See Landlord Classifications for some detail regarding the amount of your time and efforts in managing residential or commercial real estate rental properties.
If you rent a dwelling unit to others, on average for more than 7 days at a time, which you also use as a personal residence, then limitations may apply to the rental expenses that you can deduct currently or defer to be deducted in a future year. You are considered to use a dwelling unit as a personal residence if you use it for personal purposes during the tax year for more than the greater of:
- 14 days, or
- 10% of the total days you rent it to others at a fair rental price.
Note that if you rent a dwelling unit to others, on average for 7 days or less at a time, then it is not considered a rental activity for purposes of the IRC §469(c) and Reg. §1.469-1T(e)(3) vacation rental rules, but your material participation is still required to avoid the passive loss rules. see T.C. Memo. 1996-56.
It is possible that you will use more than one dwelling unit as a personal residence during the year. For example, if you live in your main home for 11 months, your home is a dwelling unit used as a personal residence. If you live in your vacation home for the other 30 days of the year, your vacation home is also a dwelling unit used as a personal residence unless you rent your vacation home to others at a fair rental value for 300 or more days during the year.
A day of personal use of a dwelling unit is any day that it is used by:
- You or any other person who has an interest in it, unless you rent your interest to another owner as his or her main home under a shared equity financing agreement
- A member of your family or of a family of any other person who has an interest in it, unless the family member uses it as his or her main home and pays a fair rental price
- Anyone under an agreement that lets you use some other dwelling unit
- Anyone at less than fair rental price
If you use the dwelling unit for both rental and personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. You will not be able to deduct your rental expense in excess of the gross rental income limitation (your gross rental income less the rental portion of mortgage interest, real estate taxes, and casualty losses, and rental expenses like realtors’ fees and advertising costs). However, you may be able to carry forward some of these rental expenses to the next year, subject to the gross rental income limitation for that year. If you itemize your deductions on Form 1040, Schedule A (PDF), Itemized Deductions, you may still be able to deduct your personal portion of mortgage interest, property taxes and casualty losses on that schedule.
There is a special rule (as may have been used by participants in Ty Pennington’s TV show Extreme Makeover: Home Edition) if you use a dwelling unit as a personal residence and have rented it out for fewer than 15 days during the year. In this case, do not report any of the rental income and do not deduct any expenses as rental expenses.
Another special rule applies if you rent part of your home to your employer and provide services for your employer in that rented space. In this case, report the rental income. You can deduct mortgage interest, qualified mortgage insurance premiums, real estate taxes, and personal casualty losses for the rented part, subject to any limitations, but do not deduct any business expenses. For information on these limits, refer to Publication 587, Business Use of Your Home (Including Use by Daycare Providers).
For more information on offering residential property for rent, refer to Publication 527, Residential Rental Property (Including Rental of Vacation Homes).
There are six exceptions to the definition of rental (paraphrased, as follows)
§ 1.469-1T(e)(3)(ii) Exceptions.
- The average period of customer use is seven days or less. For example: condo weekend rentals, short-term use of hotel/motel rooms, and businesses that rent videos/tuxedos/cars/tools, etc.
- The average period of customer use is 30 days or less and significant personal services are provided with the rental. Examples: hotels and motels.
- Extraordinary personal services are provided with the rental. Examples: hospitals, nursing homes and boarding schools.
- The rental is incidental to a non-rental activity.
- The taxpayer customarily makes the rental property available during defined business hours for nonexclusive use by various customers. Example: golf courses, health clubs and spas.
- The taxpayer provides the property for use in a non-rental activity of his own partnership, S Corporation, or joint venture.
The key word here is “provides,” not “rents.” For example: a partner contributes property in exchange for an ownership interest. This non-leasing transaction with the partnership is not a rental. Reg. § 1.469-1T(e)(3)(vii) states: “Thus, if a partner contributes the use of property to a partnership, none of the partner’s distributive share of partnership income is income from a rental activity…”
§ 1.1402(a)-4(a) In general.
