Rental Property Income and Loss Limitations - Gleim Publication PDF

1 STUDY UNIT THREE RENTAL PROPERTY AND LOSS LIMITATIONS 3.1 Rental Property Income................................................. 1 3.2 Rental Property Expenses......................................

1 STUDY UNIT THREE RENTAL PROPERTY AND LOSS LIMITATIONS 3.1 Rental Property Income................................................. 1 3.2 Rental Property Expenses............................................... 3 3.3 Loss Limitations....................................................... 5 The first two subunits discuss the items included in rental property income and expenses. The last subunit discusses loss limitations associated with at-risk rules and passive activity rules. 3.1 RENTAL PROPERTY INCOME 1. Cash or the fair market value (FMV) of property or services received for the use of real estate or personal property is taxable as rental income. a. Rent from real estate is income from an investment, not from the operation of a business. b. Schedule E is not used to report income and expenses from the rental of personal property, such as equipment or vehicles. Instead, Schedule C is used if the taxpayer is in the business of renting personal property. A taxpayer is in the business of renting personal property if the primary purpose for renting the property is income or profit and the taxpayer is involved in the rental activity with continuity and regularity. If rental of personal property is not a business, any income belongs on Form 1040 (Schedule 1). c. A bonus received by a landlord for granting a lease is included in gross income. d. A lessee’s refundable deposit intended to secure performance under the lease is not income to the lessor. e. Value received by a landlord to cancel or modify a lease is gross income. 1) Amounts received by a lessee to cancel a lease, however, are treated as amounts realized on disposition of an asset or property (a capital gain). f. An amount paid by a lessee to maintain the property in lieu of rent, e.g., for property tax, is gross income to the lessor. 1) The lessor includes the payment in gross income and may be entitled to a corresponding deduction, e.g., property tax deduction. EXAMPLE 3-1 Payments of Lessee in Lieu of Rent While a taxpayer is out of town, the furnace in the taxpayer’s rental property stops working. The tenant pays for the necessary repairs and deducts the repair bill from the next rent payment. The repair bill paid by the tenant and any amount received as rent payment are included as rental income. The taxpayer may deduct the repair payment made by the tenant as a rental expense. g. The FMV of lessee improvements made to the property in lieu of rent is also gross income to the lessor. 1) The FMV of the lessee improvements are also allowable as a deduction in the computation of income from the rental activity. h. The value of lessee improvements that are not made in lieu of rent is excluded from the lessor’s gross income. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 3: Rental Property and Loss Limitations i. Prepaid rent is included in gross income when received (the same as for cash-method and accrual-method taxpayers). 1) Lease cancellations are included. 2) Tenant improvements, in lieu of rent, are included. 3) Security deposits are not considered income when the property owner is obligated to return them to the tenants. 4) Advance rental payments must be deducted by the payee during the tax periods to which the payments apply. j. Rental income from a residence is included in gross income unless the residence is rented out for less than 15 days in a given year. 1) If rental income is excluded from gross income, the corresponding rental deductions are also disallowed. k. Rental income received by an individual where no significant services are provided should be reported along with any respective rental expenses on Schedule E (Form 1040). 1) If significant services are provided, the rental income and expenses should be reported on Schedule C (Form 1040). l. Income and expenses from business should be reported on Schedule C, Profit or Loss From Business. Not-for-Profit Rental Income 2. If property is not rented to make a profit, taxpayers can deduct their rental expenses only up to the amount of their rental income. A taxpayer cannot deduct a loss or carry it forward to the next year if rental expenses are more than rental income for the year. a. Not-for-profit rental income is reported on Form 1040 or 1040-NR. Taxpayers can include their mortgage interest (if the property is used as their main home or second home), real estate taxes, and casualty losses on the appropriate lines of Schedule A if they itemize their deductions. b. If rental income is more than rental expenses for at least 3 years out of a period of 5 consecutive years, taxpayers are presumed to be renting property to make a profit. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 3: Rental Property and Loss Limitations 3 3.2 RENTAL PROPERTY EXPENSES 1. Expenses related to the production of rental income are generally deductible to arrive at adjusted gross income. a. Rental property expenditures may be deducted by depreciation. Generally, a Sec. 179 deduction includes certain depreciable tangible personal property used predominantly to furnish lodging or in connection with furnishing lodging. 2. Generally, repair and maintenance expense is considered a current-period deduction. However, certain repairs may be classified as improvements, which must be capitalized. There are safe harbor rules that allow repairs and maintenance to always be classified as current-period expenses instead of capitalized. a. Taxpayers who have elected to use the de minimis expense treatment must expense all repairs up to the de minimis amount (i.e., $2,500). b. The costs of performing certain routine maintenance activities for property may result in an improvement to the unit of property, the costs of which must be capitalized. 