 Income Tax 2021-2022 Rental Property Special Situations Part 2 Get ready to get refunds to the max. Dive into Income Tax 2021-2022 Most of this information can be found in Publication 527 Residential Rental Property Tax Year 2021 IRS website IRS.gov IRS.gov The Income Tax formula, looking at line 1 income, we would have a sub-schedule, basically an income statement with income and expenses, expenses basically being deductions to net then what rolls in to line 1 income as well as eventually page 1 of the form 1040. This is the schedule E, basically the income statement schedule, the supplemental income and laws we're focusing in on the rental real estate. So we're continuing on our discussion, we're looking at the renting of property. 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 had two separate pieces of property. So this is another area where of course the confusion comes into play if we have, for example, our personal residence and we rent part of that residence. Now we've got a situation similar to a business situation where we have mixing of kind of the business and the personal, which makes it more difficult to calculate the business versus the personal, and we need to do so import for the tax calculation. So you would think that you might need some kind of ratio analysis to determine those expenses that are going to be deductible for the business side of things, the rental side of things versus those that might not be deductible and certainly are not deductible as the rental kind of component, although they might be deductible somewhere else, such as, for example, on a Schedule A. So you can deduct the expenses related to part of the property used for rental purposes, such as home mortgage interest, mortgage insurance premiums, and real estate taxes as rental expenses on the Schedule E. Now notice that some of those expenses, you might also be able to deduct, say, on the Schedule A if it was for personal use. In other words, we've got the normal situation for income taxes, usually the things that would be deductible are those things that you needed to use in order to help to generate the income so that the income tax would not be imposed on the gross income, but rather the net income. That's just what you would think would be fair for natural income taxes. That's kind of how the Schedule E works. So if you were on the Schedule E, you got those things that are necessary to generate the income, that would be a natural deduction for an income tax. But on the Schedule A, you will recall that we have other things that aren't as natural to income taxes that could be deductible for, say, a personal residence, things like the mortgage interest, things like the state taxes, possibly. So then we could have this kind of allocation between being able to deduct these items in different places, and we've got to make sure that we get the allocation leveled out properly on it. And again, it might be more beneficial sometimes to deduct from the Schedule E in some cases because then you won't have the limitations that you might have on the Schedule A that you could have, such as whether you're going to be itemizing or not. So the Schedule E could have limitations too, such as losses and the capacity to deduct losses. So in any case, you can also deduct as rental expenses a portion of other expenses that are normally non-deductible personal expenses, such as expenses for electricity or painting the outside of the house. So these are things that you couldn't deduct if it was your principal residence because it's a principal residence and the general rule would you don't get to deduct personal stuff. If it's rental property, then you would think you'd get to deduct part of that. There is no change in the type of expenses deductible for the personal use part of the property. Generally, these expenses may be deducted only if you itemize your deductions on the Schedule A. So those kind of things that you would deduct as an itemized deduction, the mortgage interest, and the taxes, for example. The amount of expenses on the personal side could be deducted on the Schedule A if you itemize possibly if it was for personal use versus the rental use. So you can't deduct any part of the cost of the first phone line even if your tenant have unlimited use of it. You don't have to divide the expenses that belong only to the rental part of your home. 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. If you install a second phone line strictly for your tenant's use, all the cost of the second line is deductible as a rental expense. In that case, you wouldn't have the second line if it wasn't for the rental as opposed to obviously the first phone line that you would have even if you didn't have the rent. So you can deduct depreciation on the part of the house used for rental purpose as well as the furniture and equipment you use for rental purposes. So that could be a big deduction. It gets a bit confusing again because now you've got the whole property. You're only renting basically part of it. The cost, you've got to figure the cost and the basis of the property and so on. And then the portion of the property that's being rented being the amount that you can calculate the depreciation on. So how to divide expenses? You might ask if an expense is for both rental use and personal use such as mortgage interest and heat for the entire house. How must divide the expense between rental and personal use? You can use any reasonable method for dividing the expense. So any reasonable method. So now we've got to be reasonable, but I don't want to be reasonable. I want to deduct a whole bunch of stuff. So, but no, we're going to be reasonable here. So, okay, it may be reasonable to divide the cost of some items. For example, water based on the number of people using them. So if you're, you know, that would be a reasonable basis, right? We're trying