 Hello, and welcome to the session in which we will discuss the rental of vacation homes. When you have a second home either on a beach in the mountains or in your favorite city and sometime what you do you might rent that home as a source of income when you are not there. So what is the treatment of that rental income if you do have that second home? Well we have to understand a vacation home may have three different classification which are primarily personal use residence, primarily rental use residence and personal slash rental use residence which is a hybrid category. So the first thing before you determine how to treat the income and the expenses from your vacation home you have to understand what does it qualify under is it's a primary use personal primarily rental or is it a hybrid personal slash rental use residence. Starting with primary personal use residence which is the easiest category and let's go ahead and discuss this when is the vacation home considered a primarily personal use residence is a residence that's rented for less than 15 days during the tax year then it's a primarily personal use residence. So you do have that second vacation home however you rented it for less than 15 days if you rented it less than 15 days guess what it's water under the bridge the taxpayer is not required to report any income from the rent of personal use residence also you have to understand you also cannot deduct any expenses associated with the residence of course except for qualified mortgage interest and real estate taxes but those they go on your itemize deduction on schedule A that's different so you have to understand if it's a primarily personal use nothing to worry about let's take a look at an example before we proceed any further I have a public announcement about my company farhatlectures.com Farhat accounting lectures is a supplemental educational tool that's gonna help you with your CPA exam preparation as well as your accounting courses my CPA material is aligned with your CPA review course such as Becker Roger Wiley Gleam Miles my accounting courses are aligned with your accounting courses broken down by chapter and topics my resources consist of lectures multiple choice questions true false questions as well as exercises go ahead start your free trial today no obligation no credit card required. Garcia owns a beach house during the current tax year she rented it to an unrelated party for 10 days for $2300 the house was vacant for the remainder of the year. Garcia incurred the following expenses in relation to the house utilities maintenance depreciation property taxes mortgage interest of 300 for income tax purposes determine the appropriate treatment of the income and the expenses well given that Garcia rented the house for 10 days only well it's less than 15 days we consider this as a personal use property therefore Garcia is not required to report the income regarding the expenses she's allowed to deduct the property taxes and mortgage interest which is total of 1500 on her schedule A let's take a look when the property is a primarily rental use property when is it a primarily rental use well when it's rented for more than 15 days also not used for personal purpose for more than the greater of so it has to be more than 15 days and when it comes to personal use you did not use it more than 14 the greater of 14 days or 10% of the total rental days when it's treated as a rental use property so for example a few rented it 200 days times 10% that's 20 days so now you did not use it the greater of 14 or 20 days you would look at 20 days so you cannot use it more than 20 days for personal use now a taxpayer is required to report any income earned from the rent of the rent of this rental property in addition he or she made about the expenses associated with the rental use of the property well what we have here is a rental property technically for rental use property a taxpayer is allowed to report a net loss from the rental activity so if you do have a loss you can report that net loss now it's worth noting or mentioning following the tax cuts and jobs act of 2017 the mortgage interest on this type of property is no longer deductible as itemized deduction because the property does not qualify as a personal residence told the straight let's take a look at this example going back to Garcia Garcia rented her beach house for unreal for an unrelated party for 40 days for 5200 and personally used it for 10 days now on the first example I told you Garcia has a beach house and she rented it for 10 days you could also rent your own home for 10 days it doesn't have to be a second house and it will be also a personal residence now we rented it more than 15 days so notice it's no longer considered personal residence and Garcia incurred the following expenses utilities of 1200 maintenance of 700 depreciation of a thousand property taxes of 1700 and mortgage interest of 2560 let's determine the appropriate treatment for the income and the expenses under the scenario well the first thing is it's no longer a primarily residence home here why because we rented it more than 15 days also it was used for personal purpose for 10 days now which is less than the greater of 14 days or 10% of rental days the rental days were 40 days times 10% that's equal to 4 days well so 10 days the personal use 10 days is less than the greater of 14 and for the greater is 14 it's less than 14 therefore this property is classified as rental use property rental use property means just simply put we have a schedule E and we fill out our income and expenses there let's take a look at what we do for this example the numbers that we need to compute as expense related to the rental property if you want to copy the numbers down the expenses we're gonna go to the second slide well income is the same personal rental or personal it doesn't matter the income is reported for 5200 now what do we have to deal with you with utilities remember we have utilities of let's see utilities were total of 1200 the total was 1200 now we are going to prorate the utilities we're gonna give 10% 20% how did we come up with 20% 10 days divided by 50 where's the 50 coming from 10 personal 40 rental we have 50 days and the rental portion 40 divided by 50 which is 80% so we're gonna prorate the utilities 20% personal 80% business same thing with maintenance which is $700 in total 20% depreciation was a thousand property taxes let's see 1360 plus 340 that's 1700 and mortgage interest the same thing we're gonna prorate them prorate them 20 and a 20 and 80% now the income is 5200 the total deductible expenses for this