Tax Treatment of Rental Property

Cardboard house cut out with a "for rent" tag on it

Accurate tax categorization of rental activity is one of the most challenging aspects of annual reporting for many filers. That’s not surprising, given the complex way the IRS treats rental income and expenses. Just two key questions control most tax-related questions regarding rental activities:

  • Is the taxpayer’s involvement active or passive?
  • Does the taxpayer materially participate in the rental activity?

But though the questions may seem simple, determining the answers requires taxpayers to navigate a maze of rules and exceptions that create headaches each year. If you’re one of those taxpayers, here’s what you need to know.

The Basics

Rental of tangible property is automatically classified as a passive activity unless the activity meets one of six exceptions which must be applied each year. Meeting any of these exceptions means the rental activity is categorized as business-related, at which point the material participation tests determine whether the activity is active or passive.

The IRS considers taxpayers to be material participants only if they are involved on a regular, continuous and substantial basis. Seven tests can help taxpayers decide if their activity meets this standard. Material participation renders the rental activity not passive; any income derived from this activity must be treated as business income.

If the rental activity does qualify as passive, then any losses associated with the activity are treated like other passive losses and are subject to standard loss limits. But like almost every aspect of rental activity, this rule has exceptions:

  1. Real estate professionals cannot treat rental activity losses as passive, and
  2. Taxpayers can deduct up to $25,000 of losses on real estate rental activities against active or portfolio income. This benefit is reduced by 50% of a taxpayer’s AGI in excess of $100,000. To qualify for this exception taxpayers must meet specific IRS rules regarding active participation and ownership.

Other Exceptions

In addition to the exceptions already discussed, the IRS imposes a number of special rules regarding rental activity. Notably, net rental income from a self-rented property is not treated as passive income. Rental income from non-depreciable property is also not considered passive in some situations.

Rental treatment of a vacation home follows one of three different sets of rules, depending on the balance between personal and rental usage. These rules control the deductibility of expenses and the tax treatment of income the property generates.

If the owner uses the vacation home fewer than 15 days in a given tax year, the property is considered a rental property rather than a residence and the vacation home rules do not apply. If, on the other hand, the property is rented for fewer than 15 days per year, the property is a residence and the rental income does not have to be reported at all. For rental periods between those two extremes, income and expenses must be pro-rated based on days of rental and personal use to establish allowable rental expense deductions.

Safe Harbor Provision

Calculating allowable deductions for maintenance and repairs on rental property can be complicated, but the IRS provides a safe harbor provision that simplifies the process. The de minimis safe harbor for tangible property allows taxpayers to deduct certain maintenance and repair costs as rental expenses on Schedule E rather than capitalizing them.

The safe harbor provision isn’t available to all taxpayers. Its limits are triggered by a number of factors, including:

  • The taxpayer’s average annual gross receipts
  • The unadjusted cost basis of the property
  • Repair costs relative to the property’s unadjusted basis
  • Total amount of rent over the lease term, for leased property

Rental activities offer taxpayers an effective method to increase income and lower taxable income. However, it is critical for owners to understand and comply with all IRS rules regarding tax reporting and calculation of rental-related deductions. For tax-efficient strategies that help you maximize the benefits of all types of rental activities, please contact the tax professionals at HBP today.