9.9 Allocating Expenses of a Residence to Rental Days

When you rent out your home or other dwelling unit (9.7) for part of the year at fair market value and also use it personally on some days during the taxable year, expenses are allocated between personal and rental use. By law, deductible rental expenses are limited by this fraction:

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The days a unit is held out for rent but not actually rented are not counted as rental days. Any day for which the unit is rented at a fair rental price is counted as a rental day for allocation purposes even if in fact you use it for personal purposes on that day.

Mortgage interest and real estate taxes.

There is a conflict of opinion between the IRS and some courts over the issue of whether the above fractional formula applies also to interest and taxes. According to the IRS, it does. According to the Tax Court and two federal appeals courts, interest and taxes are allocated on a daily basis. Thus, if a house is rented for 61 days in 2012, 16.67% (61/366) of the deductible interest and taxes is deducted first from the rental income. This rule allows a larger amount of other expenses to be deducted from rental income than is allowed under the IRS application of the formula; see Example 2 below.

Claiming expenses on Schedule E if personal use limits a loss deduction.

If your personal use of a residence exceeds the 14-day/10% test (9.7), the residence was rented for at least 15 days during the year, and the allocable rental expenses (including depreciation) exceed rental income, you cannot deduct the net loss from other income. Some of the expenses will not be currently deductible. The allocable rental expenses are deducted from rental income in a specific order:

Step 1. The rental portion of the following expenses is fully deductible on Schedule E of Form 1040, even if the total exceeds rental income: deductible home mortgage interest (15.1), real estate taxes (16.4), deductible casualty and theft losses (Chapter 18), and directly related rental expenses. Directly related rental expenses are rental expenses not related to the use or maintenance of the residence itself, such as office supplies, rental agency fees, advertising, and depreciation on office equipment used in the rental activity.
Step 2. If there is any rental income remaining after the income is reduced by the expenses in Step 1, the balance is next offset by the rental portion of operating expenses for the residence itself, such as utilities, repairs, and insurance. Do not include depreciation on the rental part of the home in this group.
Step 3. If any rental income remains after Step 2, depreciation on the rental portion of the residence may be deducted from the balance.

Step 1 expenses, as well as the expenses from Steps 2 and 3 that offset rental income, are deducted on the applicable lines of Schedule E. Operating expenses from Step 2 and depreciation from Step 3 that exceed the balance of rental income are carried forward to the next year as rental expenses for the same property. In the next year, the carried-over expenses are deductible only to the extent of rental income from the property for that year, following Steps 1–3, whether or not your personal use of the residence exceeds the 14-day/10% test (9.7) for that carryover year.

If you itemize deductions, you claim the personal-use portion of deductible mortgage interest, real estate taxes, and casualty and theft losses on Schedule A of Form 1040.

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image Filing Tip
Carryover of Disallowed Expenses
If your deductions for operating expenses and depreciation are limited by the personal-use rules, the disallowed amounts may be carried over to the following year.
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Interest expenses.

If you personally use a rental vacation home for more than the greater of 14 days or 10% of the fair market rental days (9.7), the residence may be treated as a qualifying second residence under the mortgage interest rules (15.1). The interest on a qualifying second home is generally fully deductible and is not subject to disallowance under the passive activity restrictions in Chapter 10. As shown in Step 1 above, the portion of the deductible mortgage interest allocable to the rental portion is deducted from rental income (along with taxes) before other expenses.

EXAMPLES
1. You rent out your vacation home for June and July of 2012 (61 days), receiving rent of $2,000. You also use the home yourself for 61 days during the year. You may deduct expenses only up to the amount of rental income because your personal use exceeds the 14-day/10% rental test (9.7). Your expenses are mortgage interest of $1,600, real estate taxes of $800, and maintenance and utility costs of $1,200. Depreciation (based on 100% rental use) is $1,500. Assume the vacation home is a qualifying second home (15.1), so that all the interest is deductible under the mortgage interest rules. Under the IRS method, one-half of all the expenses (61 rental days divided by 122 total days of use), including the interest and taxes, are deducted on Schedule E in this order:
Rent income $ 2,000
   Less: Interest (½ of $1,600) $ 800
Taxes (½ of $800)    400    1,200
   $ 800
   Less: Maintenance (½ of $1,200)       600
   Less: Depreciation (½ of $1,500, or $750)    $ 200
limited to $200 balance of rental income)    $ 200
Under the Tax Court’s method of allocating interest and taxes,16.71% (61/365) of the interest and taxes would be deducted from rental income, rather than one-half as under the IRS method. The balance of interest and taxes is deductible as itemized deductions provided you claim itemized deductions on Schedule A of Form 1040.
Depreciation not deductible because of the rental income limitation may be carried forward to the following year.
If the vacation home were not a qualifying second residence as discussed in 15.1, the interest would not be deducted with taxes from the $2,000 of rental income, but would be treated as an operating expense and deducted along with the maintenance expenses.
2. The Boltons paid interest and property taxes totaling $3,475 on their vacation home. Maintenance expenses (not including depreciation) totaled $2,693. The Boltons stayed at the home 30 days and rented it for 91 days, receiving rents of $2,700. Because the personal use for 30 days exceeded the 14-day limit, the Boltons could deduct rental expenses only up to the gross rental income of $2,700, reduced by interest and taxes allocable to rental. In figuring the amount of interest and taxes deductible from rents, they divided the number of rental days, or 91, by 365, the number of days in the year. This gave them an allocation of 25%. After subtracting $869 for interest and taxes (25% of $3,475) from rental income, they deducted $1,831 ($2,700 − $869) of maintenance expenses from rental income.
The IRS argued that 75% of the Boltons’ interest and tax payments had to be allocated to the rental income. The IRS used an allocation base of 121 days of personal and rental use. Thus, the IRS allocated 75% (91/121) of the interest and taxes, or $2,606, to gross rental income of $2,700. This allocation allowed only $94 maintenance expenses to be deducted ($2,700 − $2,606).
The Tax Court sided with the Boltons and an appeals court (the Ninth Circuit) agreed. The IRS method of allocating interest and taxes to rental use is bizarre. Interest and taxes are expenses that accrue ratably over the year and are deductible even if a vacation home is not rented for a single day. Thus, the allocation to rental use should be based on a ratable portion of the annual expense by dividing the number of rental days by the number of days in a year.
The Tenth Circuit appeals court also supports the Tax Court allocation method.
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image Court Decision
Allocation of Taxes and Interest
The IRS position on allocating mortgage interest and real estate taxes to rental income is not as favorable as the position adopted by the Tax Court and several appeals courts.
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