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Old 04-13-2014, 11:41 AM
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Join Date: Apr 2014
Posts: 2
Contradictory IRS rules

I am confused by two IRS rules on rentals which seem to contradict one
another.

Consider a person who rents a couple of rooms in his house out to tenants.
He deducts a pro-rated portion of various house expenses (such as utilities,
property tax, mortgage interest, depreciation, etc.) on Schedule E based on
the square footage he rents out compared to the total square footage of the
house. This person is not a real estate pro, and meets all the requirements
for actively managing the rental and for it being passive income, etc. The
rental results in a small tax loss each year of a couple of thousand
dollars. The question is can he report this loss (i.e., negative income) on
his tax return each year to offset his regular income from employment, etc.

On one hand, I see a rule that says you have to show a profit in 3 out of 5
years to establish that you are renting for profit. On the other hand, I see
a rule that says you can deduct up to $25,000 in rental losses each year
assuming you meet all the rules for passive, active, etc. Don't these rules
contradict one another?

Here are the rules from Pub 527 that I'm talking about:

"If you do not rent your property to make a profit, you can deduct your
rental expenses only up to the amount of your rental income. You cannot
deduct a loss or carry forward to the next year any rental expenses that are
more than your rental income for the year." It further states "If your
rental income is more than your rental expenses for at least 3 years out of
a period of 5 consecutive years, you are presumed to be renting your
property to make a profit."

That seems pretty clear cut.

But in another section of the same manual it says: "If you or your spouse
actively participated in a passive rental real estate activity, you may be
able to deduct up to $25,000 of loss from the activity from your nonpassive
income. This special allowance is an exception to the general rule
disallowing losses in excess of income from passive activities. Similarly,
you may be able to offset credits from the activity against the tax on up to
$25,000 of nonpassive income after taking into account any losses allowed
under this exception."

No mention here of having to show a profit 3 out of 5 years.

How do we reconcile these two seemingly contradictory instructions?

I should note one other thing. In this case, the owner actually does make a real profit on the rental each year, but it shows up on the return as a loss (i.e., negative rental income) because included in his rental expenses on Schedule E is a pro-rated portion of his mortgage and property tax expense reflecting the portion of the house he rents out (the remaining part of his tax and mortgage interest is included on Schedule A). In reality, these expenses would be incurred and deducted in full on schedule A whether or not he does the rental. If you exclude them from Schedule E, he actually shows a net positive rental income. But I don't know if the IRS would look it that way in assessing whether or not he has negative rental income.



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Old 04-14-2014, 04:47 AM
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Join Date: Oct 2010
Posts: 5,227
Quote:
Originally Posted by rickwm View Post
I am confused by two IRS rules on rentals which seem to contradict one
another.

Consider a person who rents a couple of rooms in his house out to tenants.
He deducts a pro-rated portion of various house expenses (such as utilities,
property tax, mortgage interest, depreciation, etc.) on Schedule E based on
the square footage he rents out compared to the total square footage of the
house. This person is not a real estate pro, and meets all the requirements
for actively managing the rental and for it being passive income, etc. The
rental results in a small tax loss each year of a couple of thousand
dollars. The question is can he report this loss (i.e., negative income) on
his tax return each year to offset his regular income from employment, etc.

On one hand, I see a rule that says you have to show a profit in 3 out of 5
years to establish that you are renting for profit. On the other hand, I see
a rule that says you can deduct up to $25,000 in rental losses each year
assuming you meet all the rules for passive, active, etc. Don't these rules
contradict one another?

Here are the rules from Pub 527 that I'm talking about:

"If you do not rent your property to make a profit, you can deduct your
rental expenses only up to the amount of your rental income. You cannot
deduct a loss or carry forward to the next year any rental expenses that are
more than your rental income for the year." It further states "If your
rental income is more than your rental expenses for at least 3 years out of
a period of 5 consecutive years, you are presumed to be renting your
property to make a profit."

That seems pretty clear cut.

But in another section of the same manual it says: "If you or your spouse
actively participated in a passive rental real estate activity, you may be
able to deduct up to $25,000 of loss from the activity from your nonpassive
income. This special allowance is an exception to the general rule
disallowing losses in excess of income from passive activities. Similarly,
you may be able to offset credits from the activity against the tax on up to
$25,000 of nonpassive income after taking into account any losses allowed
under this exception."

No mention here of having to show a profit 3 out of 5 years.