business adding up all the expenses is 5728 all in all we have a loss of 528 and this loss is deductible for a GI assuming the at risk and passive activity or loss are satisfied so you can deduct this income against other income assuming we satisfy this at risk rule which we'll talk we'll talk about in a separate recording in addition what's gonna happen with Garcia the $340 of property taxes that was considered personal this will go on her schedule a and she'll be able to deduct this the mortgage interest as well as other expenses associated with the personal use which are let me just show you what's gonna happen to these expenses this this this this too bad those you cannot use basically she lost them it's personal use and it's not deductible now let's take a look at personal slash rental use property so this one is not primary residence it's not primary rental we have a rental place and it's hybrid when do we consider a place as a hybrid well first the place has to be rented more than 15 days and used and used notice here not used and used for personal purposes for the greater of again 14 days or 10% of the total rental days as it's treated as per as as personal slash rental use property so rather than not used now it's used for the for the greater of these though so let's take a look at we'll look we'll look at an example in this case of a personal slash rental use property the taxpayer is required to report the income from the rental property so the income that's not an issue we have to report the income however the expenses must be allocated between the personal and rental use on a pro rata basis the expenses related to the rental use property are allowed as a deduction to the extent of rental income so the expenses we can deduct them they have to be first prorated then we can deduct them but here's the thing we can deduct them to the extent of rental income what does that mean it means the expenses cannot be more than income so in other words no loss is allowed the rental activity may not result in a loss so the best case scenario is for tax purposes we would have we break even zero so we have 10 thousand of income we can only deduct 10 000 of expenses although we have more than 10 000 prorated to that business to that rental we can't it's up to zero it's like a hobby loss a hobby activity you cannot create a net loss additionally the expenses deducted they have to follow in order first we deduct the real estate taxes then end the mortgage interest which are deductible in all cases here all cases means on schedule a then we would look at operating expenses such as utility maintenance insurance and depreciation now for personal slash rental use property which is the hybrid the mortgage interest and the real estate associated with that are can be allowed as itemized deductions so that's why we start with them we start deducting them first that's why we deduct them first because if they are not if they are not deducted for rental they are deducted on schedule a let's take a look at an example to illustrate this concept again going back to Garcia now she rented her house to an unrelated party for 45 days so it's more than 15 it's it's not it's no longer primary residence and personally used it for 15 days well let's look at the expenses that she incurred utilities of 1700 maintenance 900 depreciation 1200 property taxes 1200 and mortgage interest of 2760 how do we treat those incomes and expenses well let's take a look at it first Garcia's home was rented for 45 days which is more than 15 means no longer a primary residence additionally it was used for personal purpose for 15 days which is what the greater greater than 14 days or 10 percent of rental period 45 days times 10 percent 4.5 well 15 days is greater than 14 days so now what we have is we have a hybrid therefore the beach house in this situation classify as a hybrid personal slash rental use property now how do we allocate the expenses because the income has to be reported fully well we are gonna have the denominator for the ratio is 60 days which is 45 rental plus 15 personal 60 days so personal is 15 over 60 which is 25 percent the rental is 45 over 60 which is 75 percent the income is all goes toward the rental then the mortgage is allocated 75 to 25 property taxes same concept utilities maintenance and depreciation now if we add up all the expenses and let's go ahead and add up all the expenses that we computed here so if we take 20 70 plus 14 25 plus 20 75 plus 6 75 plus 900 if we add up all the expenses all the expenses will add up to be if my math is right 6345 well if that's the case if this is our expenses and we generated income of 6200 we should have a loss well we cannot we are limited in terms of in terms of let me go ahead and add up all the expenses first that we prorated so 2000 and 70 plus 14 25 plus 12 75 plus 6 75 plus 900 if we add up all the expenses it's going to be 6345 the expenses that we are prorated to the rental property based on a 75 percent ratio well guess what we cannot take all the deductions why not because we are limited to 6200 in deduction so what's going to happen is this we can only take from depreciation we're going to go to the depreciation and we are only deduction is limited to 755 why 755 because if we take 755 plus the all the other expenses will give us exactly 6200 remember this is a hybrid situation therefore we cannot report a loss it has to be zero now what's going to happen the depreciation it will be carried over for the personal personal portion well we have the mortgage and the property taxes those will be reported on schedule a utilities maintenance and depreciation well depreciation the personal portion is not allowed basically they're going to be not simply put not used simply put not used so let's review as a result this is a hybrid no gain and no loss for Garcia although she has 6345 she can only deduct 6200 in fact the deduction of depreciation is limited to 755 and remaining depreciation carried forward to future years it's also important that the basis of the depreciation is reduced by 755 the basis of the property because it's depreciated so when you sell it later it's a reduction because remember when you take depreciation it reduces your basis well which we'll talk about that later in a separate session when we talk about depreciation and cost recovery in addition Garcia has allowed to deduct 1165 which are the the sum of the taxes on the property and the mortgage interest associated now let's discuss a topic about the allocation of expenses because the IRS will have a different role than the courts this is beyond the scope of