless there is evidence to the contrary.

Security deposits. Do not include a security deposit in your income when you receive it if you plan to return it to your tenant at the end of the lease. But if you keep part or all of the security deposit during any year because your tenant does not live up to the terms of the lease, include the amount you keep in your income in that year.

If an amount called a security deposit is to be used as a final payment of rent, it is advance rent. Include it in your income when you receive it.

If you keep part or all of the security deposit because the tenant breaks the lease by vacating the property early, include the amount you keep in your income that year. If you keep part or all of the security deposit because the tenant damaged the property and you must make repairs, include the amount you keep in that year if your practice is to deduct the cost of repairs as expenses. To the extent the security deposit reimburses those expenses, do not include the amount in income if your practice is not to deduct the cost of repairs as expenses. If a security deposit amount is to be used as the tenant’s final month’s rent, it is advance rent that you include as income when you receive it, rather than when you apply it to the last month’s rent.

Part interest. If you own a part interest in rental property, you must report your part of the rental income from the property.

Rental of property also used as your home. If you rent property that you also use as your home and you rent it less than 15 days during the tax year, do not include the rent you receive in your income and do not deduct rental expenses. However, you can deduct on Schedule A (Form 1040) the interest, taxes, and casualty and theft losses that are allowed for nonrental property. See Personal Use of Dwelling Unit (Including Vacation Home), later.

TAXALERT

If you plan to convert your rental property into your principal residence, the amount of gain you may be able to exclude from a future sale of that home may be limited. Generally, you are allowed to exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. The sale of a home will qualify for this exclusion if the home is a taxpayer’s principal residence for at least two of the five years ending on the date of the sale or exchange. Under this law, the period of time you rented the residence after 2008 and before you converted it into your principal residence will figure into a formula that reduces the maximum exclusion ($250,000, or $500,000 if married filing a joint return) you can apply to offset gains realized when you ultimately sell that home. See chapter 15, Selling your home, for more information.

TAXALERT

The New “Sharing Economy.” An emerging area of activity in the past few years, the sharing economy has changed how people commute, travel, rent vacation places, and perform many other activities. Also referred to as the on-demand, gig, or access economy, sharing economies allow individuals and groups to utilize technology advancements to arrange transactions to generate revenue from assets they possess—such as cars and homes—or services they provide—such as household chores or technology services. Although this is a developing area of the economy, there are tax implications for the companies that provide the services and the individuals who perform the services.

In March 2017, the IRS updated relevant information for those participating in the sharing economy. If you are an Uber or Lyft driver, an Airbnb owner, or any other person who is participating in the sharing economy sector, you should visit the following website for timely and relevant information concerning this emerging sector: https://www.irs.gov/businesses/small-businesses-self-employed/sharing-economy-tax-center.

Note. There may also be state and local income tax issues, in addition to the federal ones covered on the IRS website.

Rental Expenses

This part discusses expenses of renting property that you ordinarily can deduct from your rental income. It includes information on the expenses you can deduct if you rent part of your property, or if you change your property to rental use. Depreciation, which you can also deduct from your rental income, is discussed later.

Personal use of rental property. If you sometimes use your rental property for personal purposes, you must divide your expenses between rental and personal use. Also, your rental expense deductions may be limited. See Personal Use of Dwelling Unit (Including Vacation Home), later.

Part interest. If you own a part interest in rental property, you can deduct expenses that you paid according to your percentage of ownership.

Example

Roger owns a one-half undivided interest in a rental house. Last year he paid $968 for necessary repairs on the property. Roger can deduct $484 (50% × $968) as a rental expense. He is entitled to reimbursement for the remaining half from the co-owner.

When to deduct. If you are a cash-basis taxpayer, you generally deduct your rental expenses in the year you pay them. If you use the accrual method, see Pub. 538 for more information.

Depreciation. Depreciation is a capital expense. It is the mechanism for recovering your cost in an income producing property and must be taken over the expected life of the property. You can begin to depreciate rental property when it is ready and available for rent. See Placed-in-Service under When Does Depreciation Begin and End in chapter 2 of Pub. 527.

Pre-rental expenses. You can deduct your ordinary and necessary expenses for managing, conserving, or maintaining rental property from the time you make it available for rent.

Uncollected rent. If you are a cash-basis taxpayer, do not deduct uncollected rent. Because you have not included it in your income, it is not deductible.

Vacant rental property. If you hold property for rental purposes, you may be able to deduct your ordinary and necessary expenses (including depreciation) for managing, conserving, or maintaining the property while the property is vacant. However, you cannot deduct any loss of rental income for the period the property is vacant.

EXAMPLE

You own a rental property that was vacant for about half the year. You had rental income of $12,000 during the year and ordinary and necessary expenses of $15,000, which resulted in an overall loss of $3,000. As long as you can demonstrate that you have been actively trying to rent the property (e.g., newspaper or online clippings advertising the property for rent), you would be able to deduct your expenses up to $12,000. If you meet the passive activity loss rules discussed later in this chapter, the remaining $3,000 of expenses can be carried over to the next year or deducted in the current year if qualified. See Limits on Rental Losses, later in this chapter, for special rules and how to report rental income and expenses. Also see How To Report Rental Income and Expenses, later in this chapter.

Vacant while listed for sale. If you sell property you held for rental purposes, you can deduct the ordinary and necessary expenses for managing, conserving, or maintaining the property until it is sold. If the property is not held out and available for rent while listed for sale, the expenses are not deductible rental expenses.

Repairs and Improvements

Generally, an expense for repairing or maintaining your rental property may be deducted if you are not required to capitalize the expense.

Improvements. You must capitalize any expense you pay to improve your rental property. An expense is for an improvement if it results in a betterment to your property, restores your property, or adapts your property to a new or different use.

Betterments. Expenses that may result in a betterment to your property include expenses for fixing a pre-existing defect or condition, enlarging or expanding your property, or increasing the capacity, strength, or quality of your property.

Restoration. Expenses that may be for restoration include expenses for replacing a substantial structural part of your property, repairing damage to your property after you properly adjusted the basis of your property as a result of a casualty loss, or rebuilding your property to a like-new condition.

Adaptation. Expenses that may be for adaptation include expenses for altering your property to a use that is not consistent with the intended ordinary use of your property when you began renting the property.

The expenses you capitalize for improving your property can generally be depreciated as if the improvement were separate property.

EXPLANATION

If a so-called improvement does not prolong useful life or add to value, it is deductible currently as a repair. It is the “nature” of the repair rather than the “amount” that determines whether it is deductible or not.

