We already know that owning rental property is a tax-friendly investment. Let’s take it one step further…
What if your rental income isn’t taxed at all?
I know what you might be thinking – income that doesn’t have to be reported on your tax return? Surely, you can’t be serious.
Oh, I am serious. And don’t call me Shirley.
For the rest of this article, we’re going to focus on mixed-use property, or property that is used both personally and as a rental. If you have an investment property that is rented out and there are no personal use days, sorry, but this doesn’t apply to you… yet. Hopefully, after reading, you may be able to find a way to take advantage of these rules.
One example of mixed-use property would be a vacation home. A place near the beach that you frequent in the summer or a cabin in the woods that you visit for a ski weekend or two in the winter.
Another example would be your primary residence that you rent out occasionally when you’re away from home. Maybe you want to earn a little extra cash renting out your home while you’re on vacation or away on business.
So, how does it work?
The determining factors for how your rental income is reported are the number of days you:
- Rent the property out
- Use it personally
This will determine the nature of your property (residence or rental) and, therefore, the treatment of the income and expenses.
Let’s analyze three different scenarios to better illustrate the rules:
- Rental days > 15 days, and personal use days < the greater of:
- 14 days, or
- 10% of rental days
- Rental days > 15 days, and personal use days > the greater of:
- 14 days, or
- 10% of rental days
- Rental days < 15 days throughout the entire year
If you rent your property out for more than 15 days throughout the year and use the property personally for less than the greater of 14 days or 10% of the total rental days, the property is considered a rental property.
For example, you rent out the property for 250 days and use it personally for 20 days. Rental days exceed 15 days and personal use days do not exceed the greater of 14 or 10% of rental days (25).
Rental income is reported in full and expenses allocated to the rental portion (rental days divided by total rental and personal days – vacant days are not considered here) are deducted in a specific order (mortgage interest and property taxes, then all operating expenses, and then depreciation).
You are allowed to deduct losses subject to passive activity limitations, if applicable, in this scenario.
If you rent your property out for more than 15 days throughout the year and use the property personally for more than the greater of 14 days or 10% of the total rental days, the property is considered a residence.
For example, you rent out the property for 250 days and use it personally for 30 days. Rental days exceed 15 days and personal use days do exceed the greater of 14 or 10% of rental days (25).
Rental income is reported in full and expenses allocated to the rental portion are deducted in the same order as Scenario 1. The rental portion is calculated by dividing the rental days by 365. Vacant days are included in the denominator here because it provides a greater benefit for the taxpayer. Mortgage interest and real estate taxes allocated to the personal use portion can be deducted on Schedule A since the property is considered a residence, not a rental. This frees up more room to deduct operating expenses against rental income.
You are not allowed to deduct losses in this scenario because the property is considered a residence.
If you rent your property out for less than 15 days throughout the year the property is considered a residence.
Here’s the kicker…
And here’s the other kicker…
Rental income generated in this scenario does not have to be reported on your tax return.
The best part? There’s no limit and no expenses/deductions have to be allocated to the rental portion. You can rent out your home for $100,000 a day for 14 days and earn $1.4 million of tax-free income.
Side note – If those numbers resonate with you, let me know what market you’re in and if you’re looking for a partner.
I very briefly touched on losses and whether or not they’re deductible in Scenario 1 and 2.
Generally, losses generated from rental activity when the property is considered a rental are deductible and subject to passive loss limitations in most cases; when the property is considered a residence, losses are not deductible.
This concept requires a much more in-depth analysis and will be covered in more detail in a future post.
Did you like this article? Feel like it was missing something? Rate it to let me know 🙂
Nick Aiola is a CPA located in New York, NY. Nick provides the highest quality of tax and accounting services to a wide range of clients, including individuals, businesses, and fiduciary entities.
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