How do we reconcile these two seemingly contradictory instructions?

I should note one other thing. In this case, the owner actually does make a real profit on the rental each year, but it shows up on the return as a loss (i.e., negative rental income) because included in his rental expenses on Schedule E is a pro-rated portion of his mortgage and property tax expense reflecting the portion of the house he rents out (the remaining part of his tax and mortgage interest is included on Schedule A). In reality, these expenses would be incurred and deducted in full on schedule A whether or not he does the rental. If you exclude them from Schedule E, he actually shows a net positive rental income. But I don't know if the IRS would look it that way in assessing whether or not he has negative rental income.
I am confused by two IRS rules on rentals which seem to contradict one
another.Consider a person who rents a couple of rooms in his house out to tenants. He deducts a pro-rated portion of various house expenses (such as utilities, property tax, mortgage interest, depreciation, etc.) on Schedule E based on the square footage he rents out compared to the total square footage of the house. This person is not a real estate pro, and meets all the requirements for actively managing the rental and for it being passive income, etc. The rental results in a small tax loss each year of a couple of thousand dollars. The question is can he report this loss (i.e., negative income) on his tax return each year to offset his regular income from employment, etc.====>>>>>>>>>>>Basically,You need to use Sch E of 1040 , NOT Sch C of 1040 UNLESS you provide services with your tenants; If you're in the business of renting property, you must claim your income and expense on Sch C and profir/hobby rule applies to your rental biz. Rental income is considered a passive activity. Only real estate professionals who perform more than half their business time in the real estate industry and at least 750 hours per year with their rental property are permitted unlimited deduction of a rental loss. You may deduct a passive loss of up to $25k per year if you actively participate in management of a rental property, such as approving tenants and directing maintenance. However, this loss is limited for taxpayers with higher incomes. So I mean in most cases for your rental income, you need to file SCh E of 1040 as it is passive activity income regardless of its motive of for profits/hobby.

On one hand, I see a rule that says you have to show a profit in 3 out of 5 years to establish that you are renting for profit. On the other hand, I see a rule that says you can deduct up to $25,000 in rental losses each year assuming you meet all the rules for passive, active, etc. Don't these rules contradict one another?=====>>>>> If you spend the majority of your time in the real estate business as a real estate professional, your rental losses are not passive. This means that your losses are fully deductible against all income, passive and non-passive regardless of its motive for profit/hobby activity. Otherwise, your losses are passive and only deductible up to $25K against your rentals' income (deduction phases out if your modified adjusted gross income (MAGI) is between $100K and $150K). However, losses of more than $25K can be carried over to the following year.

The IRS rule: The IRS defines a real estate professional as someone who spends more than one-half of his or her working time in the rental business. This includes property development, construction, acquisition and management. You must also spend more than 750 hours per year working on your real estate rental properties. (To find extra resources about owning rental properties,

Here are the rules from Pub 527 that I'm talking about:
"If you do not rent your property to make a profit, you can deduct your
rental expenses only up to the amount of your rental income. You cannot deduct a loss or carry forward to the next year any rental expenses that are more than your rental income for the year." It further states "If your rental income is more than your rental expenses for at least 3 years out of a period of 5 consecutive years, you are presumed to be renting your property to make a profit."========UNDER the vacation home rule, if you rent a property that you also use personally, the rules for personal use of a dwelling unit may apply and the rental expenses you can deduct may be limited.

That seems pretty clear cut.

But in another section of the same manual it says: "If you or your spouse actively participated in a passive rental real estate activity, you may be able to deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you may be able to offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed =============correctaslongas you or your spouse actively participated in a passive rental real estate activity(regardeless of profit/hobby purposes unless you file sch c for your rental income) you can enjoy the credit,

under this exception."No mention here of having to show a profit 3 out of 5 years.How do we reconcile these two seemingly contradictory instructions? I should note one other thing. In this case, the owner actually does make a real profit on the rental each year, but it shows up on the return as a loss (i.e., negative rental income) because included in his rental expenses on Schedule E is a pro-rated portion of his mortgage and property tax expense reflecting the portion of the house he rents out (the remaining part of his tax and mortgage interest is included on Schedule A). ===================Actually the rule of a profit 3 out of 5 years, I mean profit/hobby rule doesn’t exactly apply to rental home situation. In general, if you rent a property that you also use personally, the rules for personal use of a dwelling unit may apply and the rental expenses you can deduct may be limited. Your deductible expenses would be limited to the amount of rental income you have. In other words, you could not offset a loss on the rental against other income you report on your tax return. You can carry forward your excess rent expenses to the following year, but they would be subject to the same limitation - your rental income for that year.
You are considered to use the property personally if a member of your family uses the property. Family members for this purpose.But this does not apply if the family member uses the property as his or her main home and pays a fair rental price. Howver,if you rent the property to a family member who uses the home as his or her main home and pays you a fair rental price, the rental would generally not be considered personal use by you.