Examples

Examples of capitalized expenses are as follows:

Improvements made to property to comply with government regulations
Expenditures to place property in a safe condition
Face-lifting to improve property’s appearance
Replacement of flashing around a building’s roof
Replacement of a gravel driveway with a cement driveway
Replacing a floor
Replacing or recovering a roof

Examples of deductible expenses are as follows:

Replacing a portion of a wood bathroom when damage has been caused by water
Repainting or repapering a room in a rooming house when it is necessary to keep the area clean and serviceable
Reinforcing sagging floors
Resurfacing a parking lot
Making piecemeal repairs to floors

Other Expenses

Other expenses you can deduct from your rental income include advertising, cleaning and maintenance, utilities, fire and liability insurance, taxes, interest, commissions for the collection of rent, ordinary and necessary travel and transportation, and other expenses, discussed next.

EXPLANATION

Although commissions paid to collect rent are deductible, commissions paid to obtain long-term rentals (greater than a 1-year period) must be capitalized and amortized. Commissions paid to acquire the rental property must be capitalized as part of the basis of that property and recovered when the property is depreciated.

Points paid to acquire a mortgage on the rental property must be amortized over the life of the mortgage. These charges are also called loan origination fees, maximum loan charges, or premium charges. Any of these charges (points) that are solely for the use of money are interest. Because points are prepaid interest, you generally cannot deduct the full amount in the year paid, but must deduct the interest over the term of the loan.

Other deductible expenses connected to renting include legal costs for dispossessing a tenant, property management fees, and pest control fees.

The “ordinary and necessary travel and transportation” category includes local transportation. You may be able to deduct your ordinary and necessary local transportation expenses if you incur them to collect rental income or to manage, conserve, or maintain your rental property. It also covers the cost of meals and lodging on trips to inspect rental property located outside the immediate area. However, for the cost of nonlocal transportation and some other expenses to be deductible, the primary purpose of the trip must be to take care of the rental property. (See chapter 27, Car expenses and other employee business expenses, for a discussion of how to deduct expenses when you use your personal automobile in your trade or business.) In addition, the expense must be “ordinary” in nature. An ordinary expense is one that is common and accepted for the activity.

Example

If you take a 1-week trip to Florida and spend 1 day inspecting your rental property, no nonlocal transportation expenses are deductible. If, on the other hand, 6 of the 7 days are used to repair and attend to the property, all nonlocal transportation expenses are deductible. In both cases, local transportation expenses incurred traveling to and from the property are deductible. However, if a stretch limousine is rented for the local travel, more than likely the IRS would not consider the expense an “ordinary” expense. Any deduction allowed would be limited to the amount that would be considered “ordinary,” such as the cost of a rental car or cab fare.

Insurance premiums paid in advance. If you pay an insurance premium for more than one year in advance, you cannot deduct the total premium in the year you pay it. For each year of coverage, you deduct only the part of the premium payment that applies to that year.

Legal and other professional fees. You can deduct, as a rental expense, legal and other professional expenses, such as tax return preparation fees you paid to prepare Schedule E (Form 1040), Part I. For example, on your 2017 Schedule E, you can deduct fees paid in 2017 to prepare your 2015 Schedule E, Part I. You can also deduct, as a rental expense, any expense (other than federal taxes and penalties) you paid to resolve a tax underpayment related to your rental activities.

Local benefit. In most cases, you cannot deduct charges for local benefits that increase the value of your property, such as charges for putting in streets, sidewalks, or water and sewer systems. These charges are nondepreciable capital expenditures, and must be added to the basis of your property. However, you can deduct local benefit taxes that are for maintaining, repairing, or paying interest charges for the benefits.

Local transportation expenses. You may be able to deduct your ordinary and necessary local transportation expenses if you incur them to collect rental income or to manage, conserve, or maintain your rental property. However, transportation expenses incurred to travel between your home and a rental property generally constitute nondeductible commuting costs unless you use your home as your principal place of business. See Pub. 587, Business Use of Your Home, for information on determining if your home office qualifies as a principal place of business.

Generally, if you use your personal car, pickup truck, or light van for rental activities, you can deduct the expenses using one of two methods: actual expenses or the standard mileage rate. For 2017, the standard mileage rate for business use is 53.5 cents per mile. For more information, see chapter 27.

Rental of equipment. You can deduct the rent you pay for equipment that you use for rental purposes. However, in some cases, lease contracts are actually purchase contracts. If so, you cannot deduct these payments. You can recover the cost of purchased equipment through depreciation.

EXPLANATION

A lease with an option to buy may be a purchase contract. Generally, if the sum of the rental payments on a lease with an option to buy amounts to a substantial part of what would be the purchase price, and if the option period is clearly less than the useful life of the property, the transaction is treated as a sale. Income is recognized under the installment sale rules. (See chapter 14, Sale of property, for details.)

If the lease is treated as a sale on the date the lease is entered into, rather than the date the option is exercised, there may be unwanted tax consequences for the landlord. The payments that the landlord receives will be proceeds from the sale of property, and he or she will report the gain on the installment method. The landlord may also have to report imputed interest income (see chapter 12, Other income). Consequently, the landlord might have more income and fewer deductions than expected.

Rental of property. You can deduct the rent you pay for property that you use for rental purposes. If you buy a leasehold for rental purposes, you can deduct an equal part of the cost each year over the term of the lease.

Travel expenses. You can deduct the ordinary and necessary expenses of traveling away from home if the primary purpose of the trip is to collect rental income or to manage, conserve, or maintain your rental property. You must properly allocate your expenses between rental and nonrental activities. You cannot deduct the cost of traveling away from home if the primary purpose of the trip was to improve your property. You recover the cost of improvements by taking depreciation. For information on travel expenses, see chapter 27.

See Rental Expenses in Pub. 527 for more information.

Property Changed To Rental Use

If you change your home or other property (or a part of it) to rental use at any time other than the beginning of your tax year, you must divide yearly expenses, such as taxes and insurance, between rental use and personal use.

You can deduct as rental expenses only the part of the expense that is for the part of the year the property was used or held for rental purposes.

You cannot deduct depreciation or insurance for the part of the year the property was held for personal use. However, you can include the home mortgage interest, qualified mortgage insurance premiums, and real estate tax expenses for the part of the year the property was held for personal use as an itemized deduction on Schedule A (Form 1040).

Example

Your tax year is the calendar year. You moved from your home in May and started renting it out on June 1. You can deduct as rental expenses seven-twelfths of your yearly expenses, such as taxes and insurance.

