Short-Term Rental, Special Treatment

With the advent of online sites such as Airbnb, VRBO, and HomeAway, many individuals have taken to renting out their first or second home through these online rental sites, which match property owners with prospective renters. If you are doing that or are planning to do so, there some special tax rules you need to know.

These special (and sometimes complex) taxation rules are based upon the length of time you rent your property out and with varying tax outcomes. In some situations, the rental income may be tax-free. In other situations, your rental income and expenses may need to be treated as a business, as opposed to a rental activity. The following is a general synopsis of the rules governing short-term rentals (those rented for average rental periods of 30 days or less).

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:

A. 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.

B. 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 instead of Schedule E, the IRS form used to report longer-term real estate rentals. 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 furnishing heat and light, cleaning public areas, collecting 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 and 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 – but phases out when one’s 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 us to determine how they apply to your particular circumstances and what actions you can take to minimize the tax liability and maximize the tax benefits from your rental activities.

Important — Rental Owners! Guidance Related to the 20% Pass-Through Deduction

Ever since tax reform was passed over a year ago, taxpayers have been uncertain whether rental property will be classified as a trade or business for purposes of qualifying for the new IRC Sec 199A 20% pass-through deduction (commonly referred to as the 199A deduction).

Finally, on January 18, 2019, the IRS issued a notice which provided “safe harbor” conditions under which a rental real estate activity will be treated as a trade or business for purposes of the 199A deduction.

It’s important to note that this notice prescribes several conditions that must be met for a rental real estate enterprise (a tax term introduced by the IRS in this notice) to be deemed to be a trade or business and eligible for the section 199A 20% deduction. For purposes of this safe harbor, a rental real estate enterprise is defined as an interest in real property held for the production of rents and may consist of an interest in multiple properties.

Failure of the taxpayer to satisfy the requirements of this safe harbor does not preclude a taxpayer from otherwise establishing that a “rental real estate enterprise” is a trade or business for purposes of section 199A. The following are the requirements that must be satisfied for the safe harbor:

  1. Separate books and records must be maintained for each rental real estate enterprise;
    a. A real estate enterprise can consist of a single or multiple real estate rentals.
    b. Commercial and residential rentals cannot be combined in the same real estate enterprise.
  2. For years prior to 2023, at least 250 hours of rental services must be performed by the taxpayer and workers for the taxpayer for the year in question with reference to each rental real estate enterprise.
    A three-year lookback rule applies for taxable years for 2023 and following. It specifies that the taxpayer must meet the 250-hour requirement for the rental enterprise for any three of the five prior consecutive taxable years; and
  3. The taxpayer must maintain contemporaneous records, including time reports, logs, or similar documents, to document the following:
    a. hours of all services performed;
    b. a description of all services performed;
    c. dates on which such services were performed; and
    d. who performed the services.Because the safe harbor requirements were issued after the close of 2018, the requirement for contemporaneous records for 2018 will not apply.

    Rental services that may be counted toward the 250 hour requirement include: (i) advertising to rent or lease the real estate; (ii) negotiating and executing leases; (iii) verifying information contained in tenant applications; (iv) collecting rent; (v) daily operation, maintenance, and repair of the property; (vi) management of the real estate; (vii) purchase of materials for operation such as repairs; and (viii) supervision of employees and independent contractors.

    However, rental services do NOT include financial or investment management activities, such as arranging financing; procuring property; studying and reviewing financial statements or reports on operations, planning, managing, or constructing long-term capital improvements; or hours spent traveling to and from the real estate.

    Rental services counted toward the 250 requirement may be performed by owners or employees, agents, and/or independent contractors working for the owners.

Triple net Leases are not eligible for safe harbor. Real estate rented or leased under a triple net lease agreement is not eligible for this safe harbor. A triple net lease includes a lease agreement that requires the tenant or lessee to pay taxes, fees, and insurance, and to be responsible for maintenance activities for a property in addition to rent and utilities. Also ineligible for the safe harbor is a property leased under an agreement that requires the tenant or lessee to pay a portion of the taxes, fees, and insurance, and to be responsible for maintenance activities allocable to the portion of the property rented by the tenant.

