Rental real estate offers tremendous tax advantages and opportunity for tax planning. Taxpayers can deduct interest on borrowed capital, exchange rather than sell properties to defer tax on gains, use installment sales to defer tax on sales, and profit from preferential rates on long-term capital gains. Most importantly, you may be able to generate “positive cash flow,” or monthly income, with depreciation deductions that effectively turn the actual income into tax losses.
However, deductions are not unlimited. For example, real estate income and loss is generally considered passive income and loss for tax purposes. Taxpayers generally cannot use passive activity losses (PALs) to offset ordinary income from employment, self-employment, interest and dividends, or pensions and annuities. The rental real estate loss allowance and real estate professional status are two important exceptions to this rule. In addition, the tax consequences of renting out a vacation home depend upon the amount of time the home is rented and the amount of time you use the home for personal purposes.
As one exception to the PAL rules, taxpayers with adjusted gross incomes (AGI) of $150,000 or less can claim a rental real estate loss allowance of up to $25,000 for property they actively manage. The amount of the loss allowed is based on a sliding scale that begins with AGIs of $100,000 and that is phased out for AGIs over $150,000. Active management standards are met if the taxpayer participates in the management of the property in a significant and bona fide manner. Examples of active management include approving new tenants, deciding on rental terms, and approving expenditures. In addition, this exception only applies to taxpayers owning at least 10% of the property.
The second exception allows real estate professionals not to treat their rental activity as a passive activity. Therefore, their losses are not limited to passive income. This exception requires material participation by the taxpayer which is demonstrated by meeting one of seven tests. These tests are complex and include the number of hours of participation and the facts and circumstances of the participation in the activity.
The tax rules regarding a personal residence used as a vacation home depends upon how long the homeowner rents the property. If you rent your vacation home for fewer than 15 days during the year, no rental income is includible in gross income. Thus if your vacation home is near a resort area, you could conceivably rent your home for $10,000 a week and have $20,000 of tax-free income. If you rent the property for 15 or more days during the tax year and it is used by you for the greater of (a) more than 14 days or (b) more than 10% of the number of days during the year for which the home is rented, the rental deductions are limited. Under this limitation, the amount of the rental activity deductions may not exceed the amount by which the gross income derived from such activity exceeds the deductions otherwise allowable for the property, such as interest and taxes.
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