Short-Term Rental, Special Treatment

If you are one of the many taxpayers who rents out a first or second home using rental agents or online rental services (such as Airbnb, VRBO and HomeAway) that match property owners with prospective renters, then some special tax rules may apply to you.

These special (and sometimes complex) taxation rules can make the rents that you charge tax-free. However, other situations may force your rental income and expenses to be treated as a business reported on a Schedule C, as opposed to a rental activity reported on Schedule E.

The following is a synopsis of the rules governing short-term rentals.

Rented for Fewer than 15 Days During the Year – When a property is rented for fewer than 15 days during the tax year, the rental income is not reportable, and the expenses associated with that rental are not deductible. Interest and property taxes are not prorated, and the full amounts of the qualified mortgage interest and property taxes are reported as itemized deductions (as usual) on the taxpayer’s Schedule A.

The 7-Day and 30-Day Rules – Rentals are generally passive activities. However, an activity is not treated as a rental if either of these statements applies:

  • The average customer use of the property is for 7 days or fewer—or for 30 days or fewer if the owner (or someone on the owner’s behalf) provides significant personal services.
  • The owner (or someone on the owner’s behalf) provides extraordinary personal services without regard to the property’s average period of customer use.

If the activity is not treated as a rental, then it will be treated as a trade or business, and the income and expenses, including prorated interest and taxes, will be reported on Schedule C. IRS Publication 527 states: “If you provide substantial services that are primarily for your tenant’s convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C.” Substantial services do not include the furnishing of heat and light, the cleaning of public areas, the collecting of trash, and such.

Exception to the 30-Day Rule – If the personal services provided are similar to those that generally are provided in connection with long-term rentals of high-grade commercial or residential real property (such as public area cleaning and trash collection), and if the rental also includes maid and linen services that cost less than 10% of the rental fee, then the personal services are neither significant nor extraordinary for the purposes of the 30-day rule.

Profits & Losses on Schedule C – Profit from a rental activity is not subject to self-employment tax, but a profitable rental activity that is reported as a business on Schedule C is subject to this tax. A loss from this type of activity is still treated as a passive-activity loss unless the taxpayer meets the material participation test – generally, providing 500 or more hours of personal services during the year or qualifying as a real estate professional. Losses from passive activities are deductible only up to the passive income amount, but unused losses can be carried forward to future years. A special allowance for real-estate rental activities with active participation permits a loss against nonpassive income of up to $25,000 – phasing out when modified adjusted gross income is between $100K and $150K. However, this allowance does NOT apply when the activity is reported on Schedule C.

These rules can be complicated; please call this office to determine how they apply to your particular circumstances and what actions you can take to minimize tax liability and maximize tax benefits from your rental activities.

Facing a Huge Gain from a Realty Sale?

If you are contemplating selling real-estate property, there are a number of issues that could impact the taxes that you might owe, and there are steps you can take to minimize the gain, defer the gain, or spread it over a number of years.

The first and possibly most important issue is adjusted basis. When computing the gain or loss from the sale of property, your gain or loss is measured from your adjusted basis in the property. Thus, your gain or loss would be the sales price minus the sales expenses and adjusted basis.

So what is adjusted basis? Determining adjusted basis can sometimes be complicated, but in a simplified overview, it is a dollar amount that starts with your acquisition value and is then adjusted up for improvements to the property, down for depreciation taken on the property, and down for any casualty losses claimed on the property. The acquisition value could be the price you paid for the property, the fair market value of an inheritance at the date of the decedent’s death, or, in the case of a gift, the donor’s adjusted basis at the time of making the gift.

As you can see, it is extremely important that you keep track of your basis, since it is a key factor in determining gain or loss upon the sale of the property. Failure to keep a record and substantiating documentation could cost you dearly in income tax.

If the property was a rental and the rental operated at a loss, there is a chance that the losses were not fully deductible in the year of the loss because of the passive loss limitation rules; in this case, you will have a passive loss carryover that can be used to offset the gain. In addition, passive loss carryovers you may have from other properties can also be used to offset any gain from selling a rental property.

