Chapter 9
Income From Real Estate Rentals and Royalties

Use Schedule E of Form 1040 to report real estate rental income and expenses. You must also file Form 4562 with your 2017 return to claim depreciation deductions for buildings you placed in service during the year.

Use Schedule C instead of Schedule E if you provide substantial services for the convenience of the tenants, such as maid service. That is, Schedule C is used to report payments received for the use and occupancy of rooms or other areas in a hotel, motel, boarding house, apartment, tourist home, or trailer court where services are provided primarily for the occupant.

If you rent out an apartment or room in the same building in which you live, you report the rent income less expenses allocated to the rental property (9.4).

The law prevents most homeowners from deducting losses (expenses in excess of income) on the rental of a personal vacation home or personal residence if the owner or close relatives personally use the premises during the year. Tests based on days of personal and rental use determine whether you may deduct losses (9.7).

Rental losses may also be limited by the passive activity rules discussed in Chapter 10. Real estate professionals may avoid the passive restrictions on rental income. An investor who actively manages property may deduct rental losses of up to $25,000 under an exception to the passive activity loss restrictions.

Use Schedule E to report royalties, but if you are a self-employed author, artist, or inventor, report royalty income and expenses on Schedule C.

Business rentals of equipment, vehicles, or similar personal property are reported on Schedule C, not Schedule E.

9.1 Reporting Rental Real Estate Income and Expenses

On the cash basis, you report rent income on your tax return for the year in which you receive payment or in which you “constructively” receive it, such as where payment is credited to your bank account.

On the accrual basis, you report income on your tax return for the year in which you are entitled to receive payment, even if it is not actually paid. However, you do not report accrued income if the financial condition of the tenant makes collection doubtful. If you sue for payment, you do not report income until you win a collectible judgment.

Schedule E reporting. Use Schedule E (Form 1040) to report rental real estate income and expenses unless you are providing substantial services for tenants that go beyond the provision of utilities, trash collection, and cleaning of public areas. For example, if you operate a hotel or motel, and provide cleaning services such as maid service and changing linens, you should use Schedule C (Profit or Loss from Business (40.6)) rather than Schedule E.

Advance rentals. Advance rentals or bonuses are reported in the year received, whether you are on the cash or accrual basis.

Tenant’s payment of landlord’s expenses. The tenant’s payment of your taxes, interest, insurance, mortgage amortization (even if you are not personally liable on the mortgage), repairs, or other expenses is considered additional rental income to you. If your tenant pays your utility bills or your emergency repairs and deducts the amount from the rent payment, you must include as rental income the full rental amount, not the actual net payment. However, you can claim an offsetting deduction for expenses, such as repairs, that would have been deductible had you paid them.

Tenant’s payment to cancel lease. A tenant’s payment for canceling a lease or modifying its terms is considered rental income in the year you receive it regardless of your method of accounting. You may deduct expenses incurred because of the cancellation or modification and any unamortized balance of expenses paid in negotiating the lease.

Insurance. Insurance proceeds for loss of rental income because of fire or other casualty are rental income.

Improvements by tenants. You do not realize taxable income when your tenant improves the leased premises, provided the improvements are not substitute rent payments. Furthermore, when you take possession of the improvements at the time the lease ends, you do not realize income. However, you may not depreciate the value of the improvements as the basis to you is considered zero.

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

If you agree upon a specified price for services rendered, that price is generally treated as the fair market value.

Rental losses. Rental income may be offset by deductions claimed for depreciation, mortgage interest, and repair and maintenance costs. However, if these expenses exceed rental income, the resulting loss is subject to the passive activity loss restrictions. If you do not qualify as a real estate professional (10.3), you generally may not deduct rental losses from other income (nonpassive income such as salary, interest, and dividends) under the passive loss rules. Rental losses may offset only other rental and passive activity income; excess losses are carried forward to later years until there is passive income to offset or the property is disposed of (10.13). However, if you perform some management role, you may deduct from other income real estate rental losses of up to $25,000, provided your adjusted gross income does not exceed $100,000 (10.2). These restrictions on passive losses make rental income attractive, since the rental income can be offset by the passive losses. See Chapter 10 for details on the passive loss restrictions.

Application of the passive activity loss rules and exceptions assumes that the property is not considered a residence under the personal-use rules (9.7). If a rented property is treated as a residence, rental expenses are deductible from rental income (9.9) but a loss is not allowed for that property.

9.2 Checklist of Rental Deductions

The expenses in this section are deductible from rental income on Schedule E of Form 1040 in determining your profit.

Real estate taxes but not assessments for local improvements. Deductible real estate taxes do not include special assessments for paving, sewer systems, or other local improvements; these assessments are added to the cost of the land. However, you can deduct as real estate taxes assessments that merely maintain or repair local benefits, and which do not increase the value of your property. See 16.4 through 16.7 for details on real estate tax deductions.

