When you think of rental property, most people think about the traditional rental. That is, a single-family residence rented on a monthly or annual basis. Or maybe even a multi-family or commercial property with longer term tenants. With the advent of new generational thinking and the shared economy, the perennial question arises this time of year regarding the tax treatment of non-traditional rental property. That is, what does the preparer have to consider when reporting vacation-type property or even the “room for rent” under a shared economy model?
Just how many Code sections come into consideration when accounting for rental property? The list is often more extensive than you think, and the determinations are very factually driven. In this article I will peel back just a few layers to help the preparer sort through some of these aspects. Specifically, let’s look at Internal Revenue Code (IRC) sections 280A and 469. We will save IRC sections 199A, 1402, and 1411 for Part 2.
But first, are you considering purchasing a rental property? If so, this great guide on buying rental property might come in useful. There are some fantastic real estate resources online designed to help people who are thinking of investing in rental properties in the USA, so do not be afraid to do some research to make sure that your decisions are well informed.
So, let’s think a little more about non-traditional property. What does it look like? Well, it could be many forms including a vacation condo on the beach, a short-term property in town, or a spare bedroom in your house. Each of these properties have special considerations beyond simply reporting income and deductions.
IRC section 280A, Business Use of Home, is one of my first mental stops when looking at a non-traditional property. I need to know if the property is a “dwelling unit”. This includes many assets that you may not initially consider. The Code provides a list of dwelling units to include “… house, apartment, condominium, mobile home, boat or similar property, and all structures or other property appurtenant to such dwelling unit.” IRC section 280A(f)(1). The courts have further expanded the list to include motor homes, travel trailers, and houseboats. The regulations further explain a dwelling unit is any arrangement with the capacity to sleep, cook, and toilet. Prop. Treas. Reg. 1.280A-1(c)(1). So, you can see the definition of a dwelling unit is quite broad.
Once I determine the property is a dwelling unit then I need to determine if it is a “residence”. The dwelling unit is deemed to be a residence if there is personal use of the greater of 14 days or 10% of the days at fair rental value (FRV). IRC section 280A(d). Personal use is further defined, in general, to include occupancy by any owner, any family member of any owner, or anyone at less than FRV. IRC section 280A(d)(2). There are a couple exceptions to personal use which include occupancy for maintenance or if a relative is occupying the property as their primary residence.
Why are these definitions so critical? The character of the property will determine the allocation and possible limitations of expenses. Expenses of the dwelling unit are required to be allocated between personal use and FRV use beginning with the first day of personal use. So, let’s look at a few examples.
Example 1. Your client has a rental duplex that is rented one half to an unrelated party and the other half to their mother as her principal residence. Both tenants pay $900 per month which is deemed to be FRV. The property consists of two dwelling units; each side of the duplex is a living unit. Even though one unit is rented to a family member it is not deemed personal because it is rented at FRV as her principal residence. IRC section 280A(d)(3).
Example 2. Changing the facts slightly in Example 1, the mother only pays $500 per month. Now her side of the duplex is deemed a personal residence of the owner and you must allocate expenses for that unit based on personal use. If she occupied the unit for the entire year, then 100% of expenses (including depreciation) are deemed personal and not reported on Schedule E (or equivalent). Rents paid are reported as Other Income and the expenses are personal; mortgage interest and real estate taxes flow to Schedule A with applicable limitations applied.
Example 3. Your client has an in-law suite in their principal residence with an outside entrance. They want additional income, so they list the room for rent. The rental comes with limited access to the kitchen, laundry, and family pool. They are successful in renting the room for 100 days during the year. They also had family visitors throughout the year who stayed in the room for a total of 50 nights. The client now has a mixed-use footprint that requires an allocation of expenses based on occupancy. Expense to maintain the room are allocated between the personal use (50 nights) and the FRV use (100 nights). Therefore, 2/3rds of the expenses are allocable to the rental subject to the passive loss rules. The only expenses allocable to the rentals are those exclusive use to the rental; there is no allocation for costs related to common areas such as the kitchen, laundry, or pool.
Passive activity loss (PAL) limitation under IRC section 469 is the next question to consider when looking at these rentals. This can be a complex set of rules but let’s take a brief look at our basic examples.
In Example 1 the treatment is the common situation. The rental is per se passive with the exception when the client is a real estate professional (topic for another article). Additionally, if the client has modified adjusted gross income (MAGI) under $100,000 they may qualify for the $25,000 special allowance.
In Example 2 the PAL rules do not come into play for the mother’s side of the duplex. The income and expense are both excluded from the PAL computations. The income is under Other Income and the expenses are all personal; thus, no affect. The unrelated rental has the same application as in Example 1.
In Example 3 you have to develop some additional facts after you have carved off the deemed personal use portion of the expenses. Now you must compute the average customer use; that is, was the average customer use 7 days or less. If so, the activity is deemed not a rental under PAL and the client looks to the hourly material participation tests to determine passive status. Treas. Reg. 1.469-1(e)(3)(ii)(A). There are some additional exceptions to the rental rule if significant or extraordinary personal services are provided but that is beyond the scope of this article. If the activity has an average customer use of more than 7 days, it is deemed a rental. IRC section 469(c)(2). This is an annual determination, so the in-law suite could be a rental in Y1 and excluded from the rental definition in Y2.
This will give you a few more points to consider the next time a client says, “I bought a short-term rental property….” There are many points of law to consider and I have addressed a few here. I will extend these scenarios further into IRC sections 199A, 1402, and 1411 in Part 2.
About the Author:
Kelly H. Myers, MBA, EA, Tax Consultant, is a consultant with Myers Consulting Group, LLC providing seminars, tax planning, consulting, and controversy services to clients across the United States. Kelly has spoken nationally both as a consultant and during his 30+ year career with the IRS (retired 2017). Kelly spent his last 20 years of his IRS career working for the Washington, DC Headquarters as a Senior Technical Advisor. Kelly is an Enrolled Agent (EA) qualifying to practice before the Internal Revenue Service. He has an MBA from the University of Tampa with emphasis in Accounting and Taxation. His BA is from Western State College with a double major in Accounting and Business Administration with a minor in Economics. He resides in Huntsville, Alabama.