Next, you have to decide whether you want to take (i.e., report on your tax return) all the income in one year or whether to attempt to spread the income over a period of years with an installment sale (by carrying back a loan) or defer the income into a replacement property through a tax-deferred exchange.

In an installment sale, the seller acts as the lender to the buyer. That can entail holding the first trust deed or taking back a second trust deed for only a portion of the loan amount. However, second trust deeds are as the name implies: They are second in line to be paid if the buyer defaults on the loan and thus are riskier. When set up as an installment sale, part of the gain is reported for each year that payments are received, generally as capital-gain income. In addition, the interest that the buyer pays the seller is taxable as ordinary income to the seller. Installment sales can be structured as short- or long-term loans, but remember, the buyer can always pay off the loan early or refinance. Either of these actions would make the balance of the profit from the sale taxable at that time.

Another option if the property is held for investment or used in a trade or business is to defer the gain down the road. This is accomplished by using the rules of IRS Code Section 1031, which allows the taxpayer to acquire like-kind property and defer the gain into the replacement property, which also must be used for business or be held for investment. However, the rules for like-kind exchanges are complicated, have strict timing issues, and require advance planning with a professional familiar with Section 1031 rules.

Adding complications to the sale-planning issue is the surtax on net investment income. This 3.8% additional tax kicks in when a taxpayer’s modified adjusted gross income (MAGI) exceeds $200,000 ($250,000 for married joint filers and $125,000 for married individuals filing separately). Gain from the realty sale is included in the MAGI and could cause the MAGI threshold to be exceeded, resulting in this surtax applying to some or all of the realty gain. However, it may be minimized, or possibly eliminated, by using an installment sale and spreading the gain over a number of years or deferring down the road with a tax-deferred exchange.

If the real estate is your home (primary residence), there are special rules. Generally, if you own and occupy the home in two out of the five years prior to the sale, you will be able to exclude a substantial portion of your gain. The tax-deferred exchange rules do not apply to personal-residence sales.

As you can see, the result of selling real-estate property can include a number of tax issues, and minimizing current taxes requires some careful planning. Please give this office a call for assistance in planning your real-estate transactions

Using the Home Sale Gain Exclusion for More than Just Your Home

With careful planning, and provided the rules are followed, the tax code allows the home sale gain exclusion every two years.

Let’s assume you own a home, perhaps a second (vacation) home, or maybe are even thinking about buying a fixer-upper and flipping it. With careful planning, it is possible to apply the full home sale exclusion to all three of the properties.

Here is how it works. The tax code allows you to exclude up to $250,000 ($500,000 for married couples) of gain from the sale of your primary residence if you have lived in it and owned it for two of the five years immediately preceding the sale and you have not previously taken a home sale exclusion within the two years immediately preceding the sale. In addition, there is no limit on the number of times you can use the exclusion, as long as the requirements are met.

It makes sense to start off by selling the home you currently live in because you probably already meet the two-out-of-five-years ownership and use tests. The next step, if you have a second home, would be to move into it and make it your primary residence. After you have lived there for two full years and it has been more than two years since the previous home was sold, you can sell the property and take the home sale exclusion again. If you are handy, and find the right property, the next possible step would be to purchase and occupy a fixer-upper while you make repairs and improvements in preparation for its eventual sale after the two-year ownership and occupancy rules have been met. When that time is up, you can sell the fixer-upper and take the third exclusion. This makes it possible for a married couple to exclude as much as $1,500,000 of home sale profit in just over four years if they follow the rules carefully and time the sales correctly.

If you own a rental property, and you occupy the rental for two years prior to its sale, you will be able to exclude a portion of the gain for that property as well. Because so many rental owners were occupying their rentals before selling them and taking a home sale exclusion, Congress enacted a law barring the exclusion of gain attributable to rental periods after 2008. Thus, the home sale exclusion can only be used to exclude gain attributable to periods before 2009 and periods after 2008 in which the home was used as a primary residence.