Construction period interest and taxes. These expenses generally have to be capitalized and depreciated (16.4).

Depreciation of a rental building. You may start claiming depreciation in the month the building is ready for tenants. For example, you bought a house in May 2017 and spent June and July making repairs. The house was ready to rent in August and you began advertising for tenants. On your 2017 return you can begin depreciation as of August, even if a tenant did not move in until September or some later month. The month the building is ready for tenants is the month that determines the first-year depreciation write-off under the mid-month convention. See 9.5 for the monthly depreciation rates for residential rental property. Rates for nonresidential buildings are at 42.13.

Depreciation for furniture and appliances. Furniture, carpeting, and appliances such as stoves and refrigerators used in residential rental property are considered five-year property for MACRS depreciation purposes. Furniture used in office buildings is considered seven-year property. See 42.5 for MACRS rates.

Management expenses. Include fees paid to a company for collecting the rent.

Maintenance expenses. Include heating, repairs, lighting, water, electricity, gas, telephone, coal, and other service costs (9.3).

Salaries and wages. Include payments to superintendents, janitors, elevator operators, and service and maintenance personnel.

Traveling expenses to look after the properties. If you travel “away from home” to inspect or repair rental property, be prepared to show that this was the primary purpose of your trip, rather than vacationing or other personal purposes. Otherwise, the IRS may disallow deductions for round-trip travel costs.

Legal expenses for dispossessing tenants. But expenses of long-term leases are capital expenditures deductible over the term of the lease.

Interest paid on mortgages and other indebtedness. But deductible interest does not include expenses paid to obtain a mortgage such as mortgage commissions and abstract or recording fees. Such costs are capital expenses that can be amortized over the life of the mortgage. For a mortgage obtained in 2017, amortization is claimed on Part VI of Form 4562 (“Depreciation and Amortization”) and amortization for expenses of pre-2017 mortgages is claimed on Schedule E as an “Other expense.”

Commissions paid to collect rentals. But commissions paid to secure long-term rentals must be deducted over the life of the lease. Commissions paid to acquire the property are capitalized as an addition to basis.

Premiums for fire, liability, and plate glass insurance. If payment is made in one year for insurance covering a period longer than one year, you amortize and deduct the premium over the life of the policy, even though you are on a cash basis.

Tax return preparation. You may deduct as a rental expense the part of a tax preparation fee allocable to Part 1 of Schedule E (income or loss from rentals or royalties). You may also deduct, as a rental expense, a fee paid to a tax consultant to resolve a tax underpayment related to your rental activities.

Charging below fair market rent. If you rent your property to a friend or relative for less than the fair rental value, you may deduct expenses and depreciation only to the extent of the rental income (9.8).

Co-tenants. One of two tenants-in-common may deduct only half of the maintenance expenses even if he or she pays the entire bill. A tenant-in-common who pays all of the maintenance expenses of the common property is entitled to reimbursement from the other co-tenant, so one-half of the bill is not his or her ordinary and necessary expense. Each co-tenant owns a separate property interest in the common property that produces separate income for each. Each tenant’s deductible expense is that portion of the entire expense that each separate interest bears to the whole, and no more.

As noted in the Court Decision in this section, a different rule may apply to a co-tenant’s payment of real estate taxes (or mortgage interest).

Costs of canceling lease. A landlord may pay a tenant to cancel an unfavorable lease. The way the landlord treats the payment depends on the reason for the cancellation. If the purpose of the cancellation is to enable the landlord to construct a new building in place of the old, the cancellation payment is added to the basis of the new building. If the purpose is to sell the property, the payment is added to the cost of the property. If the landlord wants the premises for his or her own use, the payment is deducted over the remaining term of the old lease. If the landlord gets a new tenant to replace the old one, the cancellation payment is also generally deductible over the remaining term of the old lease.

9.3 Distinguishing Between a Repair and an Improvement

Maintenance and repair expenses are not treated in the same way as expenses for improvements and replacements. Only maintenance and incidental repair costs are deductible against rental income. Improvements that add to the value or prolong the life of the property or adapt it to new uses are capital improvements. Capital improvements may not be deducted currently but may be depreciated (42.12). If you make improvements to property before renting it out, add the cost of the improvements to your basis in the property. A safe harbor under final IRS regulations (see below) may allow you to claim a current deduction for an expense that would otherwise have to be treated as an improvement.

A repair keeps your property in good operating condition. For example, repairs include painting, fixing gutters or floors, fixing leaks, plastering, and replacing broken windows. However, putting a recreation room in an unfinished basement, paneling a den, putting up a fence, putting in new plumbing or wiring, and paving a driveway are all examples of depreciable capital improvements (42.12). Putting on a new roof is generally a depreciable capital improvement; however, the Tax Court has allowed current deductions for roof replacements intended to prevent leaks; see Example 2 below.

