 Income tax 2022-2023, rental property, special situations not rented for profit and example of change to rental use. Let's do some wealth preservation with some tax preparation. Most of this information comes from publication 527 residential rental property including rental of vacation homes tax year 2022. You can find on the IRS website, irs.gov, irs.gov. Looking at the income tax formula, we're focused on line one income. Remember on the first half of the income tax formula is in essence an income statement, but just an outline other forms and schedules flowing into these line items. One of those, the Schedule E, an income statement in and of itself in essence having rental income minus rental expenses. The net rental income flowing into line one income of our income tax formula. So now we're talking about renting part of property. So in prior presentations, we've been focusing mainly on the more straightforward types of scenarios where you have a separate piece of rental property that's 100% used for rental property. And now that we've gotten some ideas and the general concepts down, which will typically be applicable to more complex scenarios as well. We'll take a look at some more of those kind of wrinkles, some more complexities that are thrown into the mix. So now we have renting part of property as an added complexity. So if you rent part of your property, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes as though you actually have two separate pieces of property. So in other words, it's nice and easy when you have a separate piece of property that is used 100% for rental use because that makes the bookkeeping nice and easy so that we can separate personal and business usages. However, if we have a situation where we have a one piece of property, we're using it partially for rent, partially for personal. Then we have the situation that we have to parse out the business and the personal clearly usually most commonly on the expense side of things because the rental income will be the rental income. It's going to be coming from the rental side of things. The expenses, however, might need to be divvied up if they're for the entire property so that we can allocate the proper amount to the rental portion, which may be a deductible portion. So you can deduct the expenses related to the part of the property used for rental expenses such as home mortgage interest and real estate taxes as rental expenses on Schedule E form 1040. Now this also becomes a little bit more complex because when we think about some types of deductions, we might actually get a deduction for them if it was our personal residence on a Schedule A, which is a little bit strange because in an income tax type of system, we would expect the deductions that would be natural to the income tax system are those that we needed to consume in order to generate the revenue so that we're taxed on the net income, not on the gross income. But when we look at personal taxes, like on the Schedule A, the itemized deductions, a lot of those don't follow the general concept rule. There are other reasons. There's political reasons or whatever they were thinking that they put all this other stuff on there, right? So the real estate taxes that you might be able to deduct on the Schedule A aren't because it's business property, but rather for whatever other reason they put that on there. And so same with the interest. So the interest, which isn't for your rental property, but for your personal home, you would think wouldn't be deductible naturally just like interest on your personal car loan or something isn't usually deductible. But they have those as deductions on the Schedule A. So now you're in a situation of saying, okay, if I have one piece of property, I live in part of it, I rent part of it, then I might be able to deduct the real estate taxes. I'd have to divvy it out between the two areas that I might get a benefit from it, right? On the real estate Schedule E and on possibly the Schedule A kind of situation. Alright, you can also deduct as rental expenses a portion of other expenses that are normally deduct a non deductible personal expenses such as expenses for electricity or painting the outside of the house. So if you have your own home, then you can't deduct personal stuff on the home except for the mortgage interest and the property tax for whatever reason, right? You can't paint the home and get a deduction for the painting of the home. Why? Because painting the home is a personal expenditure, not a business expenditure, therefore not deductible. But if you rent part of the home, now if you painted the home, you would expect that part of the painting process was for the rental of the home and therefore a business or renting type expense and therefore possibly deductible on the Schedule E. Alright, there is no change in the types of expenses deductible for the personal use part of your property. Generally, these expenses may be deducted only if you itemize your deductions on Schedule A. So for the personal side, you only get the benefit if you itemize, which means your itemized deductions typically have to be greater than the standard deduction to get a benefit from them. You can't deduct any part of the cost of the first phone line, even if your tenants have unlimited use of it. You don't have to divide the expenses that belong only to the rental part of your property. For example, if you paint a room that you rent or pay premiums for liability insurance in connection with renting a room in your home, your entire cost is a rental expense. In other words, if you've got a home, you rented part of the home. If you paint the whole outside of the house, the whole house, well then you're going to have to divvy up the cost of that painting project to the rental and the personal part. But if you rent or if you paint just the inside of the place that you're renting, the part of the home that you are renting or the part of the place that you're renting, then obviously that whole cost is for the rental portion and therefore you would be able to deduct the whole thing. The problem occurs is when we have costs that are for the whole unit, the whole structure that we need to be allocating between personal and business because we use it partially for personal, partially for business. So if you install a second phone line strictly for your tenants' use, all the cost of the second line is deductible as a rental expense. You can deduct depreciation on the part of the house used for rental purposes as well as on the furniture and equipment you use for rental purposes. So how to divide expenses. So if and expense. So now we've got this issue. We see the issue. How are we going to do this? How are we going to get this done? We're going to need some kind of ratio analysis or something to be breaking these expenses out between rental and personal. Let's think about it. If an expense is for both rental use and personal use such as mortgage interest or heat for the entire house, you must divide the expenses between rental use and personal use. That's the issue. You can use any reasonable method for dividing the expense. Obviously reasonable being a key term and one that's not very specific. So could you give me some suggestions on a reasonable method? So it may be reasonable to divide the cost of some items, for example, water based on the number of people using them. So now we've got, if you've ever dealt with managerial accounting kind of concepts, we have this like activity based concept in that we have to use some kind of ratio in order to be breaking these different expenses out. And the first thing that probably comes to mind is to use like a square footage