Rentals from real estate and from personal property leased with the real estate (including such rentals paid in crop shares) and the deductions attributable thereto, unless such rentals are received by an individual in the course of a trade or business as a real-estate dealer, are excluded. Whether or not an individual is engaged in the trade or business of a real-estate dealer is determined by the application of the principles followed in respect of the taxes imposed by sections 1 and 3. In general, an individual who is engaged in the business of selling real estate to customers with a view to the gains and profits that may be derived from such sales is a real-estate dealer. On the other hand, an individual who merely holds real estate for investment or speculation and receives rentals therefrom is not considered a real-estate dealer. Where a real-estate dealer holds real estate for investment or speculation in addition to real estate held for sale to customers in the ordinary course of his trade or business as a real-estate dealer, only the rentals from the real estate held for sale to customers in the ordinary course of his trade or business as a real-estate dealer, and the deductions attributable thereto, are included in determining net earnings from self-employment; the rentals from the real estate held for investment or speculation, and the deductions attributable thereto, are excluded. Rentals paid in crop shares include income derived by an owner or lessee of land under an agreement entered into with another person pursuant to which such other person undertakes to produce a crop or livestock on such land and pursuant to which (1) the crop or livestock, or the proceeds thereof, are to be divided between such owner or lessee and such other person, and (2) the share of the owner or lessee depends on the amount of the crop or livestock produced. See, however, paragraph (b) of this section.
§ 1.1402(a)-4(c) Rentals from living quarters
(1) No services rendered for occupants. Payments for the use or occupancy of entire private residences or living quarters in duplex or multiple-housing units are generally rentals from real estate. Except in the case of real-estate dealers, such payments are excluded in determining net earnings from self-employment even though such payments are in part attributable to personal property furnished under the lease.
(2) Services rendered for occupants. Payments for the use or occupancy of rooms or other space where services are also rendered to the occupant, such as for the use or occupancy of rooms or other quarters in hotels, boarding houses, or apartment houses furnishing hotel services, or in tourist camps or tourist homes, or payments for the use or occupancy of space in parking lots, warehouses, or storage garages, do not constitute rentals from real estate; consequently, such payments are included in determining net earnings from self-employment. Generally, services are considered rendered to the occupant if they are primarily for his convenience and are other than those usually or customarily rendered in connection with the rental of rooms or other space for occupancy only. The supplying of maid service, for example, constitutes such service; whereas the furnishing of heat and light, the cleaning of public entrances, exits, stairways and lobbies, the collection of trash, and so forth, are not considered as services rendered to the occupant.
(3) Example. The application of this paragraph may be illustrated by the following example:
A, an individual, owns a building containing four apartments. During the taxable year, he receives $1,400 from apartments numbered 1 and 2, which are rented without services rendered to the occupants, and $3,600 from apartments numbered 3 and 4, which are rented with services rendered to the occupants. His fixed expenses for the four apartments aggregate $1,200 during the taxable year. In addition, he has $500 of expenses attributable to the services rendered to the occupants of apartments 3 and 4. In determining his net earnings from self-employment, A includes the $3,600 received from apartments 3 and 4, and the expenses of $1,100 ($500 plus one-half of $1,200) attributable thereto. The rentals and expenses attributable to apartments 1 and 2 are excluded. Therefore, A has $2,500 of net earnings from self-employment for the taxable year from the building.
What Property Qualifies for an IRC §1031 Tax-Free Exchange?
Both the property given up and the property received by the taxpayer must be held for productive use in a trade or business or for investment (§1031(A)(1)). For confusion’s sake, IRC §1031 does not define business or investment, therefore, conventional wisdom assumes that the terms have the same meaning as elsewhere in the code. The qualified use test is determined by the use of each property, both given and received, in the taxpayer’s hands. Therefore, the use of either property in the hands of the other party involved in the exchange is irrelevant (Rev. Rul. 75-291).
“Held for productive use in trade or business.” Qualifying property must be used in a trade or business in which the taxpayer is engaged (§162; §1231). For example, trade or business property would include buildings owned and used by a business, office buildings, apartment houses, machinery and equipment, business trucks, and automobiles.
Confusion reigns in this area. Rental units are business property. For tax and exchange purposes, rental units are considered to be business property, not investment property. Most investors think rentals are investments, which is not true. Investment property has the negative result of creating a capital loss whereas business property creates a fully deductible ordinary loss. So what is included in the very limited definition of investment property?
“Held for investment.” This probably refers to property held for future use or future appreciation in value (§212). Examples of investment property include unimproved raw land, recreational property, and possibly second homes and/or condominiums.
Personal residences and certain vacation homes don’t qualify. A personal residence (or a vacation home not held for investment) is not qualified use property because it is being used for personal purposes, not for business or investment purposes (Barry E. Moore and Deborah E. Moore v. Comm., TCM 2007-134).
The IRS has provided a safe harbor when an exchange involves a dwelling unit. The IRS will not challenge whether a dwelling unit qualifies under §1031 if the relinquished property was rented at fair rental value for at least 24 months immediately before the exchange (and was not used personally more than 14 days or 10% of the days rented) and the replacement property was rented for at least 24 months immediately after the exchange (and was not used personally more than 14 days or 10% of the days rented) (Rev. Proc. 2008-16).