Repairs may not be separated from capital expenditures when both are part of an improvement program; see Example 3 below.

IRS regulations distinguish repairs from improvements. Under final IRS regulations, an expense that results in the betterment, restoration, or adaptation to a new and different use of property is treated as an improvement that must be capitalized (and depreciated) unless a special safe harbor (see below) allows a current deduction. For example, the regulations affirm the long-held IRS position that replacing a roof is a restoration that is treated as an improvement to the building structure and as such it must be capitalized. An example of a betterment is the installation of bolts to a building located in an earthquake prone area to add structural support and resistance to seismic forces. An example of an adaptation is making modifications to a manufacturing building so it can be used as a showroom.

The regulations also identify specific building systems, called “units of property” or UOPs, and require that an improvement to a particular UOP must be depreciated rather than deducted currently. These UOPs include the HVAC (heating, ventilation, air conditioning), plumbing, electrical, fire protection, security and gas distribution systems.

Safe harbors under the IRS regulations. The final regulations provide safe harbors that may allow a current deduction. There are three safe harbors: a de minimis safe harbor, a safe harbor for small taxpayers, and a safe harbor for routine maintenance. To the extent that a safe harbor applies, a current deduction is allowed, although the expense might otherwise be considered a depreciable improvement. The de minimis safe harbor and small taxpayer safe harbor are annual elections made on a statement attached to your return; they are not a change in accounting method.

1. De minimis safe harbor. This safe harbor allows you to deduct amounts up to $2,500 per item or invoice. Thus, a low-cost purchase (such as a small appliance or window replacement) is fully deductible if it costs $2,500 or less. To elect the de minimis safe harbor, the IRS requires that you attach a statement to your return and you must apply the safe harbor to all items purchased during the year that are within the $2,500 limit.

   There is also a $5,000 de minimis safe harbor (per item or invoice), but this applies only to taxpayers that have an applicable financial statement (AFS), which generally applies to companies required to file financial statements with the SEC or obtain certified audited financial statements.

2. Safe harbor for small taxpayers. This safe harbor allows small taxpayers (average annual gross receipts of no more than $10 million in the three prior years) to elect an overall exemption from the capitalization rules for repairs, maintenance, and improvements, but the benefit is limited. The safe harbor applies separately to each building you own, but only buildings with an unadjusted basis of up to $1 million qualify. For each such building, the safe harbor allows a current deduction only if your expenses do not exceed the lesser of $10,000 or 2% of the unadjusted basis of the building. This limit applies to the total expenses during the year for repairs, maintenance, and improvements to that building. Thus, for a building with a $250,000 unadjusted basis, the expense limit is $5,000 (2% × $250,000).

   To the extent that the annual expenses fall within the $10,000/2% ceiling, a deduction is allowed for amounts that would otherwise be considered improvements. To claim the safe harbor, you must file an election on a timely filed original tax return for that year, including extensions. For a building owned by a partnership or S corporation, the election must be made by the entity and not by the shareholders or partners.

   If the total expenses for the year for repairs, maintenance, and improvements exceed the $10,000/2% limit, the safe harbor is not allowed for any of the expenses, and the general rules for determining whether an item is a repair or an improvement apply. This means that a low-cost item may be deductible under the de minimis safe harbor, or an expense may be allowed under the routine maintenance safe harbor.

3. Safe harbor for routine maintenance. This safe harbor allows you to deduct an expense that is for keeping the property in efficient operating condition if it is reasonably expected that the expense will have to be performed more than once over a 10-year period. An IRS example of a qualifying expense is maintenance of an HVAC system at the manufacturer’s recommended schedule of once every four years, including inspection, cleaning, and repair or replacement of component parts.

9.4 Reporting Rents From a Multi-Unit Residence

If you rent out an apartment or room in a multi-unit residence in which you also live, you report rent receipts and deduct expenses allocated to the rented part of the property on Schedule E of Form 1040 whether or not you itemize deductions. You deduct interest and taxes on your personal share of the property as itemized deductions on Schedule A of Form 1040 if you itemize deductions. If you or close relatives personally use the rented portion during the year and expenses exceed income, loss deductions may be barred under the personal-use rules (9.7).

Even if a loss is not barred by the personal-use rules (9.7), a loss shown on Schedule E is subject to the passive loss restrictions discussed in Chapter 10. The loss, if it comes within the $25,000 allowance (10.2) or the exception for real estate professionals (10.3), may be deducted from any type of income. If your only passive activity losses are rental losses of $25,000 or less from actively managed rental real estate and your modified adjusted gross income is $100,000 or less, you do not have to use Form 8582 to deduct losses under the $25,000 allowance (10.12). If you are not a qualifying real estate professional and cannot claim the allowance, the loss may be deducted only from passive activity income.