Vacation rentals are not eligible for safe harbor. Real estate used as a residence by the taxpayer for any portion of the taxable year is not eligible for the safe harbor rules.

The Statement must be attached to the tax return. A statement signed by the taxpayer, or the person responsible for keeping the records with personal knowledge of them, must be attached to the return declaring that all of the safe harbor requirements have been met and must include the following language: “Under penalties of perjury, I (we) declare that I (we) have examined the statement, and, to the best of my (our) knowledge and belief, the statement contains all the relevant facts relating to the revenue procedure, and such facts are true, correct, and complete.”

Double-edged sword. The 199A deduction is 20% of a taxpayer’s qualified business income from all of the taxpayer’s trades or businesses subject to certain limitations. Many rentals do not show a profit and a rental that is treated as a trade or business that shows a loss for the year will reduce the qualified business income of other trades or businesses of an individual, and as a result, reduces the 199A deduction of that individual.

If you have questions regarding rentals as a trade or business or other issues related to this new 199A deduction, please call us to schedule a consultation.

Tax Reform Limits Sec 1031 Exchanges to Defer Taxes

Note: This is one of a series of articles explaining how the various tax changes made by the GOP’s Tax Cuts & Jobs Act (referred to as the “Act” in the article), passed late in December 2017, might affect you and your family in 2018 and future years, and offering strategies you might employ to reduce your tax liability under the new tax laws.

Whenever you sell business or investment property and have a gain, you generally have to pay tax on the gain at the time of sale. In the past, the tax code provided an exception and allowed you to postpone paying tax on the gain if you reinvested the proceeds into similar property as part of a qualifying like-kind exchange. These types of exchanges are commonly called Sec. 1031 exchanges (referring to the tax code section that allows them). These rules have applied to real estate, cars, farm animals and other business and investment items that are like-kind property.

However, under the Act, and beginning in 2018, Sec. 1031 exchanges will only be allowed for exchanges of real property that is not held primarily for sale. It is important to note that real property located in the U.S. and real property located outside of the U.S. are not like-kind property for the purposes of these rules. Thus, exchanges of personal property and intangible property will no longer qualify for tax-deferred treatment.

Transition Rule – The provision generally applies to exchanges completed after December 31, 2017. However, an exception is provided for any exchange if the taxpayer disposes of the property disposed in the exchange on or before December 31, 2017, or if the taxpayer receives the property in the exchange on or before this date.

An example of this law change’s impact is when a business property such as a vehicle or machinery is traded in for a replacement. In the past, it was a tax strategy to sell the old property if its disposition resulted in a deductible tax loss and trade it in toward the new property if the disposition would result in a gain, thereby deferring the gain into the future. The Act has taken away that option, and now even trade-ins will result in a taxable transaction, whether it is a gain or loss.

Another example is investors in virtual currency who trade one type of virtual currency for another. They will be required to report their trades as capital gains/losses and won’t be able to use the 1031 tax-deferral rules.

If you have questions about how this change will impact your business or investment transactions, please give us a call.

Sold Your Home Last Year? Thinking of Selling? Read This!

If you sold your home last year, or if you are thinking about selling it, you should be aware of the many tax-related issues that could apply to that sale so that you will be prepared at tax time and not have to deal with unpleasant surprises. This article covers home sales and the home-sale gain exclusion, particularly when that gain exclusion applies and what portion of it applies. Certain special issues always affect home sales, such as the use of a portion of the home as an office or daycare center, previous use of the property as a rental, and acquisition in a tax-deferred exchange. Other frequently encountered issues are related to the “2 years out of 5” rules for ownership and use, as these rules must be followed to qualify for gain exclusion.

