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Rental Real Estate Losses & U.S. Tax Code

This article will focus on rental real estate losses.  However, please keep in mind my general advice on taking tax losses is that the U.S. Tax Code is very stingy on allowing loses.  So whenever you believe you are entitled to take a loss, be it a capital loss, a supplemental income loss – like a rental loss, a partnership loss, or a net business loss, my rule of thumb is to check the law, check it again, and check it a third time, just to make sure that the loss is allowed.  Why?  Because the Tax Code is very stingy on allowing losses.

Rental real estate losses

Are you a New York snowbird that has a condo in Florida that you spend the winter months in but “rent” it out for a couple of weeks a year so that you can write off significant expenses related to the property as rental losses?

Do you rent to family members for the price of the utilities?

Or do you simply own rental real estate and incur large losses that you use to absorb other income  with?

If you answered yes to any of these questions, then you should beware of the potential for an IRS audit that may ruin you.

What I am speaking of in tax terms are losses related to passive activities which concern renting property.

There are a host of rules – hurdles really – that must be overcome in order to take losses related to renting property.  I have had numerous cases where taxpayers took large losses year after year and then after the audit was over, they ended up owing the IRS incredible sums of tax, penalties and interest, which lead them to financial ruin.

In a nutshell, here are some of the traps set for rental property owners.

Renting to family members raises a red audit flag

The IRS loves this one.  I’ve been involved in many cases where the taxpayers own several apartments.  Many times one or more of these apartments are occupied by the taxpayer’s adult children.  The children of course are living in their parents’ units because they can’t afford to rent somewhere else.

The IRS will jump on this because, I.R.C. (the U.S. Tax Code) §280A, disallows any loss claimed by the parents, if the rental is used by a member of the family and that family member is not paying fair rental value for the apartment.

Under this scenario, the taxpayers are considered to be using the apartment themselves.  As such, the rental unit is (fictionally) being personally used by mom and dad.  And mom and dad (or you and I) cannot incur losses related to the personal use of our apartments.

Renting the vacation home raises a red flag

The tax law does not allow deductions for the personal use of property.  Generally, the “vacation home” case is one where the taxpayers own a house in New York, and a condo in Florida (or Aspen, or wherever).

The taxpayers use the second home personally for part of the year and rent it out for part of the year.  Then the taxpayers deduct all of the expenses related to their second home as “rental” expenses, which greatly exceed any rental income received.   This results in a rental loss that absorbs other income reported by the taxpayers.  The overall effect is a much reduced income tax liability.

Unfortunately, the tax law does not allow for losses related to the “personal” use of the second home.  Additionally, in these types of cases, deductions are limited to the amount of rental income received.

When the second home is used as a rental and a residence, there is an allocation formula that is used to determine the amount of deductible expenses.

The formula is as follows:  Number of days rented, divided by number of days used (by renter and owners) times the expenses incurred.

For example, the owners rent a property for 25 days for $250 dollars.  The owners use the property themselves for 50 days.  The total expenses incurred (landscaping, snow removal, utilities, repairs) are $1,000.

Thus, $333 of expenses can be allocated to the rental use of the property (25 divided by 75 equals  0.333 times $1,000 = $333)

However, allowable rental expenses (under 280A) are capped at the amount of rental income received.  Thus, in this example, the owners may deduct only $250 of the $333.33.

Also, please be aware that the law provides that a rental property is a residence of the owners (and thus any rental losses are not allowed) if the owners use the property for a certain number of days a year.  In order to fall into this trap the taxpayers must use the property the greater of either 14 days, or 10% of the number of days rented.

For example, a snowbird rents his condo, at fair value, for 150 days of the year and he stays there for 30 days.  The property is considered a residence under §280A.  Thus, he or she cannot incur a loss, because he used the place as a residence for more than 15 days (10% of the number of days rented = 15, which is greater than 14).

The allowable rental loss – passive activity

Generally, taxpayers cannot incur losses related to passive activities (I.R.C. §469).  Passive activities by definition include rental activities and any other activity which involves the operation of a trade or business in which the taxpayers did not materially participate.

In the rental world, in order to materially participate (and be entitled to whatever loss amount possible), the taxpayer needs to spend more than one-half of all his working hours working on his rental activity and those hours have to exceed 750 hours per rental property (unless an election to lump all properties into one activity is utilized).

However, and here is one of the few places where the Tax Code is generous regarding losses, even if the taxpayer did not materially participate in his or her rental activity, he or she can deduct up to a $25,000 loss, per year, as long as two conditions are met.

First, the taxpayer must actively participate in the rental activity (this is really not a defined term but the taxpayer is not actively participating if he or she owns less than 10 percent of the property).

Second, the $25,000 loss will be reduced by .50 cents for every dollar that the taxpayer’s income is above $100,000.  Thus, a taxpayer with $150,000 in income will not be able to take a loss that year.

Please remember, this allowed loss only applies to taxpayers that do not use the rental as a residence.   Fall into §280A, and no loss is allowable.

Also, please remember that a lot of taxpayers lose audits and become very, very miserable because they failed to properly substantiate their expenses.  Do you have evidence of your utilities, landscaping and snow removal?  If not, then the IRS will disallow the expense because the taxpayers could not substantiate these otherwise allowable expenses.


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