9.5Depreciation on Converting a Home to Rental Property

When you convert your residence to rental property, you may depreciate the building. You figure depreciation on the lower of:

• Fair market value of the building at the time you convert it to rental property; or
• Your adjusted basis at the time of the conversion. This is your original cost for the building, exclusive of land, plus permanent improvements and other capital costs, and minus items that represent a return of your cost, such as casualty or theft loss deductions claimed on prior tax returns.

You claim MACRS depreciation based on a 27½-year recovery period, which extends to 28 or 29 years due to the mid-month convention. The specific rate for the year of conversion is the rate for the month in which the property is ready for tenants. For example, you move out of your home in May and make some minor repairs. You advertise the house for rent in June. Depreciation starts in June because that is when the home is ready for rental, even if you do not actually obtain a tenant until a later month. Under a mid-month convention, the house is treated as placed in service during the middle of the month. This means that one-half of a full month’s depreciation is allowed for that month. In Table 9-1, the monthly depreciation rates for the year the property is placed in service and later years are shown. The table incorporates the mid-month convention.

Depreciating a rented cooperative apartment. If you rent out a co-op apartment, you may deduct your share of the total depreciation claimed by the cooperative corporation. The method for computing your share depends on whether you bought your co-op shares as part of the first offering. If you did, follow these steps: (1) Ask the co-op corporation officials for the total real estate depreciation deduction of the corporation, not counting depreciation for office space that cannot be lived in by tenant-shareholders. (2) Multiply Step 1 by the following fraction: number of your co-op shares divided by total shares outstanding. The result is your share of the co-op’s depreciation, but you may not deduct more than your adjusted basis.

The computation is more complicated if you bought your co-op shares after the first offering. You must compute your depreciable basis as follows: Increase your cost for the co-op shares by your share of the co-op’s total mortgage. Reduce this amount by your share of the value of the co-op’s land and your share of the commercial space not available for occupancy by tenant-stockholders. Your “share” of the co-op’s mortgage, land value, or commercial space is the co-op’s total amount for such items multiplied by the fraction in Step 2 above, that is, the number of your shares divided by the total shares outstanding. After computing your depreciable basis, multiply that basis by the depreciation percentage for the month your apartment is ready for rental.

Basis to use when you sell a rented residence. For purposes of figuring gain, you use adjusted basis at the time of the conversion, plus subsequent capital improvements, and minus depreciation and casualty loss deductions. For purposes of figuring loss, you use the lower of adjusted basis and fair market value at the time of the conversion, plus subsequent improvements and minus depreciation and casualty losses. You may have neither gain nor loss to report; this would happen if you figure a loss when using the above basis rule for gains and you figure a gain when using the basis rule for losses.

Depreciation on a vacant residence. If you move from your house before it is sold, you generally may not deduct depreciation on the vacant residence while it is held for sale. The IRS will not allow the deduction, and, according to the Tax Court, a deduction is possible only if you can show that you held the house expecting to make a profit on an increase in value over and above the value of the house when you moved from it. That is, you held the house for sale on the expectation of profiting on a future increase in value after abandoning the house as a residence.

9.6 Renting a Residence to a Relative

The tax law distinguishes between a rental of a unit used by a close relative as a principal residence and a rental of a unit that is not the relative’s principal residence, such as a second home or vacation home. It is easier to deduct a rental loss on the principal residence rental.

On a fair market rental of a unit used by the close relative as a principal residence, your relative’s use is not considered personal use by you that could bar a loss under the personal-use test (9.7). A relative’s use of the unit as a second or vacation home is attributed to you in applying the personal-use test (9.7), even if you receive a fair market value rent.

Close relatives who come within these rules are: brothers and sisters, half-brothers and half-sisters, spouses, parents, grandparents, children, and grandchildren.

Fair market rental is the amount a person who is not related to you would be willing to pay. The most direct way to determine fair market rental is to ask a real estate agent in your neighborhood for comparative rentals.

9.7 Personal Use and Rental of a Residence During the Year

The number of personal-use days and fair-market-rental days for your residential unit determines how you must report rental income and expenses. If you rent the property for 15 or more days and your personal use of the unit exceeds the 14 -day/10% limit described below, the unit is treated as a residence rather than rental property, and in this case, some of your rental expenses are deductible only to the extent of the rental income from the property (9.9).

Personal-use days include not only your days of personal use but may also include rental days to family members listed at 9.6 and use days under co-ownership agreements. See 9.8 for details on personal-use days.

Dwelling units subject to the 14-day/10% test. The daily-use tests apply to any “dwelling unit” you rent out that is also used as a residence during the year by yourself or other family members. A dwelling unit may be a house, apartment, condominium, cooperative, house trailer, mini motor home, boat, or similar property with basic living accommodations, including any appurtenant structure such as a garage. A dwelling unit does not include property used exclusively as a hotel, motel, inn, or similar establishment.