Home Sale Exclusion – Generally, the tax code allows for the exclusion of up to $250,000 ($500,000 for married couples) of gain from the sale of a primary residence if you lived in it and owned it for at least 2 of the 5 years immediately preceding the sale. You also cannot have previously taken a home-sale exclusion within the 2 years immediately preceding the sale. There is no limit on the number of times you can use the exclusion as long as you meet these time requirements. However, extenuating circumstances can reduce the amount of the exclusion. The home-sale exclusion only applies to a primary residence, not to a second home or a rental property.

2 out of 5 Rule – To qualify for the home-sale gain exclusion, you must have used and owned the home for 2 out the 5 years immediately preceding the sale. If you are married, both you and your spouse must meet the use requirement, but only one of you needs to meet the ownership requirement. Vacations, short absences and short rental periods do not reduce the use period. When only one spouse in a married couple qualifies, the maximum exclusion is limited to $250,000 instead of $500,000. Although this situation is quite rare, if you acquired the home as part of a tax-deferred exchange (sometimes referred to as a 1031 exchange), then you must have owned the home for a minimum of 5 years before the home-gain exclusion can apply.

Some provisions allow you to reduce your gain by a prorated amount if you were required to sell the home because of extenuating circumstances such as a job-related move, a health crisis or other unforeseen events. Another rule extends the 5-year period to account for the deployment of military members and certain other government employees. Please call this office if you have not met the “2 out of 5” rule to see if you qualify for a reduced exclusion.

Business Use of the Home – If you used your home for business—for instance, by claiming a tax deduction for a home office, storing inventory in the home or using it as a daycare center—that deduction probably included an amount to account for the home’s depreciation. In that case, up to the extent of the gain, the claimed depreciation cannot be excluded.

Figuring Gain or Loss from a Sale – The first step is to determine how much the home cost, combining purchase price and the cost of improvements. From this total cost, subtract any claimed casualty losses and any depreciation taken on the home. The result is your tax basis. Next, subtract the sale expenses and this tax basis from the sale price. The result is your net gain or loss on the sale of the home.

If the result is negative, the sale is a loss. However, losses on personal-use property such as homes cannot be claimed for tax purposes.

If the result is a gain, however, subtract any home-gain exclusion (discussed above) up to the extent of the gain. This is your taxable gain, which is, unfortunately, subject to income tax and possibly to the net-investment income tax as well. If you owned the home for at least a year and a day, the gain will a be a long-term capital gain; as such, it will be taxed at the special capital-gains rates, which range from zero for low-income taxpayers to 20% for high-income taxpayers. Depending on the amount of your income, the gain may also be subject to the 3.8% net investment income surtax that was added as part of the Affordable Care Act. The tax computation can be rather complicated, so please call us for assistance.

Another issue that can affect your home’s tax basis (discussed above) applies if you owned your home before May 7, 1997 and purchased it after selling another home. Prior to that date, instead of a home-gain exclusion, any gain from a sale was deferred to the replacement home. Although this is now rare, if it matches your situation, the deferred gain would reduce your current home’s tax basis and add to any gain.

Another Twist – If you previously used your home as a rental property, the law includes a provision that prevents you from excluding any gain attributable to the home’s appreciation while it was a rental. The law’s effective date was the beginning of 2009, which means that you only need to account for rental appreciation starting in that year. This law was passed to prevent landlords moving into their rentals for 2 years so that they could exclude the gains from those properties. Some landlords did this repeatedly.

Records – Assets that are worth hundreds of thousands of dollars, including your home, need your attention, particularly regarding records. When figuring your gain or loss, you will, at a minimum, need the escrow statement from the purchase, a list of improvements (not maintenance work) with receipts, and the final escrow statement from the sale. When you encounter any of the issues discussed in this article, you may need additional documentation.

A few other rare home-sale rules are not included here. As you can see, home-sale computations and tax reporting can be very complicated, so please call us if you need assistance.

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.