In reality, these expenses would be incurred and deducted in full on schedule A whether or not he does the rental. If you exclude them from Schedule E, he actually shows a net positive rental income. But I don't know if the IRS would look it that way in assessing whether or not he has negative rental income.======>>>>>>actually personal use related exp are reported on SCH A so you need to itemize deduction son SCh A of 1040 to deduct them on your return.ONLY rental relatd exp are deducted on Sch E of 1040 , NOT on SCH A of 1040 or Sch C of 1040 UNLESS you are a r/e pro.

NOTE; Theirsreminds taxpayers to follow appropriate guidelines when determining whether an activity is a business or a hobby, an activity not engaged in for profit; The rental expense deduction for property classified as a vacation home has its own Internal Revenue Code. However, hobby loss passive activity and interest expense rules, as well as court cases also determine allowable vacation home rental deductions.



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Old 04-14-2014, 04:01 PM
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Join Date: Apr 2014
Posts: 2
Just to Clarify

Yes, in the example I mentioned, the rental income and expenses are reported on Schedule E and not Schedule C.

If I read your response correctly, you seem to be saying that the three out of five years of profit rule would only come into play for a real-estate professional using Schedule C to report business income. Is that correct? In this case, the person is not a real-estate professional, but he does actively participate in the rental and the rental activity is clearly passive. So based on what you are saying, he should have no concerns about reporting a loss of a few thousand dollars each year (well below the $25K limit), correct? His total income (mostly from wages) would be well below the limits where the $25K loss maximum is reduced.

You also mention the vacation home rule. You say "In general, if you rent a property that you also use personally, the rules for personal use of a dwelling unit may apply and the rental expenses you can deduct may be limited. Your deductible expenses would be limited to the amount of rental income you have. In other words, you could not offset a loss on the rental against other income you report on your tax return."

Just to be clear on this, the owner lives in the house 365 days per year, but there is a portion of the house which he does not use and considers to be the rental portion for 365 days a year. He prorates his rental expenses based on the sq. footage ratio of the part he rents out to the part he lives in. So in that sense, the property he rents out (which is the portion of his house he does not use for personal purposes) is totally dedicated to the rental.

So based on the above clarifications, is it still correct that the 3 of 5 year rule does not apply in this situation and he can continue to report a loss each year that is well below the $25K max?

Thanks for the response!



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Old 04-15-2014, 05:08 AM
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Posts: 5,227
Quote:
Originally Posted by rickwm View Post
Yes, in the example I mentioned, the rental income and expenses are reported on Schedule E and not Schedule C.

If I read your response correctly, you seem to be saying that the three out of five years of profit rule would only come into play for a real-estate professional using Schedule C to report business income. Is that correct? In this case, the person is not a real-estate professional, but he does actively participate in the rental and the rental activity is clearly passive. So based on what you are saying, he should have no concerns about reporting a loss of a few thousand dollars each year (well below the $25K limit), correct? His total income (mostly from wages) would be well below the limits where the $25K loss maximum is reduced.

You also mention the vacation home rule. You say "In general, if you rent a property that you also use personally, the rules for personal use of a dwelling unit may apply and the rental expenses you can deduct may be limited. Your deductible expenses would be limited to the amount of rental income you have. In other words, you could not offset a loss on the rental against other income you report on your tax return."

Just to be clear on this, the owner lives in the house 365 days per year, but there is a portion of the house which he does not use and considers to be the rental portion for 365 days a year. He prorates his rental expenses based on the sq. footage ratio of the part he rents out to the part he lives in. So in that sense, the property he rents out (which is the portion of his house he does not use for personal purposes) is totally dedicated to the rental.

So based on the above clarifications, is it still correct that the 3 of 5 year rule does not apply in this situation and he can continue to report a loss each year that is well below the $25K max?

Thanks for the response!