Starting with June, you can deduct as rental expenses the amounts you pay for items generally billed monthly, such as utilities.

Renting Part of Property

If you rent part of your property, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes, as though you actually had two separate pieces of property.

You can deduct the expenses related to the part of the property used for rental purposes, such as home mortgage interest, qualified mortgage insurance premiums, and real estate taxes, as rental expenses on Schedule E (Form 1040). You can also deduct as rental expenses a portion of other expenses that normally are nondeductible personal expenses, such as expenses for electricity or painting the outside of your house.

There is no change in the types of expenses deductible for the personal-use part of your property. Generally, these expenses may be deducted only if you itemize your deductions on Schedule A (Form 1040).

You cannot deduct any part of the cost of the first phone line even if your tenants have unlimited use of it.

You do not have to divide the expenses that belong only to the rental part of your property. For example, if you paint a room that you rent, or if you pay premiums for liability insurance in connection with renting a room in your home, your entire cost is a rental expense. If you install a second phone line strictly for your tenants’ use, all of the cost of the second line is deductible as a rental expense. You can deduct depreciation, discussed later, on the part of the house used for rental purposes as well as on the furniture and equipment you use for rental purposes.

How to divide expenses. If an expense is for both rental use and personal use, such as mortgage interest or heat for the entire house, you must divide the expense between the rental use and the personal use. You can use any reasonable method for dividing the expense. It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them. The two most common methods for dividing an expense are based on (1) the number of rooms in your home, and (2) the square footage of your home.

Not Rented for Profit

If you do not rent your property to make a profit, you can deduct your rental expenses only up to the amount of your rental income. You cannot deduct a loss or carry forward to the next year any rental expenses that are more than your rental income for the year. For more information about the rules for an activity not engaged in for profit, see Not-for-Profit Activities in chapter 1 of Pub. 535.

Where to report. Report your not-for-profit rental income on Form 1040, line 21. For example, you can include your mortgage interest and any qualified mortgage insurance premiums (if you use the property as your main home or second home), real estate taxes, and casualty losses on the appropriate lines of Schedule A (Form 1040) if you itemize your deductions.

If you itemize your deductions, claim your other rental expenses, subject to the rules explained in chapter 1 of Pub. 535, as miscellaneous itemized deductions on Schedule A (Form 1040). You can deduct these expenses only if they, together with certain other miscellaneous itemized deductions, total more than 2% of your adjusted gross income.

Personal Use of Dwelling Unit (Including Vacation Home)

If you have any personal use of a dwelling unit (including a vacation home) that you rent, you must divide your expenses between rental use and personal use. In general, your rental expenses will be no more than your total expenses multiplied by a fraction, the denominator of which is the total number of days the dwelling unit is used and the numerator of which is the total number of days actually rented at a fair rental price. Only your rental expenses may be deducted on Schedule E (Form 1040). Some of your personal expenses may be deductible if you itemize your deductions on Schedule A (Form 1040).

You must also determine if the dwelling unit is considered a home. The amount of rental expenses that you can deduct may be limited if the dwelling unit is considered a home. Whether a dwelling unit is considered a home depends on how many days during the year are considered to be days of personal use. There is a special rule if you used the dwelling unit as a home and you rented it for less than 15 days during the year.

TAXSAVER

This is one of the very few instances in which the IRS considers income to be nontaxable. You should be on the lookout for opportunities to rent property for less than 15 days to take advantage of this tax loophole. Residents of Augusta, Georgia, for example, have an annual opportunity to rent their homes for a short period during the Masters golf tournament.

Explanation

In general, the tax rules governing the rental of vacation homes and other dwelling units are the same as those governing any rental property. The allowable methods of depreciation, the types of deductible expenditures, and the types of expenditures that should be capitalized are all determined in the same way for both categories of rental property. However, if you or a member of your family uses the vacation home or dwelling unit during the year, the amount of deductible expenses may be limited by special rules.

Here’s an easy way to figure out whether or not you have to follow the special rules for reporting rental income outlined later:

Step 1. Determine the number of days the property was rented at fair market value during the year. If this number is less than 15, STOP. You may not deduct any rental expenses, and you do not report any rental income. (Note: You may always deduct qualified residence interest, taxes, casualty losses, and theft losses if you itemize deductions. To do so, simply take the deduction for the entire amount of these items on Schedule A (Form 1040).) If the number of days rented is 15 or more, you must report rental income. Proceed to Step 2.

Step 2. Determine the number of days you personally use the property. If this number does not exceed the greater of (a) 14 days or (b) 10% of the number of days in which the property was rented at fair market value, you are not subject to any special rules. After completing Step 3, you determine your rental income or loss in the same way you would for any type of rental property.

If your personal use of the property exceeds the limits described earlier, you are subject to special rules limiting the amount of deductible expenses. After completing Step 3, you determine your rental income or loss using the rules discussed in this section.

Step 3. Allocate all expenses between the rental period and the period in which you use the property personally, using the method described in the following section. Expenses allocated to the period of personal use are not deductible, except for interest, taxes, and casualty and theft losses (see Step 1). Then determine your rental income or loss, using either the general rules for rental property or the special rules regarding the personal use of vacation homes, whichever is appropriate.

Note: See What Is a Day of Personal Use?, later, regarding use of a home before or after renting.

Dwelling unit. A dwelling unit includes a house, apartment, condominium, mobile home, boat, vacation home, or similar property. It also includes all structures or other property belonging to the dwelling unit. A dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities.

A dwelling unit does not include property used solely as a hotel, motel, inn, or similar establishment. Property is used solely as a hotel, motel, inn, or similar establishment if it is regularly available for occupancy by paying customers and is not used by an owner as a home during the year.

Example. You rent a room in your home that is always available for short-term occupancy by paying customers. You do not use the room yourself, and you allow only paying customers to use the room. The room is used solely as a hotel, motel, inn, or similar establishment and is not a dwelling unit.

EXPLANATION

A dwelling unit must provide basic living accommodations, such as sleeping space, a bathroom, and cooking facilities.

The Tax Court has ruled that a mini–motor home qualifies as a dwelling unit.

An outbuilding used in conjunction with the main building to provide living accommodations, such as a garage, a barn, or a greenhouse, constitutes part of the main dwelling unit. When renting one of these outbuildings, you may deduct expenses only to the extent you have income. You may not deduct a rental loss because the outbuilding is not considered separate from the main building that is being used as a personal residence or vacation home.