to find some allocation between the water bill and we can think about how many people are in the home. And that could be one way that we could do our allocation. That might not, now notice there you're using like different activity basises. You might not use that same method to allocate other things such as like painting the outside of the house or something like that. Might not really tie out to, you might use square footage or something like that ratio to figure it out. So the two most common methods of dividing an expense are one, the number of rooms in your home and two, the square footage of your home. So that would be the most common kind of thing to do. You'd say, okay, well here's my square footage for the rental space divided by the square footage for the whole space. That ratio is the thing that you're usually going to be used. That would be using the main or one activity base as they might call for everything. But you could use these other reasonable things for other kind of measurements if you wanted to, such as the number of people using the water to do the allocation. That might be, you know, another method you could use. You'd come up to a different number than you would if you just used like the square footage of the rental property. Most likely you'd come up with a different number than if you used like the number of people and so on. So example, you rent a room in your house. The room is 12 by 15 feet or 180 square feet. Your entire house has 1,800 square feet of floor. So you can deduct as rental expense 10% of any. So we're dividing that out obviously. So we took out the trustee ruler and measured out the square footage of that one space to 12 times to 15. We got the 180 divided by the total square feet of the home that gives us the 0.1. If we multiply it times 100, that's the 10, 10%. So you can deduct as rental expense 10% of any expense that must be divided between rental use and personal use. If you're heating bill for the year for the entire house with $660, 600 times to 10% is the rental expense. The balance $540 is a personal expense that you can't deduct. So duplex, a common situation is the duplex where you live in one unit and rent out the other. 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. For example, you own a duplex and live in one half, rent in the other half. Both units are approximately the same size. Last year you paid a total of $10,000 mortgage interest and $2,000 real estate taxes for the entire property. You can deduct $5,000, half of it because they're approximately the same size. We said mortgage interest and 1,000 real estate taxes on schedule E. If you itemize your deductions, include the other 5,000 mortgage interest and 1,000 real estate taxes when figuring the amount you can deduct on schedule A. So itemized deductions, the part that was personal versus the schedule E for the part that was rental for the types of things that you might get a deduction either way depending on if you can get the itemized deductions, that being the mortgage interest and the real estate taxes, not rented for profit. So if you're not renting it for profit, this often happens like in family units where things get quite complex. And now you've got a rental agreement where it's not an arms-length transaction and so that complicates things. So if you don't rent your property to make a profit, you can't deduct rental expenses in the excess of the amount of your rental income. So they're skeptical, of course, of losses in that case. In those cases, if it's not for profit because then if you gifted something, say to a sibling or a child and they're using the property and then you're taking a loss on it because you're not collecting the proper amount of rent that you would get if you rented it to someone else and so on. So 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, Line 8i. If you itemize your deductions, includes your mortgage interest and mortgage insurance premiums, if you use the property as your main home or second home, real estate taxes and casualty losses from your not-for-profit rental activity when figuring the amount you can deduct on Schedule A, presumption of profit. So when you argue with the IRS about it, then now you've got this question, the IRS saying, were you in it for profit or not? Am I innocent till proven guilty or does the IRS take in the stance that I'm guilty until I prove innocent, which sometimes these are two different stances that when you get in the argument with the IRS. 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. So that's good because in the event of an audit, then you're kind of more on the innocent until proven guilty situation. Whereas if not, then you're more on the guilty till proven innocent situation, which is a bigger hurdle to overcome. And for taxes, that becomes kind of a big thing because where the IRS is going to stand, what they have to prove. And you have a similar kind of thing on the Schedule C, by the way, arguing it for profit versus kind of like a hobby type of situation. So postponing decision, if you are starting your rental activity and don't have three years showing a profit, you can elect to have a presumption made after you have five years of experience required by the test. You may choose to postpone your 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, determining whether 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 to disallow deductions attributable to the activity. More information, so more information about the rules for an activity not engaged in for profit. You can see not for profit activities in Chapter 1 of publication 535. Example, property changed to rental use. In January, Eileen bought a condominium apartment to live in. Instead of selling the house she had been living in, she decided to change it to rental property. So she selected a tenant and started renting the house on