Example: You purchased and began renting a residence on July 1, 2005. On July 1, 2013, you occupied the property as your primary residence; and, on August 1, 2015, you sell the property for a gain of $230,000. You had owned the property for a total of 121 months, of which 67 were before 2009 or during which you occupied the property as your primary residence after 2008. Thus .5537 (67/121) of the gain is subject to the exclusion. As a result, $127,351 (.5537 x $230,000) of the gain qualifies for the exclusion.

In the preceding example, had the gain exceeded the exclusion limits, $250,000 for single taxpayers and $500,000 married taxpayers, the exclusion would have been capped at the exclusion limits.

There is one final issue to consider. If any of the residences were acquired though a tax-deferred (Sec 1031) exchange from another property, then the residence must be owned for a period of five years prior to its sale to qualify for the exclusion.

Since situations may differ, we highly recommend that you consult with this office prior to initiating such a plan.

Should You Keep Home Improvement Records?

Many taxpayers don’t feel the need to keep home improvement records, thinking the potential gain will never exceed the amount of the exclusion for home gains ($250,000 or $500,000 if both filer and spouse qualify) if they meet the 2-out-of-5-year use and ownership tests. Here are some situations when having home improvement records could save taxes:

(1) The home is owned for a long period of time, and the combination of appreciation in value due to inflation and improvements exceeds the exclusion amount.(2) The home is converted to a rental property, and the cost and improvements of the home are needed to establish the depreciable basis of the property.

(3) The home is converted to a second residence, and the exclusion might not apply to the sale.

(4) You suffer a casualty loss and retain the home after making repairs.

(5) The home is sold before meeting the 2-year use and ownership requirements.

(6) The home only qualifies for a reduced exclusion because the home is sold before meeting the 2-year use and ownership requirements.

(7) One spouse retains the home after a divorce and is only entitled to a $250,000 exclusion instead of the $500,000 exclusion available to married couples.

(8) There are future tax law changes that could affect the exclusion amounts.

Everyone hates to keep records, but consider the consequences if you have a gain and a portion of it cannot be excluded. You will be hit with capital gains (CG), and there is a good chance the CG tax rate will be higher than normal simply because the gain pushed you into a higher CG tax bracket. Before deciding not to keep records, carefully consider the potential of having a gain in excess of the exclusion amount.

If you have questions related to the home gain exclusion or questions about how keeping home improvement records might directly affect you, please give this office a call.

Tax Break for Sales of Inherited Homes

People who inherit property are often concerned about the taxes they will owe on any gain from that property’s sale. After all, the property may have been purchased years ago at a low cost by a deceased relative but may now have vastly appreciated in value. The usual question is: “Won’t the taxes at sale be horrendous?”

Clients are usually pleasantly surprised by the answer—that special rules apply to figuring the tax on the sale of any inherited property. Instead of having to start with the decedent’s original purchase price to determine gain or loss, the law allows taxpayers to use the value at the date of the decedent’s death as a starting point (sometimes an alternate date is chosen). This often means that the selling price and the inherited basis of the property are practically identical, and there is little, if any, gain to report. In fact, the computation frequently results in a loss, particularly when it comes to real property on which large selling expenses (realtor commissions, etc.) must be paid.

This also highlights the importance of having a certified appraisal of the home to establish the home’s tax basis. If an estate tax return or probate is required, a certified appraisal will be completed as part of those processes. If not, one must be obtained to establish the basis. It is generally not acceptable just to refer to a real estate agent’s estimation of value or comparable sale prices if the IRS questions the date of death value. The few hundred dollars it may cost for a certified appraisal will be worth it if the IRS asks for proof of the basis.

Another issue is whether a loss on an inherited home is deductible. Normally, losses on the sale of personal use property such as one’s home are not deductible. However, unless the beneficiary is living in the home, the home becomes investment property in the hands of the beneficiary, and a loss is deductible but subject to a $3,000 ($1,500 if married and filing separately) per year limitation for all capital losses with any unused losses carried forward to a future year.