Rental pools and time-shares. Rental pools are agreements under which two or more vacation homes are made available for rent by their owners, who agree to share “at least substantially part of the rental income from the homes regardless [of] which of the vacation homes are actually rented.” Under proposed IRS regulations, special rules apply when you are computing income, expense, and personal use days.

Also, under proposed IRS regulations, individuals owning a time-share that they rent are to treat their rental income and expense separately with respect to their unit. Consult your tax advisor.

Dividing Expenses

If you use a dwelling unit for both rental and personal purposes, divide your expenses between the rental use and the personal use based on the number of days used for each purpose.

When dividing your expenses, follow these rules.

Any day that the unit is rented at a fair rental price is a day of rental use even if you used the unit for personal purposes that day. This rule does not apply when determining whether you used the unit as a home.
Any day that the unit is available for rent but not actually rented is not a day of rental use.

Example. Your beach cottage was available for rent from June 1 through August 31 (92 days). During that time, except for the first week in August (7 days) when you were unable to find a renter, you rented the cottage at a fair rental price. The person who rented the cottage for July allowed you to use it over the weekend (2 days) without any reduction in or refund of rent. Your family also used the cottage during the last 2 weeks of May (14 days). The cottage was not used at all before May 17 or after August 31.

You figure the part of the cottage expenses to treat as rental expenses as follows.

The cottage was used for rental a total of 85 days (92 – 7). The days it was available for rent but not rented (7 days) are not days of rental use. The July weekend (2 days) you used it is rental use because you received a fair rental price for the weekend.
You used the cottage for personal purposes for 14 days (the last 2 weeks in May).
The total use of the cottage was 99 days (14 days personal use + 85 days rental use).
Your rental expenses are 85/99 (86%) of the cottage expenses.

Note. When determining whether you used the cottage as a home, the July weekend (2 days) you used it is considered personal use even though you received a fair rental price for the weekend. Therefore, you had 16 days of personal use and 83 days of rental use for this purpose. Because you used the cottage for personal purposes more than 14 days and more than 10% of the days of rental use (8 days), you used it as a home. If you have a net loss, you may not be able to deduct all of the rental expenses. See Dwelling Unit Used as a Home, next.

TAXSAVER

The Tax Court allows you to use a different allocation formula for interest and taxes than the one the IRS describes. Under the Tax Court formula, interest and taxes are allocated in the ratio of days rented to days in the year instead of in the ratio of days rented to days used. Using the Tax Court ratio results in a smaller amount of interest and taxes being allocated to the rental property, which creates the potential for you to deduct a larger amount of your other rental expenses.

Example

You own a cabin, which you rented for June and July, lived in for 1 month, and tried to rent the rest of the year. Your rental income for the 2 months was $2,800. Your total expenses for the cabin were as follows:

Interest	$1,500
Taxes	900
Utilities	750
Maintenance	300
Depreciation	1,200

Both the IRS method and the Tax Court method allocate interest expense and real estate taxes partly to Schedule E (for determining net rental income) and partly to Schedule A (for personal itemized deductions). But examine how these allocations affect Schedule A.

Total interest paid is $1,500. Since the IRS method allocates $1,005 to the rental activity, the $495 balance is allocated to Schedule A. The Tax Court method allocates only $251 to the rental activity, leaving $1,249 for a deduction on Schedule A. Similarly, the IRS method allocates $603 of the $900 in real estate taxes to the rental activity, leaving $297 for Schedule A. The Tax Court method allocates only $150 to the rental activity, leaving $750 for Schedule A.

	Schedule A Deduction
	Tax Court method	IRS method	Additional itemized per Tax Court method
Interest	$1,249	$495	$754
Real estate taxes	750	297	453
			$1,207

Under the Tax Court method, you end up with additional deductions of $1,207, but you also have an additional net rental income of $891. The difference is that you reduce your taxable income by $316 more than under the IRS method. This conclusion assumes that you had enough other itemized deductions to make itemizing worthwhile and that your itemized deductions are not being limited.

The concept illustrated here is also important because rental income is considered to be passive income and, as such, can be used to offset passive losses. For more details, see chapter 24, Interest expense.

Dwelling Unit Used as a Home

If you use a dwelling unit for both rental and personal purposes, the tax treatment of the rental expenses you figured earlier under Dividing Expenses and rental income depends on whether you are considered to be using the dwelling unit as a home.

You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:

14 days, or
10% of the total days it is rented to others at a fair rental price.

See What is a day of personal use?, later.

Fair rental price. A fair rental price for your property generally is the amount of rent that a person who is not related to you would be willing to pay. The rent you charge is not a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property in your area.

If a dwelling unit is used for personal purposes on a day it is rented at a fair rental price, do not count that day as a day of rental use in applying (2) just described. Instead, count it as a day of personal use in applying both (1) and (2) just described.

What is a day of personal use? A day of personal use of a dwelling unit is any day that the unit is used by any of the following persons.

You or any other person who has an interest in the unit, unless you rent it to another owner as his or her main home under a shared equity financing agreement (defined later). However, see Days used as a main home before or after renting, later.
A member of your family or a member of the family of any other person who owns an interest in the unit, unless the family member uses the dwelling unit as his or her main home and pays a fair rental price. Family includes only your spouse, brothers and sisters, half-brothers and half-sisters, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
Anyone under an arrangement that lets you use some other dwelling unit.
Anyone at less than a fair rental price.

Main home. If the other person or member of the family in (1) or (2) just described has more than one home, his or her main home is ordinarily the one he or she lived in most of the time.

Shared equity financing agreement. This is an agreement under which two or more persons acquire undivided interests for more than 50 years in an entire dwelling unit, including the land, and one or more of the co-owners is entitled to occupy the unit as his or her main home upon payment of rent to the other co-owner or owners.

Donation of use of property. You use a dwelling unit for personal purposes if:

You donate the use of the unit to a charitable organization,
The organization sells the use of the unit at a fund-raising event, and
The “purchaser” uses the unit.

Examples. The following examples show how to determine days of personal use.

Example 1. You and your neighbor are co-owners of a condominium at the beach. Last year, you rented the unit to vacationers whenever possible. The unit was not used as a main home by anyone. Your neighbor used the unit for 2 weeks last year; you did not use it at all.

Because your neighbor has an interest in the unit, both of you are considered to have used the unit for personal purposes during those 2 weeks.

Example 2. You and your neighbors are co-owners of a house under a shared equity financing agreement. Your neighbors live in the house and pay you a fair rental price.