The hotel/motel/inn exception applies only to property that is used exclusively in such a business. The exception does not apply to the dual-use portion of a hotel, inn, or bed and breakfast. In one case, the Tax Court agreed with the IRS that the owners of a three-floor bed-and-breakfast could not claim business expense deductions for depreciation or interest on the areas that were used both in the B&B business as well as by them personally. The lobby, registration area, office, kitchen, and laundry room were used 75% of the time for the business and 25% of the time for personal purposes. Because these areas were not used solely for operating the B&B, they could not qualify for the hotel exception. The dual-use areas were treated as part of the owners’ dwelling unit for purposes of the 14-day/10% personal-use test.

14-day/10% personal-use test determines if unit is treated as a residence. A daily-use test determines whether your use of the unit during the taxable year is treated as residential use. You are considered to have used the unit as a residence if your personal-use days during the year, determined according to the rules for counting personal-use and rental days (9.8), exceeded 14 days, or, if greater, 10% of the days on which the unit was rented to others at a fair market rental price.

If the property is treated as used as a residence because your personal use exceeds the greater of 14 days or 10% of the fair market rental days, and you have a rental loss, a deduction for some of your allocable rental deductions will be limited, as the expenses are offset against rental income following a specific order; see Rule 2 below and Steps 1-3 in 9.9.

Rule 1: If your personal use does not meet the 14-day/10% test. If your personal-use days do not exceed 14 days or 10% of the fair market rental days, whichever is more, the property is treated as rental property and not property used as a residence. You report the rental income and expenses on Schedule E (Form 1040) and the rental deductions are not limited to rental income by the personal-use test. However, a loss deduction is subject to the passive activity loss restrictions (10.1). The passive loss rules generally prevent you from deducting a passive rental loss against nonpassive income, but if you are an “active participant” with modified adjusted gross income of no more than $100,000, you may deduct expenses up to $25,000 (10.2), and if you qualify as a real estate professional and materially participate (10.3), a full loss is allowed against nonpassive income.

Another consequence of not meeting the 14-day/10% personal use test is that you lose part of the mortgage interest deduction because the unit is not a qualified second home for mortgage interest purposes if personal use does not exceed the greater of 14 days or 10% of the fair market rental days. The mortgage interest allocable to the rental use (9.9) is deductible against rental income on Schedule E, but the balance is nondeductible personal interest.

Rule 2: If your personal use exceeds the 14-day/10% test and you rent the unit for 15 or more days during the year. If your personal use of the property exceeds the greater of 14 days or 10% of the fair market rental days, and you rent it for at least 15 days during the year, you cannot deduct a rental loss on Schedule E. Your rental expenses and depreciation are deductible on Schedule E only to the extent of rental income, following the allocation rules of Steps 1-3 in 9.9. Expenses not deductible in the current year under this limitation may be carried forward and will be deductible up to rental income in the following year. The deduction limit is irrelevant if your rental income exceeds expenses. When you have a profit, you report the rental income and claim all of the deductible rental expenses on Schedule E.

Rule 3: If your personal use exceeds the 14-day/10% test but you rent the unit for less than 15 days during the taxable year. If your personal use of the property exceeds the greater of 14 days or 10% of the fair market rental days, and you rent it for fewer than 15 days in the taxable year, do not report the rental income on your tax return (it is not gross income) and the only deductions allowed are those you would be allowed anyway as a homeowner. That is, if you itemize deductions on Schedule A, you deduct mortgage interest, real estate taxes, and casualty losses, if any. No other rental expenses such as depreciation and maintenance expenses are deductible. If you itemize, interest is generally fully deductible if the home qualifies as a first or second home under the mortgage interest rules discussed in Chapter 15.

9.8 Counting Personal-Use Days and Rental Days for a Residence

In applying the 14-day/10% personal-use test (9.7), personal-use days are:

• Days you used the residence for personal purposes other than days primarily spent making repairs or getting the property ready for tenants. If you use a residence for personal purposes on a day you rent it at fair market value, count that day as a personal day, not a rental day, in applying the 14-day/10% test.
• Days on which the residence is used by your spouse, children, grandchildren or great-grandchildren, parents, brothers, sisters, grandparents, or great-grandparents. However, if such a relative pays you a fair rental value to use the home as a principal residence, the relative’s use is not considered personal use by you. If you rent a vacation home to such relatives, their use is considered personal use by you even if they pay a fair rental value amount; see Example 1 below. The same rules apply if the use of the residence is by a family member of a co-owner of the property.
• Days on which the residence is used by any person under a reciprocal arrangement that allows you to use some other dwelling during the year.
• Days on which you rent the residence to any person for less than fair market value.
• Days that a co-owner of the property uses the residence, unless the co-owner’s use is under a shared-equity financing agreement discussed later in this section.

An owner is not considered to have personally used a home that is used by an employee if the value of such use is tax-free lodging required as a condition of employment (3.13).