In some cases, courts have allowed deductions for losses on an inherited home if the beneficiary also lives in the home. In order to deduct such a loss, a beneficiary must try to sell or rent the property immediately following the decedent’s death. In one case, where a beneficiary was also living in the house with the decedent at the time of death, loss on a sale was still deductible, when the heir moved out of the home within a “reasonable time” and immediately attempted to sell or rent it.

This treatment could change in the future, however. The President’s Fiscal Year 2016 Budget Proposal includes a proposal that would eliminate any step up in basis at the time of death and would require payment of capital gains tax on the increase in the value of the home at the time it is inherited.

If you have questions related to inheritances or home sales, please give this office a call.

Family Home Loan Interest May Not Be Deductible

It is not uncommon for individuals to loan money to relatives to help them buy a home. In those situations, it is also not uncommon for a loan to be undocumented or documented with an unsecured note, and the unintended result that the homebuyer can’t claim a tax deduction for the interest paid to their helpful relative.

The tax code describes qualified residence interest as interest paid or accrued during the tax year on acquisition indebtedness or home equity indebtedness with respect to any qualified residence of the taxpayer. It also provides that the term “acquisition indebtedness” means any indebtedness that is incurred in acquiring, constructing, or substantially improving any qualified residence of the taxpayer, and is secured by such residence. There are also limits on the amount of debt and number of qualified residences that a taxpayer may have for purposes of claiming a home mortgage interest tax deduction, but those details are not covered in this article, which focuses on the requirement that the debt be secured.

Secured debt means a debt that is on the security of any instrument (such as a mortgage, deed of trust, or land contract):

(i) that makes the interest of the debtor in the qualified residence-specific security of the payment of the debt,
(ii) under which, in the event of default, the residence could be subjected to the satisfaction of the debt with the same priority as a mortgage or deed of trust in the jurisdiction in which the property is situated, and
(iii) that is recorded, where permitted, or is otherwise perfected in accordance with applicable state law.

In other words, the home is put up as collateral to protect the interest of the lender.

Thus, interest paid on undocumented loans, or documented but unsecured notes, is not deductible by the borrower but is fully taxable to the lending individual. The IRS is always skeptical of family transactions. Don’t get trapped in this type of situation. Take the time to have a note drawn up and recorded or perfected in accordance with state law.

If you have questions related to this situation or other issues related to the deductibility of home mortgage interest, please give this office a call.

Installment Sale – a Useful Tool to Minimize Taxes

Selling a property one has owned for a long period of time will frequently result in a large capital gain, and reporting all of the gain in one year will generally expose the gain to higher than normal capital gains rates and subject the gain to the 3.8% surtax on net investment income added by Obamacare.

Capital gains rates: Long-term capital gains can be taxed at 0%, 15%, or 20% depending upon the taxpayer’s regular tax bracket for the year. At the low end, if your regular tax bracket is 15% or less, the capital gains rate is zero. If your regular tax bracket is 25% to 35%, then the top capital gains rate is 15%. However, if your regular tax bracket is 39.6%, the capital gains rate is 20%. As you can see, larger gains push the taxpayer into higher capital gains rates.

Surtax on net investment income – Tax law treats capital gains (other than those derived from a trade or business) as investment income upon which higher-income taxpayers are subject to a 3.8% surtax on net investment income. A large gain generally pushes a taxpayer’s income over the threshold for this tax. For individuals, the surtax is 3.8% of the lesser of (1) the taxpayer’s net investment income or (2) the excess of the taxpayer’s modified adjusted gross income (MAGI) over the threshold amount for his or her filing status. The threshold amounts are:

  • $125,000 for married taxpayers filing separately.
  • $200,000 for taxpayers filing as single or head of household.
  • $250,000 for married taxpayers filing jointly or as a surviving spouse.

This is where an installment sale could fend off these additional taxes by spreading the income over multiple years.

Here is how it works. If you sell your property for a reasonable down payment and carry the note on the property yourself, you only pay income taxes on the portion of the down payment (and any other principal payments received in the year of sale) that represents taxable gain. You can then collect interest on the note balance at rates near what a bank charges. For a sale to qualify as an installment sale, at least one payment must be received after the year in which the sale occurs. Installment sales are most frequently used when the property that is sold is real estate, and cannot be used to report the sale of publicly traded stock or securities.