1) However, a safe harbor rule allows routine repairs and maintenance to be expensed. This safe harbor rule applies to actions that maintain the asset and are reasonably expected to be performed more than once for the asset’s class life under the alternative depreciation system. 3. Special rules limit deductions on the rental of a residence or a vacation home. Minimum Rental Use a. The property must be rented for more than 14 days during the year for deductions to be allowable. 1) When the residence is rented for less than 15 days, the rental income does not need to be reported. Minimum Personal Use b. The vacation-home rules apply when the taxpayer uses the residence for personal purposes for the greater of (1) more than 14 days or (2) more than 10% of the number of days for which the residence is rented. 4. A residence is deemed to have been used by the taxpayer for personal purposes if the home is used by a. The taxpayer for personal purposes, by any other person who owns an interest in the rental property, or by the relatives of either 1) However, if the taxpayer rented or tried to rent the property for 12 or more consecutive months, the days during which (s)he used the property as a main home do not count as personal days. b. Any individual under a reciprocal arrangement, whether or not rent is charged c. Any individual unless a fair rental is charged 5. If the taxpayer spends substantially full-time repairing or maintaining the rental property, such time does not count toward the personal-use test. This is the case regardless of use of property by other family members. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 3: Rental Property and Loss Limitations Vacation Home Rules 6. If the property passes the minimum rental-use test but fails the minimum personal-use test, the property is considered a vacation home, and rental deductions may not exceed gross income derived from rental activities. a. Expenses must be allocated between the personal use and the rental use based on the number of days of use of each. b. When deductions are limited to gross income, the order of deductions is 1) The allocable portion of expenses deductible regardless of rental income (e.g., mortgage interest and property taxes) 2) Deductions that do not affect basis (e.g., ordinary repairs and maintenance) 3) Deductions that affect basis (e.g., depreciation) EXAMPLE 3-2 Order of Deductions A taxpayer with $4,000 of rental income, $2,000 of interest and taxes, $1,000 of repairs, and $10,000 of depreciation may only deduct $1,000 of depreciation. Income $ 4,000 Interest and taxes (2,000) Repairs (1,000) Depreciation (1,000) $ 0 c. Any losses disallowed may be carried forward. 7. If the property passes both the minimum Minimum Use Tests rental-use test and the minimum personal-use test, then all deductions Rental Use Personal Use may be taken and a loss may occur, Pass > 14 days ≤ 14 days or < 10% subject to the passive loss limits. Fail ≤ 14 days greater of > 14 days or > 10% EXAMPLE 3-3 Mixed Use of Real Property Jack owns a vacation condo on Miami Beach. He rents it out to vacationers most of the year but uses it himself a few times each year. In each of the following situations, Jack has a different ability to deduct expenses based on the amount of personal and rental use. Situation 1: Jack uses the condo for 4 days and rents it for 200 days at fair rental value to unrelated parties. In this situation, Jack passes the rental-use and personal-use tests and is able to take all deductions applicable, subject to the passive loss rules. Situation 2: Jack uses the condo for 24 days and rents it for 165 days at fair rental value to unrelated parties. Jack passes the rental-use test but fails the personal-use test because he personally used the rental for the greater of 14 days or 10% of the rental days. Therefore, Jack must allocate the expenses between rental use and personal use and may deduct rental expenses to the extent of rental income. Situation 3: Jack uses the condo for 10 days and rents the condo for 10 days at fair rental value to unrelated parties. Because he fails the rental-use test, he does not need to report the rental income, but he may not deduct the related rental expenses. 8. Expense deductions for not-for-profit (NFP) rentals are limited to income from such rentals. Neither loss nor carryforward is allowed for NFP expenses in excess of NFP income. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 3: Rental Property and Loss Limitations 5 3.3 LOSS LIMITATIONS 1. A taxpayer’s deductible loss is limited to the smallest amount of the following limitations: a. The taxpayer’s basis in the activity b. The at-risk rules c. The passive activity rules EXAMPLE 3-4 Business Activity Loss A taxpayer who owns both a lumber business and a boat for personal use incurred two losses during the tax year upon selling both the boat and the lumberyard to a colleague. Though the combined loss totaled $10,000, only the portion attributable to the business is potentially deductible. Losses on sales of property held for personal use are not deductible. At-Risk Rules 2. The amount of a loss allowable as a deduction is limited to the amount a person has at risk in the activity from which the loss arose. a. A loss is any excess of deductions over gross income attributable to the same activity. b. The rules apply to individuals, partners in partnerships, members in limited liability companies, shareholders of S corporations, trusts, estates, and closely held C corporations. 