Shared-equity financing agreements for co-owners. Use by a co-owner is not considered personal use by you if you have a shared-equity financing agreement under which: (1) the co-owner pays you a fair rent for using the home as his or her principal residence; and (2) you and your co-owner each have undivided interests for more than 50 years in the entire home and in any appurtenant land acquired with the residence.

Any use by a co-owner that does not meet these two tests is considered personal use by you if, for any part of the day, the home is used by a co-owner or a holder of any interest in the home (other than a security interest or an interest under a lease for fair rental) for personal purposes. For this purpose, any other ownership interest existing at the time you have an interest in the home is counted, even if there are no immediate rights to possession and enjoyment of the home under such other interest. For example, you have a life estate in the home and your friend owns the remainder interest. Use by either of you is personal use.

Rental of principal residence prior to sale. You are not considered to have made any personal use of a principal residence that you rent or try to rent at a fair rental for (1) a consecutive period of 12 months or more or (2) a period of less than 12 months that ends with the sale or exchange of the residence. For example, you move out of your principal residence on May 31, 2017, offering it for rental as of June 1. You rent it from June 15 until mid-November, when you sell the house. Under the special rental period rule, your use of the house from January 1 until May 31, 2017, is not counted as personal use. This means that deductions for the rental period are not subject to the rental income limitation (Steps 1-3 in 9.9).

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. The deductible rental portion equals your total expenses for the year multiplied by this fraction:

The days a unit is held out for rent but not actually rented are not counted as rental days in the numerator of the fraction. 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, it does not; interest and taxes are allocated on a daily basis. Thus, if a house is rented for 61 days in 2017, 16.71% (61/365) of the deductible interest and taxes is deducted first from the rental income. This Tax Court 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 the Examples 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 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.

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.

9.10 IRS May Challenge Loss Claimed on Temporary Rental Before Sale

If you are unable to sell your home and must move, it may be advisable to put it up for rent. This way you may be able to deduct maintenance expenses and depreciation on the unit even if it remains vacant. However, the IRS has disallowed loss deductions for some rentals preceding a sale on the ground that there was no “profit motive” for the rental (40.10). For example, where minimal efforts are made to rent out a vacation home in anticipation of an eventual sale, the IRS may claim, as in Example 1 below, that the home was not converted to rental property held for the production of income. Where the IRS determines that you lacked a profit motive for renting the property, it will limit your deduction for rental expenses to the amount of the rental income, and the expenses in excess of rental income cannot be carried forward to a later year. Courts have allowed loss deductions in certain cases.

9.11 Reporting Royalty Income

Royalties are payment for use of patents or copyrights or for the use and exhaustion of mineral properties. Royalties are taxable as ordinary income and are reported on Schedule E (Form 1040). Depletion deductions relating to the royalties are also reported on Schedule E. If you own an operating oil, gas, or mineral interest, or are a self-employed writer, investor, or artist, you report royalty income, expenses, and depletion on Schedule C.

Examples of Royalty Income

• License fees received for use, manufacture, or sale of a patented article.
• Renting fees received from patents, copyrights, and depletable assets (such as oil wells).
• Authors’ royalties including advance royalties if not a loan.
• Royalties for musical compositions, works of art, etc.
• Proceeds of sale of part of your rights in an artistic composition or book, for example, sale of motion picture or television rights.
• Royalties from oil, gas, or other similar interests (9.16). To have a royalty, you must retain an economic interest in the minerals deposited in the land you have leased to the producer. You usually have a royalty when payments are based on the amount of minerals produced. However, if you are paid regardless of the minerals produced, you have a sale that is taxed as capital gain if the proceeds exceed the basis of the transferred property interest. Bonuses and advance royalties that are paid to you before the production of minerals are taxable as royalty income and are entitled to an allowance for depletion. However, bonuses and advance royalties for gas and oil wells and geothermal deposits are not treated as gross income for purposes of calculating percentage depletion. If the lease is terminated without production and you received a bonus or advance royalty, you report as income previously claimed depletion deductions. You increase the basis of your property by the restored depletion deductions.

9.12 Production Costs of Books and Creative Properties

Freelance authors, artists, and photographers may deduct their costs of producing original works in the years that the expenses are paid or incurred. If you qualify, the uniform capitalization rules that generally apply to property that you produce for resale (40.3) do not apply to the expenses.

You qualify for current expense deductions if you are self-employed and you personally create literary manuscripts, musical or dance scores, paintings, pictures, sculptures, drawings, cartoons, graphic designs, original print editions, photographs, or photographic negatives or transparencies. However, the exception to the uniform capitalization rules does not apply to, and thus current deductions are not allowed for, expenses relating to motion picture films, videotapes, printing, photographic plates, or similar items.