Even though your neighbors have an interest in the house, the days your neighbors live there are not counted as days of personal use by you. This is because your neighbors rent the house as their main home under a shared equity financing agreement.

Example 3. You own a rental property that you rent to your son. Your son does not own any interest in this property. He uses it as his main home and pays you a fair rental price.

Your son’s use of the property is not personal use by you because your son is using it as his main home, he owns no interest in the property, and he is paying you a fair rental price.

Example 4. You rent your beach house to Joshua. Joshua rents his cabin in the mountains to you. You each pay a fair rental price.

You are using your house for personal purposes on the days that Joshua uses it because your house is used by Joshua under an arrangement that allows you to use his house.

Example 5. You rent an apartment to your mother at less than a fair rental price. You are using the apartment for personal purposes on the days that your mother rents it because you rent it for less than a fair rental price.

Days used for repairs and maintenance. Any day that you spend working substantially full-time repairing and maintaining (not improving) your property is not counted as a day of personal use. Do not count such a day as a day of personal use even if family members use the property for recreational purposes on the same day.

Days used as a main home before or after renting. For purposes of determining whether a dwelling unit was used as a home, you may not have to count days you used the property as your main home before or after renting it or offering it for rent as days of personal use. Do not count them as days of personal use if:

You rented or tried to rent the property for 12 or more consecutive months.
You rented or tried to rent the property for a period of less than 12 consecutive months and the period ended because you sold or exchanged the property.

However, this special rule does not apply when dividing expenses between rental and personal use.

Examples. The following examples show how to determine whether you used your rental property as a home.

Example 1. You converted the basement of your home into an apartment with a bedroom, a bathroom, and a small kitchen. You rented the basement apartment at a fair rental price to college students during the regular school year. You rented to them on a 9-month lease (273 days). You figured 10% of the total days rented to others at a fair rental price is 27 days.

During June (30 days), your brothers stayed with you and lived in the basement apartment rent free.

Your basement apartment was used as a home because you used it for personal purposes for 30 days. Rent-free use by your brothers is considered personal use. Your personal use (30 days) is more than the greater of 14 days or 10% of the total days it was rented (27 days).

Example 2. You rented the guest bedroom in your home at a fair rental price during the local college’s homecoming, commencement, and football weekends (a total of 27 days). Your sister-in-law stayed in the room, rent free, for the last 3 weeks (21 days) in July. You figured 10% of the total days rented to others at a fair rental price is 3 days.

The room was used as a home because you used it for personal purposes for 21 days. That is more than the greater of 14 days or 10% of the 27 days it was rented (3 days).

Example 3. You own a condominium apartment in a resort area. You rented it at a fair rental price for a total of 170 days during the year. For 12 of those days, the tenant was not able to use the apartment and allowed you to use it even though you did not refund any of the rent. Your family actually used the apartment for 10 of those days. Therefore, the apartment is treated as having been rented for 160 (170 − 10) days. You figured 10% of the total days rented to others at a fair rental price is 16 days. Your family also used the apartment for 7 other days during the year.

You used the apartment as a home because you used it for personal purposes for 17 days. That is more than the greater of 14 days or 10% of the 160 days it was rented (16 days).

Minimal rental use. If you use the dwelling unit as a home and you rent it less than 15 days during the year, that period is not treated as rental activity. See Used as a home but rented less than 15 days, later, for more information.

Limit on deductions. Renting a dwelling unit that is considered a home is not a passive activity. Instead, if your rental expenses are more than your rental income, some or all of the excess expenses cannot be used to offset income from other sources. The excess expenses that cannot be used to offset income from other sources are carried forward to the next year and treated as rental expenses for the same property. Any expenses carried forward to the next year will be subject to any limits that apply for that year. This limitation will apply to expenses carried forward to another year even if you do not use the property as your home for that subsequent year.

To figure your deductible rental expenses for this year and any carryover to next year, use Worksheet 9-1.

**Worksheet 9-1.** Worksheet for Figuring Rental Deductions for a Dwelling Unit Used as a Home

Reporting Income and Deductions

Property not used for personal purposes. If you do not use a dwelling unit for personal purposes, see How To Report Rental Income and Expenses, later, for how to report your rental income and expenses.

Property used for personal purposes. If you do use a dwelling unit for personal purposes, then how you report your rental income and expenses depends on whether you used the dwelling unit as a home.

Not used as a home. If you use a dwelling unit for personal purposes, but not as a home, report all the rental income in your income. Since you used the dwelling unit for personal purposes, you must divide your expenses between the rental use and the personal use as described earlier in Dividing Expenses. The expenses for personal use are not deductible as rental expenses.

Your deductible rental expenses can be more than your gross rental income; however, see Limits on Rental Losses, later.

Used as a home but rented less than 15 days. If you use a dwelling unit as a home and you rent it less than 15 days during the year, its primary function is not considered to be rental and it should not be reported on Schedule E (Form 1040). You are not required to report the rental income and rental expenses from this activity. The expenses, including qualified mortgage interest, property taxes, and any qualified casualty loss will be reported as normally allowed on Schedule A (Form 1040). See the Instructions for Schedule A (Form 1040) for more information on deducting these expenses.

Used as a home and rented 15 days or more. If you use a dwelling unit as a home and rent it 15 days or more during the year, include all your rental income in your income. Since you used the dwelling unit for personal purposes, you must divide your expenses between the rental use and the personal use as described earlier in Dividing Expenses. The expenses for personal use are not deductible as rental expenses.

If you had a net profit from renting the dwelling unit for the year (that is, if your rental income is more than the total of your rental expenses, including depreciation), deduct all of your rental expenses. You do not need to use Worksheet 9-1.

However, if you had a net loss from renting the dwelling unit for the year, your deduction for certain rental expenses is limited. To figure your deductible rental expenses and any carryover to next year, use Worksheet 9-1.

EXPLANATION

The IRS explanation on reporting income and deductions for property used for personal purposes is correct as far as it goes. However, four areas require clarification:

The starting point in determining your rental income is gross rental income, which is defined by the IRS as the gross rent received less expenses incurred to obtain tenants, such as advertising and real estate agents’ fees. This definition is important because it enables you to deduct this type of expense before taking deductions for interest, taxes, and casualty losses, which might be enough to reduce your rental income to zero. The result may be a larger total deduction. The key point is: Start with gross rent received, deduct your expenses to obtain tenants, and then proceed through the deduction process described earlier.
The total amount of a casualty or theft loss allocated to the rental period is deductible. Ordinarily, a personal casualty or theft loss is deductible only to the extent that it is more than $100 and more than 10% of your adjusted gross income, but this is not the case when you are dealing with rental property. Your loss in this case would not be subject to the $100 or 10% floor limitation. (See chapter 26, Casualty and theft losses, for further details.)
Your basis in the vacation home or other dwelling unit is reduced only by the amount of depreciation actually allowed as a deduction, not by the amount of depreciation allocated to the rental period. This, in effect, decreases any gain you have to recognize if you subsequently sell the property. For more details on sales of depreciable assets, see Depreciation, later in this chapter.
Although the deductions for operating expenses and depreciation may not reduce income below zero, the deductions for interest and real estate taxes may.