1) Personal holding companies, foreign personal holding companies, and personal service corporations are not subject to at-risk rules. c. The at-risk rules are applied separately to each trade or business or income-producing activity. d. A person’s amount at risk in an activity is determined at the close of the tax year. 1) A person’s initial at-risk amount includes money contributed, the adjusted basis (AB) of property contributed, and borrowed amounts. 2) Recourse debt requirements include the following: a) A person’s at-risk amount includes amounts borrowed only to the extent that, for the debt, the person has either personal liability or property pledged as security (no more than the FMV when pledged minus prior or superior claims is included). b) The at-risk amount does not include debt if one of the following applies: i) Property pledged as security is used in the activity. ii) Insurance, guarantees, stop-loss agreements, or similar arrangements provide protection from personal liability. iii) A person with an interest in the activity or one related to him or her extended the credit. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 3: Rental Property and Loss Limitations 3) Nonrecourse debt is generally excluded from the amount at risk. a) The amount at risk in the activity of holding real property includes qualified nonrecourse financing (QNRF). b) In qualified nonrecourse financing, the taxpayer is not personally liable, but the financing is i) Used in an activity of holding real estate; ii) Secured by the real property; iii) Not convertible to an ownership interest; and iv) Either obtained from an unrelated third party, obtained from a related party but on commercially reasonable terms, or guaranteed by a governmental entity. EXAMPLE 3-5 Nonrecourse Debt Kathy purchased a small apartment building for $200,000 using $25,000 of her own money and $25,000 borrowed from her father to make the down payment. She signed a note to pay the remainder of the purchase price to the seller. The debt to the seller was nonrecourse, secured only by the apartment building. Kathy is not at-risk for the loan from the seller because the seller is a person from whom the taxpayer acquired the property. EXAMPLE 3-6 At-Risk Rules Mooch purchased rental real estate with some money borrowed from his mother at commercially reasonable terms and the rest of the money borrowed from the seller. Both loans were nonrecourse and only secured by the property. Mooch is at risk for the loan from his mother because of the commercially reasonable terms and the nonrecourse loan is for real property. Regardless of the terms, Mooch is not at risk for the seller’s loan. 4) Adjustments to an at-risk amount are made for events that vary the investors’ economic risk of loss. a) Add contributions of money and property (its AB), recourse debt increases, QNRF increases, and income from the activity. b) Subtract distributions (e.g., from a partnership), liability reductions (recourse or QNRF), and tax deductions allowable (at year end). 5) Disallowed losses are carried forward. 6) If the amount at risk decreases below zero, previously allowed losses must be recaptured as income. 7) If a deduction would reduce basis in property and part or all of the deduction is disallowed by the at-risk rules, the basis is reduced anyway. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 3: Rental Property and Loss Limitations 7 Passive Activity Loss (PAL) Limitation Rules 3. The amount of a loss attributable to a person’s passive activities is allowable as a deduction or credit only against, and to the extent of, gross income or tax attributable to those passive activities (in the aggregate). a. The excess is deductible or creditable in a future year, subject to the same limits. EXAMPLE 3-7 PAL Limitation A wealthy taxpayer invested in an architecture partnership as a passive investor. Because the taxpayer does not engage in the business outside of occasional business consulting, any income or loss derived from the business is passive in nature. Therefore, any losses derived from the partnership may only offset passive activity gains. 4. The passive activity rules apply to individuals, estates, trusts, personal service corporations, and closely held corporations. a. Although passive activity rules do not apply to grantor trusts, partnerships, and S corporations directly, they do apply to the owners of these entities. 5. A passive activity is either rental activity or a trade or business in which the person does not materially participate. a. A taxpayer materially participates in an activity during a tax year if (s)he satisfies one of the following tests: 1) Participates more than 500 hours 2) Participation constitutes substantially all of the participation in the activity 3) Participates for more than 100 hours and exceeds the participation of any other individual 4) The activity is a significant participation activity in which the taxpayer participates more than 100 hours and the taxpayer’s participation in all significant participation activities exceeds 500 hours 5) Materially participated in the activity for any 5 years of the 10 years preceding the year in question 6) Materially participated in a personal service activity for any 3 years preceding the year in question 7) Satisfies a facts and circumstances test proving that the taxpayer participated on a “regular, continuous, and substantial” basis a) A taxpayer will not be considered to have materially participated in an activity under this test if (s)he participated in the activity for 100 hours or less during the year. EXAMPLE 3-8 Business Passive Activity Loss For 2023, Sally realized a $10,000 net loss (sales of $95,000 less expenses of $105,000) from operating a sole proprietorship, without regard to dispositions of property other than inventory. The income tax return also showed gross income of $5,000 ($2,500 of wages, $500 interest on personal savings, and a $2,000 long-term capital gain on business property). The excess of deductions over income was $19,850 ($5,000 gross income – $10,000 loss from business operations – $1,000 nonbusiness short-term capital loss on the sale of stock – $13,850 standard deduction). Because she does not engage in the business outside of occasional business consulting, any income or loss derived from the business is passive in nature. Therefore, any losses derived from the partnership may only offset passive activity gains. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 3: Rental Property and Loss Limitations 6. Rental Real Estate a. All rental activity is passive. b. Up to $25,000 of a tax year loss from rental real estate activities in excess of passive activity gross income is deductible against portfolio or active income. EXAMPLE 3-9 PAL Limitation -- Rental Real Estate Activities A taxpayer has wages of $30,000, $5,000 gain from a passive partnership interest, and $35,000 loss from active rental real estate activity. The taxpayer may first offset the passive gain (i.e., $5,000) with $5,000 of the passive loss. With the remaining $30,000 passive loss, $25,000 of the nonpassive gain (i.e., wages) may be offset. 1) The $25,000 limit is reduced by 50% of the person’s MAGI [i.e., AGI without regard to PALs, Social Security benefits, and qualified retirement contributions (e.g., IRAs)] over $100,000. 2) Excess rental real estate PALs are suspended. They are treated as other PALs carried over. EXAMPLE 3-10 PAL Limitation -- Active Participation Lynne, a single taxpayer, has $70,000 in wages, $15,000 income from a limited partnership, and a $26,000 loss from rental real estate activities in which she actively participated and is not subject to the modified adjusted gross income phase-out rule. She can use $15,000 of her $26,000 loss to offset her $15,000 passive income from the partnership. She actively participated in her rental real estate activities, so she can use the remaining $11,000 rental real estate loss to offset $11,000 of her nonpassive income (wages). EXAMPLE 3-11 Allowed Rental Loss A married taxpayer filing jointly actively participated in rental activity and incurred a rental loss of $30,000 in the current year. If the taxpayer’s MAGI is $120,000, what is the amount of rental loss that is deductible? MAGI $120,000 Loss limit $25,000 Threshold (100,000) Reduction (10,000) Excess $ 20,000 Allowed loss $15,000 Reduction % × 50% Reduction $ 10,000 c. This exception to the general PAL limitation rule applies to a person who 1) Actively participates in the activity, 2) Owns 10% or more of the activity (by value) for the entire year, and 3) Has MAGI of less than $150,000 [phaseout begins at $100,000; as discussed in b.1) above]. d. Active participation is a less stringent requirement than material participation. 1) It is met with participation in management decisions or arranging for others to provide services (such as repairs). 2) There will not be active participation if at any time during the period there is ownership of less than 10% of the interest in the property (including the spouse’s interest). Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 3: Rental Property and Loss Limitations 9 e. Real property trades or businesses rules include the following: 1) The passive activity loss rules do not apply to certain taxpayers who are involved in real property trades or businesses. 2) An individual (real estate professional) may avoid passive activity loss limitation treatment on a rental real estate activity if the following requirements are met: a) More than 50% of the individual’s personal services performed during the year are performed in the real property trades or businesses in which the individual materially participates. b) The individual performs more than 750 hours of service in the real property trades or businesses in which the individual materially participates. 3) This provision also applies to a closely held C corporation if 50% of gross receipts for the tax year are from real property trades or businesses in which the corporation materially participated. 4) Any deduction allowed under this rule is not taken into consideration in determining the taxpayer’s AGI for purposes of the phaseout of the $25,000 deduction. 5) If 50% or less of the personal services performed are in real property trades or businesses, the individual will be subject to the PAL limitation rules. f. A PAL continues to be treated as a PAL after the activity ceases to be passive in a subsequent tax year, except that it may also be deducted against income from that activity. g. Disposition of a passive activity is subject to the following rules: 1) Suspended (and current-year) losses from a passive activity become deductible in full in the year the taxpayer completely disposes of all interest in the passive activity. 2) The loss is deductible first against net income or gain from the taxpayer’s other passive activities. The remainder of the loss, if any, is then treated as nonpassive. Excess Business Loss 7. After passing the at-risk limit and the passive activity loss rule, non-C corporate business losses are now subject to the excess business loss limit. C corporations are excluded from this limitation and allowed to offset pass-through losses received from pass-through entities against non-business income (e.g., capital gains). a. Excess business loss is calculated as follows: All deductions from trades or businesses Gross income or gain from trades or businesses + $289,000 ($578,000 MFJ) floor Limitation – Limitation = Excess business loss b. The excess business loss is carried forward as an NOL. In carryover years, the NOL is limited to 80% of the years’ TI. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].