If you conduct business as an owner-employee of a personal service corporation and you are a qualifying author, artist, or photographer, the corporation may claim current deductions related to your expenses in producing books or other eligible creative works. Substantially all of the corporation’s stock must be owned by you and your relatives.

9.13 Deducting the Cost of Patents or Copyrights

If you create an artistic work or invention for which you get a government patent or copyright, you may depreciate your costs over the life of the patent or copyright. Basis for depreciation includes all expenses that you are required to capitalize in connection with creating the work, such as the cost of drawings, experimental models, stationery, and supplies; travel expenses to obtain material for a book; fees to counsel; government charges for patent or copyright; and litigation costs in protecting or perfecting title.

If you purchased the patent or artistic creation, depreciate your cost over the remaining life of the patent or copyright. If your cost for a patent is payable annually as a fixed percentage of the revenue derived from use of the patent, the depreciation deduction equals the royalty paid or incurred for that year. However, if a copyright or patent is acquired in connection with the acquisition of a business, the cost is amortizable over a 15-year period as a Section 197 intangible (42.18).

If you inherited the patent or rights to an artistic creation, your cost is the fair market value either at the time of death of the person from whom you inherited it (5.17) or the alternate valuation date if elected by the executor. You get this cost basis even if the decedent paid nothing for it. Figure your depreciation by dividing the fair market value by the number of years of remaining life.

If your patent or copyright becomes valueless, you may deduct your unrecovered cost or other basis in the year it became worthless.

9.14 Intangible Drilling Costs

Intangible drilling and development costs (IDCs) refer to drilling and development costs of items with no salvage value, including wages, fuel, repairs, hauling, and supplies incident to and necessary for the preparation and drilling of wells for the production of oil or gas, and geothermal wells. For wells you are developing in the United States, you can elect to deduct the costs currently as business expenses or treat them as capital expenses subject to depreciation or depletion.

Electing current business deduction. The election to deduct IDCs as a current business expense must be made on your income tax return for the first tax year in which you pay or incur the costs. As a sole proprietor, you deduct the IDCs as “other expenses” on Schedule C (Form 1040).

Prepayments. Tax-shelter investors may deduct prepayments of drilling expenses only if the well is “spudded” within 90 days after the close of the taxable year in which the prepayment is made. The prepayment must also have a business purpose, not be a deposit, and not materially distort income. The investor’s deduction is limited to his or her cash investment in the tax shelter. For purposes of this limitation, an investor’s cash investment includes loans that are not secured by his or her shelter interest or the shelter’s assets and loans that are not arranged by the organizer or promoter. If the above tests are not met, a deduction may be claimed only as actual drilling services are provided.

Amortizing intangible drilling costs. If you do not elect to deduct IDCs as current business expenses, you may amortize them on Form 4562 (“Depreciation and Amortization”) over a 60-month period, beginning with the month they were paid or incurred. If you elect 60-month amortization, there is no AMT adjustment; see below.

Recapture of intangible drilling costs for oil, gas, geothermal, or mineral property. Upon the disposition of oil, gas, geothermal, or other mineral property placed in service after 1986, ordinary income treatment applies to previously claimed deductions for intangible drilling and development costs for oil, gas, and geothermal wells, and to mineral development and exploration costs. Depletion deductions (9.15) are also generally subject to this ordinary income treatment upon disposition of the property.

AMT and intangible drilling costs. If you are an independent producer or royalty owner and elect to deduct IDCs as a current business expense on Schedule C, you may qualify for an exception to the AMT preference rules for IDCs, but the exception is limited. If your IDC preference (figured under the regular AMT rules) exceeds 40% of your alternative minimum taxable income, figured without regard to the AMT net operating loss deduction, the excess over 40% must be included as a preference item; see the instructions on Form 6251. The AMT adjustment can be completely avoided by electing 60-month amortization for the IDCs.

9.15 Depletion Deduction

Properties subject to depletion deductions are mines, oil and gas wells, timber, and exhaustible natural deposits.

Two methods of computing depletion are: (1) cost depletion and (2) percentage depletion. If you are allowed to compute under either method, you must use the one that produces the larger deduction. In most cases, this will be percentage depletion. For timber, you must use cost depletion.

Cost depletion. The cost depletion of minerals is computed as follows: (1) divide the total number of units (such as tons or barrels) remaining in the deposit to be mined into the adjusted basis of the property; and (2) multiply the unit rate found in Step 1 by the number of units for which payment is received during the taxable year if you are on the cash basis, or by the number of units sold if you are on the accrual basis.

Adjusted basis is the original cost of the property, less depletion allowed, whether computed under the percentage or cost depletion method. It does not include nonmineral property such as mining equipment. Adjusted basis may not be less than zero.

Timber depletion is based on the cost of timber (or other basis in the owner’s hands) and does not include any part of the cost of land. Depletion takes place when standing timber is cut. Depletion must be computed by the cost method, not by the percentage method. However, instead of claiming the cost depletion method, you may elect to treat the cutting of timber as a sale subject to capital gain or loss treatment. For further details, see IRS Publication 535.

