Categorizing Rentals For Tax Purposes
There are specific IRS rules regarding the categorization of rental properties for tax purposes. It is important to understand these regulations before you submit any tax forms to the Internal Revenue Service.
When a rental activity involves real estate, it’s usual to automatically picture reporting on Schedule E and Form 8582, subject to the $25,000 loss rule. However, there are several activities that at first glance appear to be “rentals,” but upon closer scrutiny are seen to fall under one of the exceptions.
How must these be categorized to comply with IRS rules?
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Golf course condo - John and Mary own a condo next to a golf course in Palm Springs., Their personal use never exceeds 14 days per year, and a leasing agent secures several dozen tenants during the year., The property generally shows losses in the $5,000 to $10,000 range., Is this an active participation rental?, ANSWER: This activity is not likely to be an active participation rental real estate activity., Divide the days rented by the number of tenants. If the average rental period is less than 7 days, this is just a passive activity – much like a K-1. Report it on Schedule C. Suspend the loss if no other offsetting passive income.
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Vacation homes - Same as above – condo by a golf course, but John and Mary use the property for about 30 days each year., Their typical tenant stays for a month or so., Is this a passive activity?, ANSWER: The vacation home rules take precedence over the passive loss rules., Any net loss MUST be suspended., The activity is NOT passive., The loss is suspended before Form 8582 ever comes into play!
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Rental to relative - Phil owns a residential property and rents it to his brother Bill., What pitfalls must be avoided?, ANSWER: When a taxpayer rents a home to a relative for long-term use as a principal residence, the tax treatment of the rental depends upon whether the property is rented at fair rental value or rented at less than the fair rental value.
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Commercial tenant - Joe owns a commercial property that he rents out., The tenant literally takes care of everything except the interest and taxes., How does Joe treat the property? ANSWER: This is probably not an active participation rental. If there is a loss on the property, the $25,000 loss rule will not apply.
(This used to be called a “net lease” property. Under those old rules, a property was PRESUMED to be “investment” rather than “business” if expenses other than for interest, taxes and depreciation did not exceed 15% of gross rents.)