TAXSAVER

When you personally use a dwelling unit for more than 14 days or more than 10% of the number of days it is rented at fair market value, it is generally to your advantage to use the Tax Court formula, described earlier in Dividing Expenses, for computing the amount of interest and taxes allocable to the rental period. Doing so usually allows you a greater total deduction, because interest, taxes, and casualty losses may be deducted on Schedule A, even if they are disallowed on Schedule E.

However, when your personal use of the dwelling is less than both 15 days and 10% of the number of days it is rented at fair market value, it is to your advantage to use the IRS method of allocating interest and taxes, described earlier in Dividing Expenses, because the net loss on the rental property will be allowed if your personal use is not substantial. (This assumes that the passive loss rules will not limit your net loss.) In this case, the IRS method does not reduce your total deduction; instead, it decreases your rental income (or increases your rental loss) and hence decreases your adjusted gross income.

Decreasing your adjusted gross income can be important, for the following reasons:

The amounts of certain itemized deductions, such as medical expenses, casualty losses, and most miscellaneous itemized deductions, are determined by reference to your adjusted gross income. Decreasing your adjusted gross income potentially increases your itemized deductions for these items.
Many states use adjusted gross income as the starting point in computing state taxable income. Using the IRS method may reduce your state tax liability.
If you are subject to alternative minimum tax, this method will reduce your alternative minimum taxable income.
A reduction in adjusted gross income may reduce the taxable amount of social security payments.
If you are a participant in a qualified pension plan, a decrease in your adjusted gross income may allow you to deduct contributions to an IRA.

Tangible Property Regulations

Depreciation

You recover the cost of income-producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of the cost each year on your tax return.

Three factors determine how much depreciation you can deduct each year: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures, and equipment, as an expense.

You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

You may have to use Form 4562 to figure and report your depreciation. See How To Report Rental Income and Expenses, later.

Alternative minimum tax (AMT). If you use accelerated depreciation, you may be subject to the AMT. Accelerated depreciation allows you to deduct more depreciation earlier in the recovery period than you could deduct using a straight-line method (same deduction each year).

Claiming the correct amount of depreciation. You should claim the correct amount of depreciation each tax year. If you did not claim all the depreciation you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted.

If you deducted an incorrect amount of depreciation for property in any year, you may be able to make a correction by filing Form 1040X, Amended U.S. Individual Income Tax Return. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Claiming the correct amount of depreciation in chapter 2 of Pub. 527 for more information.

Changing your accounting method to deduct unclaimed depreciation. To change your accounting method, you generally must file Form 3115, Application for Change in Accounting Method, to get the consent of the IRS. In some instances, that consent is automatic. For more information, see chapter 1 of Pub. 946.

Land. You cannot depreciate the cost of land because land generally does not wear out, become obsolete, or get used up. The costs of clearing, grading, planting, and landscaping are usually all part of the cost of land and cannot be depreciated.

More information. See Pub. 527 for more information about depreciating rental property and see Pub. 946 for more information about depreciation.

EXPLANATION

Depreciation may perhaps be best understood as a way of deducting the cost of an expenditure over many years. Depreciation is calculated in the same way whether you report income on the cash or the accrual method.

The period of time over which you depreciate your property has long been the subject of controversy. Different taxpayers, often in the same business, have depreciated the same type of property over widely different periods. Efforts to bring more uniformity to the write-off period resulted in the introduction of the Accelerated Cost Recovery System (ACRS). ACRS was replaced with MACRS (Modified ACRS) by the Tax Reform Act of 1986. Most tangible personal property can be depreciated. Artwork is an exception. It cannot be depreciated because no useful life can be established.

Under current law, leasehold improvements must be depreciated under MACRS. While MACRS generally requires you to depreciate an addition or improvement to nonresidential real property placed in service after May 12, 1993, over a 39-year period using the straight-line method, a 2004 tax provision allows qualified leasehold improvements placed in service after October 22, 2004, to be depreciated using the straight-line method over a 15-year recovery period.

Qualified improvements are any improvements to an interior portion of a building that is non-residential real property provided:

The improvement is made under a lease either by the lessee (or sub-lessee), or by the lessor, of that portion of the building to be occupied exclusively by the lessee (or sub-lessee);
The improvement is placed in service more than 3 years after the date the building was first placed in service; and
The improvement is not attributable to the enlargement of the building, any elevator or escalator, any structural component benefiting a common area, or the internal structural framework of the building.

TAXSAVER

Expensing certain assets (Section 179 deduction). You can elect to deduct all or part of the cost, up to specified limits, of certain qualifying property, including qualified leasehold improvements, in the year in which the property is purchased, rather than capitalizing the cost and depreciating it over its life. This means that you can deduct all or part of the cost up front in one year rather than take depreciation deductions spread out over many years. You must decide for each item of qualifying property whether to deduct, subject to the yearly limit, or capitalize and depreciate its cost.

Qualifying property is property purchased for use in your trade or business and property that would have qualified for the investment tax credit. Starting in 2016, investments in air conditioning and heating units are also treated as qualifying property.

Specified limits. The maximum Section 179 deduction available for qualifying property placed into service during 2017 is $510,000. The allowable deduction is reduced dollar for dollar once the cost of qualifying property placed into service during 2017 exceeds $2,030,000. These amounts are indexed annually for inflation.

Basis of qualifying property. The amount you elect to deduct is subtracted from the basis of the qualifying property. If you elect the Section 179 deduction, the amount of your allowable ACRS or MACRS deduction for this property will be reduced. If you and your spouse file separate returns in 2017, you can each deduct only $255,000, unless you and your spouse agree on a different split of the $510,000.

Other restrictions. The amount of the Section 179 deduction cannot be greater than the income derived from the active conduct by the taxpayer of any business during such taxable year (computed without regard to the property to be expensed). This rule prevents you from generating or adding to a net operating loss due to the Section 179 expense. Any Section 179 deductions disallowed under this income limitation are carried forward to the succeeding taxable year and added to the allowable amount for such year. Therefore, in the following year, you are eligible to receive the deduction ($510,000 in 2017) plus the carryover from the preceding year, limited to the amount of income.