ratio. This is the square foot of the rental versus the non rental, which makes sense. And that's a good reasonable method to use. But in some cases there might be other reasonable methods depending on the thing that you're talking about. So for example, if you're talking about water, you would expect maybe something that would be more accurate than the square footage would be the number of people that are consumed. That are consuming water in the home. And so you can take a ratio of, like if you're the homeowner, then you're only one person. And then you have renters, which are a whole family of seven people, even if they're squished into a small place for whatever reason. You would think that they might use a lot more water than the ratio of their square footage to the total square footage, right? So you might say you might use a different ratio if it's an appropriate activity base that would drive an appropriate ratio. So the two most common methods for dividing expenses are one, the number of rooms in your home and two, the square footage of your home. Example, you rent a room in your house. The room is 12 by 15 feet or 180 square feet. So your entire house is 1,800 square feet of floor space. You can deduct as rental expense 10% of any expense that must be divided between rental use and personal use. Because we're going to say it's the 180 square feet divided by the total of 1,800. And therefore, all of this stuff, like the utility bill or whatever, possibly the painting of the house, the whole house, not the one room, you break out 10% to the rental. So if you're heating bill for the year, for the year for the entire house was 660, 600 times 10%, is a rental expense. The balance 450 is personal expense that you can't deduct. Duplex, a common situation is the duplex where you live in one unit and rent out the other. That's a nice situation. So certain expenses apply to the entire property such as mortgage interest and real estate taxes and must be split to determine rental and personal expenses. So if you have a duplex, then it might be more likely that some of the stuff like utility bills and stuff is going to be more easily broken out. But some will still not be broken out, such as the mortgage interest because you bought the entire duplex as one unit and you're paying loan. On the entire property and the property taxes, which still need to be broken out between personal and the rental. And then they can possibly be deducted on each because of the personal side would be schedule A, rental side schedule E. Example, you own a duplex and live in one half renting out the other half. Both units are approximately the same size. Last year you paid a total of $10,000 mortgage interest and 2000 real estate taxes for the entire property. You can deduct 5,000 mortgage interest and 1000 real estate taxes on schedule E because it's a duplex and you would expect it would be cut in half if you're living in one half of the duplex. So if you itemize your deductions, deductions include the other 5,000 mortgage interest and 1000 real estate taxes when figuring the amount you can deduct on schedule A. Because they're personal, which means you wouldn't normally get to deduct them except that they're weird schedule A items which you may be able to deduct there. Not rented for profit. So if you don't rent your property to make a profit, you can't deduct rental expenses in excess of the amount of your rental income. So now you're renting the property, but maybe you're not looking to get a gain on the property. Well, you're still kind of renting it, but what the IRS is going to be clearly most concerned with us is this loss situation. Because if you're not looking to get a profit and you have these losses and then you're getting a tax benefit from the losses by taking the losses against other income, that's where the IRS obviously is skeptical all the time on the losses. They want your income. If you're making money, then they want a piece. If you're losing money, that's on you. That's on you, says the IRS. Don't be asking me for putting money in there. Anyways, you can't deduct a loss or carry forward to the next year any rental expenses that are more than your rental income for the year. So where to report? Report your not-for-profit rental income on Schedule 1, Form 1040, Align 8J. So if you itemize your deductions and close your mortgage interest, if you use the property as your main home or second home, real estate taxes and casually losses from your not-for-profit rental activity when figuring the amount you can deduct on Schedule A. Presumption of profit. So if your rental income is more than your rental expenses for at least three years out of a period of five consecutive years, you are presumed to be renting your property to make a profit. Now this is similar to a situation where if you have a business, a Schedule C business, the IRS is skeptical as to whether it's a hobby or not. In the classic example is that horse race situation where you had rich people that had this really expensive hobby of horse racing, but they kept on running these big losses. So you might have income, but horse racing apparently is quite expensive to own a horse, I guess. And so you could have these big losses and the IRS is like, well, look, that's a hobby and we're not going to pay for it. We don't want you to be able to take the losses against other income. But other businesses run losses, obviously. In the first three years, it's quite common to have a loss even if you have a profit motive. So then the presumption then is usually on the IRS's side to prove that it's a hobby rather than a loss. If you're saying I'm doing this for profit even though I'm running losses, then it's on the IRS to kind of prove otherwise unless you go over a certain threshold. If you have three or more three years out of more than three years of losses, at some point the IRS is going to put the presumption more on you. So we have a similar kind of situation here. Your presumption is for profit. And which is a common scenario with rental property in that losses are another big issue that we've been talking about a lot of times because you have the property that could be going up in value of the property. And so they might be thinking, I'm going to try to take losses as the property accumulates in value, but you have a similar situation here where the IRS is going to say give you a presumption that it's for profit. If you say it's for profit, and then if you go over a certain number of years of losses, then the IRS is going to say now it's on you to prove that it's for profit. It's a general kind of idea. So once again, if your rental income is more than your rental expenses for at least three years out of the five-year period, meaning you had income rather than losses that you were taking against other income, consecutive years you are presumed to be renting your property to make a profit. Okay, postponing decision. If you are starting your rental activity and don't have three years showing profit, you can elect to have the presumption made after you have the five years of experience required by the test. So you may choose to postpone the decision of whether the rental is for profit by filing form 5213. You must file form 5213 within three years after the due date of your return determined within extensions for the year in which you first carried on the activity, or if earlier within 60 days after receiving written notice from the IRS proposing the disallowed deductions attributable to the activity. Alright, more information. For more information about the rules for an activity not engaged for profit, you can see not-for-profit activities in Chapter 1 of Publication 535.