a CPA exam I'm not sure if it's going to be covered for the CPA exam in the future but nevertheless I think for a student or for an enrolled agent this is relevant the allocation of real estate taxes and mortgage interest those two between rental and personal use property differ from the court and the IRS so how you'd be able to how much to deduct depending because it's a hybrid in other words what's the denominator that we're going to be using is it going to be the amount the days rented or is it going to be the the total days in a year the court as per court real estate taxes and mortgage which the crew relatively over the tax year should be allocated between the personal and rental basis on 365 or 366 if we have a leap year so based on the number of days in a year the IRS allocation which what I basically what I used the real estate taxes and the mortgage interest should be allocated between the personal and rental based on the total number of days in which the property was used the other type of expenses such as utilities maintenance and depreciation are allocated based on the total number of days in which the property was used so when it comes to the other expenses it's how much the property are used either court or IRS however when it comes to mortgage and interest this is where they differ so let's take a look at an example to see how this what what difference does it make okay John owns a house in the Poconos during the current year he rented it for 45 days 8200 an income the home is qualified as a hybrid personal slash rental John also used it for personal use for 30 days the real estate taxes and the mortgage interest associated with the house were 6200 and 3400 respectively in addition John incurred maintenance of 1200 utilities of 2500 and depreciation expense of 3500 now what we're gonna do we're gonna determine the total deductible expenses associated with the rental use under the IRA and under the court approach so we're gonna look at both side by side and look at the numbers now if you don't have the power point slides if you're not far hat member just copy or take a picture of the slides so you can see where the numbers are coming from now whether we used the IRS or the court approach the income will always be the same under both so we it doesn't have to worry about income when it comes to the IRS approach how do we prorate we prorate based on the number of rental days well what does that mean it's the denominator is 75 days why 75 days it's the rental which is 45 plus the personal 30 we would use 75 days therefore if we use 75 days 45 divided by 75 the rental days divided by 75 the rental is 60 percent so for the mortgage we're gonna take 60 percent of the mortgage interest deducted we're gonna take 60 percent of the property taxes and for the other expenses it's gonna be 60 always 60 percent now when it comes to the IRA the court approach under the court approach here's what's gonna happen for the mortgage interest we are gonna take 3400 we're gonna take 45 days and we're gonna be using a different denominator and the denominator is 365 for mortgage interest also for property taxes we're only gonna be taken 764 for mortgage interest then when it comes to utilities it doesn't really make a difference it's gonna be based on 75 so notice the only difference it makes it when it comes to mortgage and taxes and the answer is why well we're gonna see why in a moment what what difference does it make to the taxpayer whether they use the court approach or they use the IRS approach now here's what's gonna happen since since this is a hybrid we can only have we can only have maximum we can have zero income maximum means you cannot have a loss you can have a zero income so your expenses cannot exceed your expenses cannot exceed 8200 so when we add up all our expenses we are still short of 2200 from the balance so what you do is you use the depreciation last and you would say okay my depreciation in total is 1920 I'm limited to 220 therefore if I take only 220 of depreciation 220 of depreciation and add up all the expenses based on the IRS approach I have 8200 of income 8200 of income will give me a loss of zero that's fine let's take a look at the court approach under the court approach my mortgage interest is 419 my properties 764 my utilities 1500 my maintenance is 720 therefore I can still deduct 4796 therefore I'm gonna take my full depreciation which is 1920 and after all said and done I have expenses of 5,324 well which gonna give me a net income a net income of 2876 you're gonna say I don't like the net income because I have to pay taxes on this net income well yes you would prefer to have a loss rather than a net income unless unless what's gonna happen is this unless you can take you can benefit from the amount of interest and taxes that you're gonna be able to take on schedule a so you have to determine can I benefit from my interest and taxes I take on schedule a versus paying my taxes so you have to make that decision so that's why it's different so if simply put let's let me simplify it for you if you don't itemize if you don't itemize you want the IRS approach because you want to take as much as possible in your deduction and have a zero go go ahead and break even now if you itemize you have to determine what's the effect of my itemized deduction versus the additional taxes I have to pay on this income so for each individual it will be different and if I have to guess most likely the future CPA exam they will have they might have a problems like this as part of the tax planning my guess just the speculation from my end under the IRS IRS approach the mortgage interest and the real state are allocated based on the days of use which is 75 days 45 plus 30 the court allocate based on the number of years the remaining real estate taxes and the mortgage which are not deducted and arriving at agi are allowed as itemized deduction on schedule a so you have to know if it's worth it for you those itemize deductions for example under the IRS not IRA you have 3840 under the court approach you have 8 416 you have to determine the effect of the taxes on taking these into account because the amount of taxes could be different could be way larger under certain circumstances so that's the key what should you do now go to forehead lectures look at additional mcqs through false exercises additional lectures that's going to help you understand this topic better rental income rental income taxes of rental income vacation of vacation rental income is important is an important topic on the CPA exam good luck study hard I'm always here for you and stay safe