Cost. The cost of property for the Section 179 deduction does not include any part of the basis of the property that is determined by reference to the basis of other property held at any time by the person acquiring this property. For example, if you buy a new truck to use in your business, your cost for purposes of the Section 179 deduction does not include the adjusted basis of the truck you trade in on the new vehicle.

Example. You buy a new piece of equipment, paying $2,500 cash and trading in your old equipment, which had an undepreciated cost to you of $4,000. Even though the new equipment has a tax basis to you of $6,500, you may claim the Section 179 deduction only on the $2,500 you paid out.

When to elect. You must make an election to take the Section 179 deduction, which can only be made in the first tax year in which the property is placed in service.

If you elect to deduct the cost of qualifying property, you must specify the items to which the election applies and the part of the cost of each you elect to deduct. If in 2017 you purchase and place in service two items of qualifying property, costing $360,000 and $250,000, and you want to elect the $510,000 deduction, you must specify what part of the $350,000 property and the $250,000 property you want to deduct. You may arbitrarily allocate the maximum $510,000 between the two properties. Your remaining basis of $100,000 ($610,000 total cost of property placed in service, less $510,000 maximum Section 179 expense) may be depreciated.

Use Form 4562, Depreciation and Amortization, to make the election and report the Section 179 deduction. The election is made by taking the deduction on Form 4562, filed with your original tax return. The election can be made on an amended tax return filed after the due date (including extensions), and can be revoked as long as the statute of limitations for the return is still open. Consult your tax advisor regarding the Section 179 rules.

TAXPLANNER

Gain from disposition. If you dispose of depreciable property at a gain, you may have to report, as ordinary income, all or part of the gain. See Publication 544, Sales and Other Dispositions of Assets.

When you sell an asset for more than your unrecovered cost, you face the problem of depreciation recapture, that is, reporting all or part of your gain as ordinary income as opposed to capital gain. If you sell tangible personal property at a gain, your recapture is the lower of your gain or the previous amount of depreciation.

Example

1)	Cost	$1,000	$1,000
2)	Depreciation previously claimed	(600)	(600)
3)	Unrecovered cost (adjusted basis)	$ 400	$ 400
4)	Selling price	$ 900	$1,200
5)	Gain on sale (4 minus 3)	$ 500	$ 800
6)	Recapture ordinary income (lower of 2 or 5)	(500)	(600)
7)	Possible capital gain (5 minus 6)	$ -0-	$ 200

Note that the recapture rules generally do not apply to real property if straight-line depreciation was used.

However, a 25% capital gains tax rate, as opposed to the more favorable 0%, 15%, or 20% capital gains tax rates that generally apply to long-term capital gains (see chapter 16, Reporting gains and losses, for more information) may apply to depreciation recapture on real property.

Limits on Rental Losses

If you have a loss from your rental real estate activity, two sets of rules may limit the amount of loss you can deduct. You must consider these rules in the order shown below.

At-risk rules. These rules are applied first if there is investment in your rental real estate activity for which you are not at risk. This applies only if the real property was placed in service after 1986.
Passive activity limits. Generally, rental real estate activities are considered passive activities and losses are not deductible unless you have income from other passive activities to offset them. However, there are exceptions.

At-Risk Rules

You may be subject to the at-risk rules if you have:

A loss from an activity carried on as a trade or business or for the production of income, and
Amounts invested in the activity for which you are not fully at risk.

Losses from holding real property (other than mineral property) placed in service before 1987 are not subject to the at-risk rules.

In most cases, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year. You are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity. See Pub. 925 for more information.

Passive Activity Limits

In most cases, all rental real estate activities (except those of certain real estate professionals, discussed later) are passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services.

Limits on passive activity deductions and credits. Deductions or losses from passive activities are limited. You generally cannot offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities. Any excess loss or credit is carried forward to the next tax year.

For a detailed discussion of these rules, see Pub. 925.

You may have to complete Form 8582 to figure the amount of any passive activity loss for the current tax year for all activities and the amount of the passive activity loss allowed on your tax return.

Real estate professionals. Rental activities in which you materially participated during the year are not passive activities if, for that year, you were a real estate professional. For a detailed discussion of the requirements, see Pub. 527. For a detailed discussion of material participation, see Pub. 925.

EXPLANATION

A rental activity is considered a passive activity unless you are considered a real estate professional. An activity is a rental activity if:

Tangible property is used by customers.
Income received is principally for the use of the property whether or not there is a lease, service contract, or other arrangement.

An activity is not considered a rental activity if:

The average time the customer uses the property is 7 days or less.
The average time the customer uses the property is 30 days or less and personal services have been provided by the owner in connection with the rental.
Extraordinary personal services are provided by the owner in connection with the rental.
The rental of the activity is incidental to the nonrental.
You customarily make the rental property available during defined business hours for nonexclusive use by various customers.
The property is associated with a partnership, S corporation, or joint venture.

Example

Amy owns a time-share condo and rents it to a third party for a week each year. Amy paid for no additional services except for weekly cleaning of the unit through condominium dues. This property is not considered a rental activity.

Exception for Personal Use of Dwelling Unit

If you used the rental property as a home during the year, any income, deductions, gain, or loss allocable to such use shall not be taken into account for purposes of the passive activity loss limitation. Instead, follow the rules explained in Personal Use of Dwelling Unit (Including Vacation Home), earlier.

Exception for Rental Real Estate Activities With Active Participation

If you or your spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you may be able to offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

Active participation. You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions or arranged for others to provide services (such as repairs) in a significant and bona fide sense. Management decisions that may count as active participation include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

Maximum special allowance. The maximum special allowance is:

$25,000 for single individuals and married individuals filing a joint return for the tax year,
$12,500 for married individuals who file separate returns for the tax year and lived apart from their spouses at all times during the tax year, and
$25,000 for a qualifying estate reduced by the special allowance for which the surviving spouse qualified.

If your modified adjusted gross income (MAGI) is $100,000 or less ($50,000 or less if married filing separately), you can deduct your loss up to the amount specified above. If your MAGI is more than $100,000 (more than $50,000 if married filing separately), your special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately) and your MAGI.

Generally, if your MAGI is $150,000 or more ($75,000 or more if you are married filing separately), there is no special allowance.