Yes, in the example I mentioned, the rental income and expenses are reported on Schedule E and not Schedule C.========>Then the situation is not particularly subject to for profit/hobby rule I guess but is subject to vacation home rule.

If I read your response correctly, you seem to be saying that the three out of five years of profit rule would only come into play for a real-estate professional using Schedule C to report business income. Is that correct?=========>>Perfectly accurate.

In this case, the person is not a real-estate professional, but he does actively participate in the rental and the rental activity is clearly passive. So based on what you are saying, he should have no concerns about reporting a loss of a few thousand dollars each year (well below the $25K limit), correct?========>>>>Correct UNLESS his MAGI level is OVER $100K or more. ; as said, UNLESS he is a r/e pro, then even if he actively participated in the rental activity, the rental income for him is still passive income, NOT ACTIVE /REG income offset against other reg/ordinary income; however, they enacted the $25K active participation rental property loss allowanceas a special favor for rental property owners who qualify as his case.

His total income (mostly from wages) would be well below the limits where the $25K loss maximum is reduced.==>Then I guess it’d be OK.

You also mention the vacation home rule. You say "In general, if you rent a property that you also use personally, the rules for personal use of a dwelling unit may apply and the rental expenses you can deduct may be limited. Your deductible expenses would be limited to the amount of rental income you have. In other words, you could not offset a loss on the rental against other income you report on your tax return." =====>>Correct I mean aslongas the home is subject to personl home rule(aslongas the owner used it for the laerger of 10% of rental days or 14 days I guess) but you still deduct non rental related (personal use home exp.i.e., mort int/ r./e taxes or etc on Sch A of 1040aslongas you itemize deductions if not , then no you can’t).so what I m saying is : if it is rented for 15 days or more and is used for personal use for more than 14 days or 10% of the days rented, whichever is grater, allocable rental exp are allowed only to the extent of the rental income. They are deducted in 3 seoparate steps;1. Int a nd taxes 2; utilities/ maint3. Depre. All exp are allocated between the rental and personal use days. Any unused PAL/PAC are carried over and may be used to offset future paasive income/taxes attributable to such income.

Just to be clear on this, the owner lives in the house 365 days per year, but there is a portion of the house which he does not use and considers to be the rental portion for 365 days a year. He prorates his rental expenses based on the sq. footage ratio of the part he rents out to the part he lives in. So in that sense, the property he rents out (which is the portion of his house he does not use for personal purposes) is totally dedicated to the rental.

So based on the above clarifications, is it still correct that the 3 of 5 year rule does not apply in this situation and he can continue to report a loss each year that is well below the $25K max?=========>>aslongas he actively participate the activity. So, I do not think so unless he is a r.e pro filing Sch C/Sch SE. As you know, all rental losses , UNLESS you are a pro, are passive losses (even if you actively participate your rental activity) which means a nondeductible loss has incurred because of doing an activity for personal pleasure instead of for profit.The hobby loss rule states that if an activity is profitable in3years out of 5 then it can be treated as a business in the one or two years that a loss was realized. These losses can only be written off against income from other activities though such as other rental properties.The “passive losses” that aren’t used are then carried over until you end up selling the vacation home. Once you sell the property the losses can be used to offset any gains. I guess you can contact the IRS hopefully for more info in detail.

NOTE; renting property for less than fair rental value is treated as a not-for-profit activity, much like a hobby. In this case, just like a hobby, income from the rental activity is reported on your 1040, line 21, not on Sch E of 1040.).And rental expenses are deducted on Sch A,not on Sch E of 1040 also subject to the 2% -of AGI limitation. Deductions for rental expenses are limited to rental income; excess expenses may not be carried over to future years..



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Old 04-15-2014, 05:46 AM
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Originally Posted by rickwm View Post
If I read your response correctly, you seem to be saying that the three out of five years of profit rule would only come into play for a real-estate professional using Schedule C to report business income. Is that correct? !
Sorry not really; i recheked my response and should say; all rental losses are “passive losses” or “hobby losses” which means a nondeductible loss has incurred because of doing an activity for personal pleasure instead of for profit.

The “hobby loss rule” states that if an activity is profitable in three years out of five then it can be treated as a business in the one or two years that a loss was realized. These losses can only be written off against income from other activities though such as other rental properties, a private partnership that you don’t help operate, or an actual corporation.

The “passive losses” that aren’t used are then carried over until you end up selling the vacation home. Once you sell the property the losses can be used to offset any gains.
please make of note of this



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