Can I Deduct Losses From Money-Losing Rentals Against Other Income?

by on March 14, 2013Jason Van Steenwyk

Topics addressed in this column:

  • Can I deduct rental losses?
  • Passive activity rules.
  • Ownership and use test.
  • Part-year rental property rules.

Welcome back to our Tax Corner column – where we take your tough, real estate-related tax conundrums and bring them to the attention of some of the top tax professionals in the country.

Today’s question, along with a couple of follow-ups, comes from a reader named Heidi:

Learn more about rental property tax deductions“I bought a house in another state. I intend to move into it as soon as I can find a job in that area – or, if I can’t find the right kind of job in that area, I intend to move into it when I retire (in, say, 13 years).

 In the meantime, I am renting it out, and actively collaborate (long-distance, with occasional site visits) in its management with an agent who lives near the house. The rent I collect falls short of the mortgage, never mind the taxes, insurance, maintenance, and fees for the agent.

Questions:

 1. For tax purposes, what is the classification of the house? It is not a property [that] I am renting for profit – is it still a “rental property”?   

2. Is this necessarily a Schedule E situation?

 3. If it is a Schedule E situation, can I or do I recharacterize the house when I move into it myself? How does one do this? 

4. If it is not a Schedule E situation, do I just eat the net losses each year it is rented?”

If you’re renting at fair market value, it’s a rental property, so use Schedule E as part of your personal tax return, says Michael Kaplanidis, CPA, who practices with Water Street Associates, a two-state firm with offices in Boston, Mass. and Palm Beach, Fla. But, he cautions – depending on your individual circumstances – there is a chance that you may not deduct these losses from your income on your personal tax return.

At issue: a set of rules and regulations called “passive activity” rules.

For a bit of background on why we have these rules, see this recent Tax Corner column.

According to Mr. Kaplanidis, your loss may be limited if your modified adjusted gross income exceeds $100,000, if you file as married filing separately, or if the loss exceeds $25,000. Unused losses can be carried forward to offset future income.

You can read more about passive activity losses in IRS Publication 925 – Passive Activity and At-Risk Rules. But be careful: Most of these resources only give most people just enough information to be dangerous to themselves. A tax professional has likely also read the IRS’s Audit Technique Guide, and keeps up with the various revenue rulings on the subject that sometimes come up as the IRS tries to apply the law and its own regulations to individual circumstances that don’t fit neatly into categories that Congress and regulators envisioned.

Next, Mr. Kaplanidis tackles your question about converting the house back into your primary residence.

When the house is later converted, your property will be classified as part-year rental property and as part-year main home, depending on when you “convert” or “move back in.”

Kaplanidis cautions that if you do sell the home, you still need to meet the ownership and use tests in order to qualify for the capital gains tax exclusion. To take advantage of the tax rule that lets you exclude up to $250,000 of gain on a personal residence ($500,000 for married couples), you must have owned and lived in the home for at least two years of the five-year period ending on the date of sale.

This is well understood by most people. But Kaplanidis brings something up a lot of people don’t think of. “If the home was used for business (rental), you cannot exclude the part of gain equal to the depreciation claimed or that should have been claimed while it was treated as a rental property,” he warns. Before making any decision or taking any action that may affect your personal tax situation, you should consult a qualified tax professional advisor.

Many thanks to Michael Kaplanidis and the staff of Water Street Associates for their time and effort.

Disclaimer: This column is for informational purposes only and should not be construed as specific tax advice. Tax planning is extremely dependent on your individual set of facts and circumstances. You should not rely solely on columns like this one for tax information. It is best to engage the services of a qualified tax professional. 

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