More information. See Pub. 925 for more information on the passive loss limits, including information on the treatment of unused disallowed passive losses and credits and the treatment of gains and losses realized on the disposition of a passive activity.

TAXSAVER

If you rent out your personal residence with the intention of returning to it (say, for example, you are transferred overseas for several years), the mortgage interest on the property may not be subject to the passive loss limitation rules. This can result in significant tax savings.

Example

Rental of a dwelling unit
Rent income	$15,000
Mortgage interest	(7,000)
Real estate tax	(3,000)
Other expenses	(1,000)
Depreciation	(9,000)
Net loss subject to passive loss rules	($5,000)

This loss may be deductible on your tax return, under the active participation $25,000 limitation mentioned earlier.

Rental of a personal residence with intention of returning
Rent income	$15,000
Real estate tax	(3,000)
Other expenses	(1,000)
Depreciation	(9,000)
Net rental (passive) income	$2,000
Mortgage interest (loss not subject to passive loss rules)	(7,000)
Net loss from property allowed on tax return	($5,000)

Of this loss, $7,000 (the portion representing qualified residence mortgage interest) may be deductible against nonpassive income. In addition, the $2,000 net passive income may offset passive losses from other passive activities.

Be aware that the depreciation deduction reduces the cost basis of your property, thereby increasing the gain upon sale of the property.

Explanation

You must meet the active participation standards both in the year in which the loss arose and in the year in which the loss is allowed. Losses that exceed $25,000 carried over from an active participation year can be used in a later year if the taxpayer continues to actively participate.

The $25,000 offset rule does not apply to the losses carried over from prior years where the taxpayer did not actively participate in the rental.

TAXALERT

A tax-saving opportunity exists depending on how personal property and real property are grouped. In general, a taxpayer may not treat as a single activity the rental of real property and the rental of personal property (other than personal property provided in connection with real property). Furthermore, taxpayers may treat as a single activity the rental of real property provided in connection with the rental of personal property.

Example

An individual who leases $10,000 of real property (e.g., a small structure or other fixture) in connection with renting $150,000 of computer equipment could treat as one activity the rental of both the real property and the personal property.

To make an election to treat all real property as a single activity, a taxpayer must file a statement with his or her original tax return for the tax year the taxpayer is making the election.

How To Report Rental Income and Expenses

The basic form for reporting residential rental income and expenses is Schedule E (Form 1040). However, do not use that schedule to report a not-for-profit activity. See Not Rented for Profit, earlier.

Providing substantial services. If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, report your rental income and expenses on Schedule C (Form 1040), Profit or Loss From Business, or Schedule C-EZ (Form 1040), Net Profit From Business (Sole Proprietorship). Substantial services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc. For information, see Pub. 334, Tax Guide for Small Business. You also may have to pay self-employment tax on your rental income using Schedule SE (Form 1040), Self-Employment Tax.

Use Form 1065, U.S. Return of Partnership Income, if your rental activity is a partnership (including a partnership with your spouse unless it is a qualified joint venture).

Qualified joint venture. If you and your spouse each materially participate as the only members of a jointly owned and operated real estate business, and you file a joint return for the tax year, you can make a joint election to be treated as a qualified joint venture instead of a partnership. This election, in most cases, will not increase the total tax owed on the joint return, but it does give each of you credit for social security earnings on which retirement benefits are based and for Medicare coverage if your rental income is subject to self-employment tax. For more information, see Pub. 527.

Form 1098, Mortgage Interest Statement. If you paid $600 or more of mortgage interest on your rental property to any one person, you should receive a Form 1098, or similar statement showing the interest you paid for the year. If you and at least one other person (other than your spouse if you file a joint return) were liable for, and paid interest, on the mortgage, and the other person received the Form 1098, report your share of the interest on Schedule E (Form 1040), line 13. Attach a statement to your return showing the name and address of the other person. See the instructions for Schedule E (Form 1040) for more information.

Interest expense. You can deduct mortgage interest you pay on your rental property. When you refinance a rental property for more than the previous outstanding balance, the portion of the interest allocable to loan proceeds not related to rental use generally cannot be deducted as a rental expense. Chapter 4 of Pub. 535 explains mortgage interest in detail.

Expenses paid to obtain a mortgage. Certain expenses you pay to obtain a mortgage on your rental property cannot be deducted as interest. These expenses, which include mortgage commissions, abstract fees, and recording fees, are capital expenses that are part of your basis in the property.

Schedule E (Form 1040)

If you rent buildings, rooms, or apartments, and provide basic services such as heat and light, trash collection, etc., you normally report your rental income and expenses on Schedule E, Part I.

Page 2 of Schedule E is used to report income or loss from partnerships, S corporations, estates, trusts, and real estate mortgage investment conduits. If you need to use page 2 of Schedule E, be sure to use page 2 of the same Schedule E you used to enter your rental activity on page 1. See the instructions for Schedule E (Form 1040).

TAXORGANIZER

Records you should keep:

Rental agreement
Records of tenant-paid improvements, real estate taxes, mortgage payments, etc.
A log of how many days a property is rented, used for personal purposes, or vacant
Proof of advertising vacant properties in newspapers, magazines, websites, etc.
Lists distinguishing the nature of each repair or improvement
Receipts for each repair and improvement including date and amount paid
A log of travel expenses allocating between rental and nonrental purposes
A schedule showing method of division of expenses if part of property is rented
Schedule listing depreciable assets with respect to the rental property, including amount, date purchased, life of asset, method of depreciation, and depreciation already taken
Carry forward of passive activity losses not utilized in prior years
Carry forward of rental losses in excess of $25,000 when actively participating in rental activity
Form 1098, Mortgage Interest Statement, or other form indicating mortgage interest paid
Property tax forms and receipts
Proof of tax preparation fees paid in relation to rental property
Security deposit information

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Table of Contents for Chapter 9: Rental income and expenses

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Introduction

Useful Items

Rental Income

Rental Expenses

Repairs and Improvements

Other Expenses

Property Changed To Rental Use

Renting Part of Property

Not Rented for Profit

Personal Use of Dwelling Unit (Including Vacation Home)

Dividing Expenses

Dwelling Unit Used as a Home

Reporting Income and Deductions

Tangible Property Regulations

Depreciation

Limits on Rental Losses

At-Risk Rules

Passive Activity Limits

Exception for Personal Use of Dwelling Unit

Exception for Rental Real Estate Activities With Active Participation

How To Report Rental Income and Expenses

Schedule E (Form 1040)

Table of Contents for
Chapter 9: Rental income and expenses