As your prepare your 1991 income tax returns, be careful how you treat that condo at Ocean City or Deep Creek Lake. Here are some tips for preparing tax returns on rental property.
Losses generated from rental property are normally deductible, though they are limited by various phaseout and carry-over provisions. However, losses derived from renting a vacation home are subject to additional restrictions.
A vacation home is rental property that has been used by the taxpayer for personal purposes for more than 14 days during the tax year or more than 10 percent of the number of days the home is rented at a fair rental value, whichever is greater.
In computing the allowable expense deduction, the Internal Revenue Service applies an allocation formula based on the percentage relationship between the number of days the
property is rented and the total number of days the property is used, including personal-use days. However, the tax court has partially rejected this "days-of-use" formula and divides the vacation home expenses into two categories:
* Real estate taxes and home mortgage interest.
* Repairs, maintenance, depreciation and other rent-related expenses.
The tax court formula computes the deduction for taxes and interest using a "total-year" formula, based on the number of days the property is rented as a percentage of 365 days in a year, regardless of the number of personal-use days. The deduction for other expenses is computed using the IRS days-of-use formula.
Note: The tax court decision has been affirmed on appeal by the Ninth and Tenth Circuit Courts of Appeals.
Here is an example of how the two methods work. During the year, Shelly Ruffing rents out her vacation home for 91 days and uses the home for personal purposes on 30 days. The gross rental income from the unit is $3,700 for the year. She pays $4,000 in real estate taxes and mortgage interest on the property. Expenses for maintenance, repair and utilities total $3,000. The IRS days-of-use allocation of all expenses would be based on 75 percent (91 days rented divided by 121 days used).
In contrast, the tax court would allocate taxes and interest based on 25 percent (91 days rented divided by 365 days) and use the IRS 75 percent allocation for costs of maintenance, repairs, etc.
Under either method, the entire $4,000 in interest and taxes is allowed as a deduction. The IRS method allows $3,000 to be deducted as a rent-related expense and the remaining $1,000 as an itemized deduction. The tax court formula allows $1,000 as a rent-related expense and $3,000 as an itemized deduction.
But it is with respect to maintenance, repairs and other expenses that the two methods arrive at dramatically different results. The IRS method allows only $750 (25 percent of the $3,000) as a deduction, $700 in the current year and $50 as a carry-over. In contrast, the tax court method allows $2,250 (75 percent of the $3,000) as a deduction in the current year.
When rental property is classified as a vacation home, depreciation and other expenses can be deducted only to the extent of the net rental income from the property (minus the allocable portion of mortgage interest and real estate taxes). Essentially, depreciation and rent-related expenses cannot be used to generate a net loss from a vacation home.