February 1st. Eileen charged $750 a month for the rent and collects herself. She also received $750 security deposit from her tenant because she plans to return it to her tenant at the end of the lease. She doesn't include it in her income, so it's a security deposit. Her rental expenses for the year are as follows, mortgage interest, fire insurance, miscellaneous repairs, real estate taxes coming out to $1,800, $100, $297, $1,200 respectively. She must divide the real estate taxes, mortgage interest, and fire insurance between the personal use of the property and the rental use of the property. She can deduct $1112 of these expenses as rental because she rented it. She moved in January, so she moved $11 months was rental, $1 month was personal use. So you got the ratio of $1112. So she can include the balance of the real estate taxes and mortgage interest when figuring the amount she can deduct on schedule A if she itemizes. She can't deduct the balance of the fire insurance because it is a personal expense. She bought this house in 1987 for $35,000. Her property tax was based on assessed values of $10,000 for the land and $25,000 for the house. Before changing it to rental property, she added several improvements to the house. She figures her adjusted basis as follows. So now she changed from a personal to a rental. So now we've got to have the lesser of the adjusted basis versus the fair market value of the house. So the house cost $25,000. The remodeled kitchen $4,200. Recreation room $5,800. New roof $1,600. And a patio and deck for $2,400 to come up to the adjusted basis of $39,000. On February, when she changed her house to rental property, the property had a fair market value of $152,000 of this amount. So notice again, when you look at the fair market value, it's going to include land and building or building and land. You're looking for the building amount because that's the depreciable amount of this amount. $35,000 was for land and $117,000 was for the house. Because she adjusted basis is less than the fair market value of the date of the change, she uses the $39,000, which is substantially less and a substantial non-benefit to be using, but that's the way it works out on it. You've got to use a lesser of. So as specified for residential rental property, she must use the straight line method of depreciation over the GDS and ADS recovery period. She chooses the GDS recovery period of 27.5 years. Note that I'm kind of complaining about using the lesser of the values. Notice that they could have been worse on it. They could have said that you had to recognize a gain at that point in time and pay taxes on the gain. So by taking the lesser of and not going up to the fair market value, if it increased in value, like if they let you just skip up to the increase in value, then that would be like a nice tax thing. Because basically you wouldn't be paying the gain on the increase in the value, which you don't usually do until you realize it. And so they could have been worse off. They could have said we're going to force you to realize the gain when you convert from personal to rental property. But instead they keep the lower basis so that you'll recognize, you know, you don't get the depreciation. You recognize the gain when you sell it. But in any case, so or recovery, she chooses the GDS recovery period of 27.5 years. Okay, she uses Table 22D to find her depreciation percent because she placed the property in service in February. The percent is 3.182. That's the depreciation of the property on April 1st. She bought a new dishwasher for the rental property at a cost of $425 to dishwasher's personal property used in the rental real estate activity, which has five year recovery period. We talked about that in the past. She uses Table 22A to find the depreciation percent for year one under the half year conversion 20% to figure her depreciation deduction. On May 1st, she paid $4,000 to have a furnace installed in the house. That's nice. The tenants will like that. The furnace is a residential rental property because she placed the property in service in May. The depreciation percent from Table 22D is 2.273. She figures her net rental income or loss for the house as follows. So she's got the total rental income for the 11 months. She rented it 750 times the 11 for the 8,250. And then she's got the mortgage interest, which is the 1,800 times 1112 because she rented it for 11 out of 12 years. The fire insurance was the 100 times the 1112. The miscellaneous repairs, which is going to be just the 298, 97 because she did those just for the rental property. So she does not have to multiply it times the 1112. The real estate taxes 1,200 on the year times 1112. And that gives us the total expenses of the 3,139 for a balance of the 8,250 minus the 3,139 or 5,111. Then she's got depreciation of the 39,000, which was the lesser of the adjusted basis of the fair market value, which was the adjusted basis in our case. And then she's got the dishwasher depreciation and the furnace that she bought for the tenants, which I think the tenants will really like that. So that's going to give us the total depreciation of the 1,417. So we have the 5,111 minus the 1,017 gives us the 3,694 here. Also note that the mortgage interest and the real estate taxes, for example, might be deductible on the Schedule A for that one month that it was still personal property for the principal residence. So she uses Schedule E Part 1 to report her rental income and expenses. She enters her income expenses and depreciation for the house in the column for property A because all property was placed in service this year, Elaine must use the Form 4562 to figure the depreciation. And you'd also have depreciation schedules most likely that might not be required to attach to the return. She sees the instructions for Form 4562 for more information on preparing the form.