Internal Revenue Code (IRC) §280A(g) provides a special rule when a dwelling unit is used during the taxable year as a residence by a taxpayer and is also rented during the year for fewer than 15 days. In this case, the taxpayer doesn’t report any of the rental revenue or deduct any of the operating rental expenses. But if a taxpayer uses their residence or vacation home for more than the greater of 14 days or 10% of the total number of days the unit is rented to others at a fair rental value, then the taxpayer has rental income and prorated deductible rental expenses.
The prorated rental expenses are limited to rental income and are deductible in a specific order per IRC §280A. That is, rental income is first reduced by the property’s prorated mortgage interest, real estate taxes, and casualty losses (if any). The nonprorated items are treated as itemized deductions.
Next, the taxpayer reduces the remaining rental income (but not below zero) by the operating expenses (e.g., insurance, utilities, to name a few, but not including depreciation) of the property. Any remaining rental income is reduced, but not below zero, by any basis adjusting expenses (e.g., depreciation). The adjusted basis is used to calculate a taxpayer’s gain or loss on the eventual sale or disposition of the property.
IRC §469(i) provides an exception allowing taxpayers below an adjusted gross income (AGI) threshold to deduct up to $25,000 ($12,500 for married taxpayers filing separately) of their passive losses from rental activities against other nonpassive income, such as wages, business income, and so on.
The $25,000 loss begins to phase out once the taxpayer’s AGI exceeds $100,000 ($50,000 for married filing separately), and it’s totally phased out when the AGI amount exceeds $150,000 ($75,000 for married filing separately). In addition, IRC §469(i)(5)(B) provides that married taxpayers filing separately and not living apart aren’t eligible to claim the $25,000 loss.
Finally, the excess business loss rules may apply for vacation home rental since these rules apply to all noncorporate trade or businesses per IRC §461(l). An excess business loss for a trade or business is the amount of the total deductions that exceed total gross income that’s greater than the threshold amount of $262,000, or $524,000 for joint returns, for tax year 2021. Any net operating loss that can’t be used is then carried forward indefinitely.
The prorated percentage is the ratio of time (i.e., days) that the home is rented to the total time the vacation home is used for all purposes during the taxable year (see footnote 7 in Bolton v. Commissioner of Internal Revenue). Thus, as noted in the U.S. Tax Court decision, if the vacation home is rented at fair value for 91 days out of the total 121 days that the unit is used during the year, then the taxpayer would use the fraction of 91/121, which is 75%, rather than dividing the 91 days by 365 days for the whole year.
PERSONAL USE VS. RENTAL
The term “dwelling unit” includes a house, apartment, condominium, mobile home, boat, or similar property and doesn’t include that portion of a unit that’s used exclusively as a hotel, motel, inn, or similar establishment. Proposed Reg. §1.280A-1(c) provides some clarification to qualifying dwelling units by stating that a dwelling unit provides basic living accommodations such as a sleeping space, toilet, and cooking facilities.
The more relevant issue is what constitutes a personal use day and rental period. Proposed Reg. §1.280A-1(e) provides that a personal use day is one where a taxpayer or a taxpayer’s spouse, brother, sister, or lineal descendant (to name a few) uses the property for personal purposes for a calendar day, or part of the day. Likewise, a taxpayer isn’t seen to use the property for personal purposes when the taxpayer is performing repairs or maintenance work on the property.
Determining whether the taxpayer is performing repairs or maintenance involves considering all the facts and circumstances, such as the amount of time devoted to repair and maintenance work, the frequency of the use for repair and maintenance purposes during a taxable year, and the presence and activities of companions (Proposed Reg. §1.280A-1(e)(6)). Personal use also doesn’t include situations where the taxpayer is performing repairs and maintenance on the property on a substantially full-time basis.
Proposed Reg. §1.280A-1(e)(7) gives a few examples illustrating the interpretation of a personal use day. Example 3 provides the following situation: Mort owns a lakeside cottage, which he rents during the summer. Mort and Sasha, Mort’s spouse, arrive late Thursday evening after a long drive to prepare the cottage for the rental season. They prepare dinner but don’t work on the unit that evening.
Mort works on the unit on Friday and Saturday; Sasha helps for a few hours each day but spends most of the time relaxing. By Saturday evening, the necessary maintenance work is complete. Neither Mort nor Sasha works on the unit on Sunday; they depart shortly before noon. The principal use of the unit from Thursday evening through Sunday morning is to perform maintenance work on the unit. Consequently, the use during this period won’t be considered personal use by Mort.
Another key issue is the definition of the term “day” as used in this area of the law. Proposed Reg. §1.280A-1(f) defines this term to generally mean the 24-hour period for which a day’s rental would be paid. It further illustrates this concept by saying that a person using a dwelling unit from Saturday afternoon through the following Saturday morning would generally be treated as having used the unit for seven days even though the person was on the premises for eight calendar days.
Taxpayers who engage in the rental of their primary residence or vacation home can deduct the otherwise nondeductible expenses associated with ownership of such properties. But with this opportunity comes the added responsibility to adequately document the expenses and, especially, the personal usage of the property. © 2022 A.P. Curatola