Example: You own a lot for which you originally paid $10,000. You paid it off some time ago, leaving you with no outstanding mortgage on the lot. You sell the property for $300,000 with 20% down and carry a $240,000 first trust deed at 3% interest using the installment sale method. No additional payment is received in the year of sale. The sales costs are $9,000.

Computation of Gain

Sale Price       $300,000

 Cost         <  $10,000>

 Sales costs   <   $9,000>

Net Profit      $281,000

Profit % = $281,000/$300,000 = 93.67%

Of your $60,000 down payment, $9,000 went to pay the selling costs, leaving you with $51,000 cash. The 20% down payment is 93.67% taxable, making $56,202 ($60,000 x .9367) taxable the first year. The amount of principal received and reported each subsequent year will be based upon the terms of the installment agreement. In addition, the interest payments on the note are taxable and also subject to the investment surtax. 

Thus in the example, by using the installment method the income for the year was reduced by $224,798 ($281,000 – $56,202). How that helps the taxpayer’s overall tax liability depends on the taxpayer’s other income and circumstances. 

Here are some additional considerations when contemplating an installment sale.

Existing mortgages – If the property you are considering selling is currently mortgaged, that mortgage would need to be paid off during the sale. Even if you do not have the financial resources available to pay off the existing loan, there might be ways to work out an installment sale by taking a secondary lending position or wrapping the existing loan into the new loan.

Tying up your funds – Tying up your funds into a mortgage may not fit your long-term financial plans, even though you might receive a higher return on your investment and potentially avoid a higher tax rate and the net investment income surtax. Shorter periods can be obtained by establishing a note due date that is shorter than the amortization period. For example, the note may be amortized over 30 years, which produces a lower payment for the buyer but becomes due and payable in 5 years. However, a large lump sum payment at the end of the 5 years could cause the higher tax rate and surtax to apply to the seller in that year – so close attention needs to be paid to the tax consequences when structuring the installment agreement.

Early payoff of the note – The buyer of your property may decide to pay off the installment note early or sell the property, in which case your installment plan would be defeated and the balance of the taxable portion would be taxable in the year the note is paid off early or the property is sold, unless the new buyer assumes the note.

Tax law changes – Income from an installment sale is taxable under the laws in effect when the installment payments are received. If the tax laws are changed, the tax on the installment income could increase or decrease. Based on recent history, it would probably increase.

Installment sales do not always work in all situations. To determine whether an installment sale will fit your particular needs and set of circumstances, please contact this office for assistance.

Is a 1031 Exchange Right for You?

If you own real property that you could sell for a substantial profit, you may have wondered whether there’s a way to avoid or minimize the taxes that would result from such a sale. The answer is yes, if the property is business or investment related. Normally, the gain from a sale of a capital asset is taxable income, but Section 1031 of the Internal Revenue Code provides a way to postpone the tax on the gain if the property is exchanged for a like-kind property that is also used in business or held for investment. These transactions are often referred to as 1031 exchanges and may apply to other types of property besides real estate, but the information in this article is geared toward real property.

1031 Like Kind Exchanges

It is important to note that these exchanges are not “tax-free” but are “tax deferred.” The gain that would otherwise be currently taxable will eventually be paid when the replacement property is sold in the future in a regular sale. As with all things tax, there are rules and regulations to be followed to ensure that the transaction qualifies, such as:

  • The property must be given up and its replacement must be actively used in a trade or business or held for investment, so a personal residence or a vacation home won’t qualify. However, under some circumstances a vacation home that has been rented out may qualify.
  • The properties must be of like kind. For instance, this means you can’t exchange real estate for an airplane. But the definition is quite broad for real property – for example, it is OK to exchange raw land for an office building, a single-family residential rental for an apartment building, or land in the city for farmland. Typically, the owner of a residential rental who participates in an exchange will trade for another residential rental. Both real estate properties must be located in the United States. Caution: Stocks, bonds, inventory, partnership interests and business goodwill are excluded from Sec 1031 exchanges.
  • It is unusual for two taxpayers to each have a property that the other wants where they can enter into a simultaneous exchange. Most likely, if you wanted to exchange your property, you may need to do a “deferred exchange,” which means you effectively sell your property and then find a suitable replacement property. In this case, the law is very strict. You must identify, in writing, the replacement property within 45 days of the date your property was transferred and complete the acquisition of the replacement property within 180 days of the transfer or, if earlier, by the due date, including extensions, of your tax return for the tax year in which your property was transferred. During this period you aren’t allowed to receive the proceeds from the sale of your property.
  • The property acquired in an exchange must be of equal or greater value to the one you gave up, and all of the net proceeds from the disposition of the relinquished property must be used to acquire the replacement property. Otherwise, any unused proceeds are taxable.

 

With this basic information about 1031 exchanges, you may still be wondering whether an exchange is right in your situation. So let’s consider some of the advantages and disadvantages of exchanges.

ADVANTAGES:

Tax deferral – The main reason most people choose to do a 1031 exchange is so taxes don’t have to be paid currently on the gain that would result from selling the property. The maximum federal tax rate paid on capital gains for most taxpayers is 15% (20% if you would otherwise be in the highest tax bracket of 39.6%). However, the part of the gain that is equal to the depreciation deduction you’ve claimed while you’ve owned the property is taxable at a maximum of 25%.

Leveraging the tax savings – When an exchange is used, the money that doesn’t have to be spent to pay the taxes that would have been owed on the gain from a sale can be used to acquire other property or higher-value property.

Asset accumulation – The money saved from not paying tax on the sale gain can be retained as part of your estate to be passed to your heirs, who would also get a new basis on the replacement property that is equal to its fair market value at your date of death. In this case, none of the postponed gain from the original property is ever subject to income tax. However, depending on the overall size of your estate, there could be estate tax considerations.

Potential management relief – Taxpayers sometimes decide to sell their property to get out from under the burden of managing and maintaining the property. An exchange may still accomplish this without an outright sale by allowing the taxpayer to acquire replacement property that has fewer maintenance requirements and associated costs or has on-site management.

DISADVANTAGES: 

Added complexity and expense – An exchange transaction involves more complexity than a straight sale. The timing requirements noted above must be strictly met or the transaction will be taxable. To avoid tainting the transaction when there’s a deferred exchange, the proceeds from the original property must not be received by the seller, and a qualified intermediary, also called an accommodator, must be hired to handle the money and acquire the replacement property. The intermediary’s fees will be in addition to the usual selling and purchase expenses incurred.

Low tax basis – The tax basis on the property acquired reflects the deferred gain, so the basis for depreciation will be low. Thus, the annual depreciation deduction will often be much less than it would be if the property were purchased outright. Upon sale of the property, the accumulated tax deferrals will catch up, and the result will then be a large tax bill.

No property flipping – The intent of the law permitting exchanges is for the taxpayer to continue to use the replacement property in his trade or business or as an investment. An immediate sale of the replacement property would not satisfy that requirement. How long must the replacement property be held? In most situations there is no specific guideline, but generally 2 years would probably suffice. “Intent” at the time of the exchange plays a major role according to the IRS.

Unknown future law changes – When weighing whether to do a 1031 exchange, consider the known tax liability if you sold your property versus the unknown tax that will be owed on the deferred gain when you eventually sell the replacement property in the future. If you think tax rates may be higher in the future, you may decide to pay the tax when you sell your original property and be done with it. Recent proposals by various members of Congress and President Obama would severely curtail or even eliminate 1031 exchanges and increase the depreciation period of real property from 27.5 years for residential property and 39 years for commercial property to 43 years for both. These proposals may never pass, but they are an indicator of how 1031 exchanges are currently viewed in Washington, D.C.

1031 exchanges are very complex transactions, and the information provided is very basic. Before you commit to an exchange, please call this office so that we can review your particular situation with you.