Tax Complexities of Rental Property

Tax Complexities of Rental Property

There's no simple formula for figuring depreciation and amortization on a vacation home or other residential rentals.

By Kevin McCormally

April 12, 2007

Is there an easy way to understand and figure out the depreciation and amortization on our vacation home, which we rent out six weeks of the year?

Come on ... you want taxes to be easy?

You figure your depreciation on Form 4562, basically, by dividing your tax basis in the property (purchase price, plus improvements, minus the cost of land) by 27.5 because a residential rental property is depreciated over 27½ years. First-year depreciation is reduced depending on when in the year you put the house in rental service.

Then you have to allocate the depreciation between personal (nondeductible) and rental (deductible) use on the Schedule E, where you report your rental income and rental expenses. Here's a section from my book, Cut Your Taxes, that explains the allocation methods available.

To figure your vacation-home deductions, you have to allocate expenses between personal and rental use. There are two ways to do this -- the IRS method and another approach that has been approved in court cases. The one that's best for you depends on your circumstances.

According to the IRS, you begin by adding up the total number of days the house was used for personal and business purposes. Your deductible rental expenses are the same proportion of the total as the number of rental days is to the total number of days the place was used.

For example, assume you have a cabin in the mountains that you use for 30 days during the year and rent out for 100 days. The 100 days of rental use equals 77% of the total 130 days the cabin was used According to the IRS formula, 77% of your expenses—including interest, taxes, insurance, utilities, repairs and depreciation—would be rental expenses.

The IRS is particular about the order in which you deduct those expenses against your rental income. You deduct interest and taxes first, then expenses other than depreciation, and then depreciation. The sequence is important, and detrimental, because of the rule that limits rental deductions to the amount of rental income when personal use exceeds 14 days or 10% of total use. Remember that property taxes not assigned to rental use could be claimed as regular itemized deductions instead. But by requiring you to deduct those expenses against rental income -- that might otherwise be offset by depreciation you won't get to claim -- the law squeezes the write-off for taxes as an itemized deduction.

By using a different allocation formula, though, you can limit the interest and tax expenses used to offset rental income and thereby boost the write-off of other rental costs. Courts have allowed taxpayers to allocate taxes and interest over the entire year rather than over just the number of days a property is used. In the example above of 100 days of rental use, that method would allocate just 27% (100 ÷ 365) of the taxes and interest to rental income. That would leave more rental income against which other expenses can be deducted. The extra taxes and interest can be deducted as a regular itemized deduction.

Although the court-approved formula can pay off when the 14-day or 10% test makes the property a personal residence, the IRS version can be more appealing if the place qualifies as a business property. You need to look at the specifics of your situation to determine the best method for you.

Source: Kiplinger