Percentage depletion. Percentage depletion is based on a certain percentage rate applied to annual gross income derived from the resource. In determining gross income for percentage depletion, do not include any lease bonuses, advance royalties, or any other amount payable without regard to production. A deduction for percentage depletion is allowed even if the basis of the property is already fully recovered by prior depletion deductions. The percentage to be applied depends upon the mineral involved; the range is from 5% up to 22%. For example, the maximum 22% depletion deduction applies to sulphur, uranium, and U.S. deposits of lead, zinc, nickel, mica, and asbestos. A 15% depletion percentage applies to U.S. deposits of gold, silver, copper, iron ore, and shale.

Taxable income limit. For properties other than oil and gas, the percentage depletion deduction may not exceed 50% of taxable income from the property computed without the depletion deduction. In computing the 50% limitation, a net operating loss deduction is not deducted from gross income. A 100% taxable income limit applies to oil and gas properties (9.16).

Oil and gas property. Percentage depletion for oil and gas wells was repealed as of January 1, 1975, except for small independent producers and royalty owners (9.16).

9.16 Oil and Gas Percentage Depletion

Small independent producers and royalty owners generally are allowed to deduct percentage depletion at a 15% rate for domestic oil and gas production. The deduction is subject to a taxable income limit.

The 15% rate applies to a small producer exemption that equals the gross income from a maximum daily average of 1,000 barrels of oil or 6 million cubic feet of natural gas, or a combination of both. Gross income from the property does not include advance royalties or lease bonuses that are payable without regard to the actual production.

The depletable natural gas quantity depends on an election made annually by independent producers or royalty owners to apply part of their 1,000-barrel-per-day oil limitation to natural gas. The depletable quantity of natural gas is 6,000 cubic feet times the barrels of depletable oil for which an election has been made. The election is made on an original or amended return or on a claim for credit or refund. For example, if your average daily production is 1,200 barrels of oil and 6.2 million cubic feet of natural gas, your maximum depletable limit is 1,000 barrels of oil, which you may split between the oil and gas. You could claim depletion for 500 barrels of oil per day and for 3 million cubic feet of gas per day: 3 million cubic feet of gas is the equivalent of the remaining 500 barrels of oil limit (500 barrels × 6,000 cubic feet depletable gas quantity equals 3 million cubic feet of gas).

Ineligible retailers and refiners. Percentage depletion cannot be claimed by a producer who owns or controls a retail outlet for the sale of oil, natural gas, or petroleum products unless gross sales of oil and gas products are $5 million or less for the tax year, or if all sales of oil or natural gas products occur outside the United States and none of the taxpayer’s domestic production is exported. Bulk sales of oil or natural gas to industrial or utility customers are not to be treated as retail sales.

Percentage depletion also is not allowed to a refiner who refines (directly or through a related person) more than 75,000 barrels of crude oil on any day during the year. The limit is based on average (rather than actual) daily refinery runs for the tax year.

Figuring average daily domestic production. Average daily production is figured by dividing your aggregate production during the taxable year by the number of days in the taxable year. If you hold a partial interest in the production (including a partnership interest), production rate is found by multiplying total production of such property by your income percentage participation in such property.

The production over the entire year is averaged regardless of when production actually occurred. If average daily production for the year exceeds the 1,000-barrel or 6-million-cubic-feet limit, the exemption must be allocated among all the properties in which you have an interest.

Taxable income limits on percentage depletion. The percentage depletion deduction for a small producer or royalty owner may not exceed the lesser of (1) 100% of the taxable income from the property before the depletion allowance or the deduction for production activities, or (2) 65% of your taxable income from all sources computed without regard to the depletion deduction allowed under the small producer’s exemption, the deduction for production activities, any net operating loss carryback, and any capital loss carryback. Any amount not deductible because of the 65% limit can be carried over and added to the next year’s depletion allowance.

Limitations where family members or related businesses own interests. The daily exemption rate is allocated among members of the same family in proportion to their respective production of oil. Similar allocation is required where business entities are under common control. This affects interests owned by you, your spouse, and minor children; by corporations, estates, and trusts in which 50% of the beneficial interest is owned by the same or related persons; and by a corporation that is a member of the same controled group.

Depletion for marginal production. For independent producers and royalty owners with production from “marginal” wells, the 15% depletion rate could be increased by 1% for each whole dollar that the “reference price” (the average annual wellhead price as estimated by the IRS) of domestic crude oil for the previous year was below $20 per barrel. However, despite relatively low oil prices in recent years, the reference price has been substantially over $20 per barrel, and therefore the basic 15% rate has applied for marginal production every year from 2001 through 2017, and this is likely to remain the case for the foreseeable future.