Author: Leon Clinton

If you have a home that you both rent out and use personally, you have a tax-code-defined vacation home.

Under the tax code rules, that vacation home is either

• a personal residence, or
• a rental property.

The tax code classifies your vacation home as a rental property if

• you rent it out for more than 14 days during the year, and
• your personal use during the year does not exceed the greater of (a) 14 days or (b) 10 percent of the days you rent the home out at fair market rates.

Count actual days of rental and personal use. Disregard days of vacancy, and disregard days that you spend mainly on repair and maintenance activities.

For vacation homes that are classified as rental properties, you must allocate mortgage interest, property taxes, and other expenses between rental and personal use, based on actual days of rental and personal occupancy.

Mortgage Interest Deductions

Mortgage interest allocable to personal use of a rental property does not meet the definition of qualified residence interest for itemized deduction purposes. The qualified residence interest deduction is allowed only for mortgages on properties that are classified as personal residences.

Schedule E Losses and the PAL Rules

When allocable rental expenses exceed rental income, a vacation home classified as a rental property can potentially generate a deductible tax loss that you can claim on Schedule E of your Form 1040. Great!

Unfortunately, your vacation home rental loss may be wholly or partially deferred under the dreaded passive activity loss (PAL) rules. Here’s why.

You can generally deduct passive losses only to the extent that you have passive income from other sources (such as rental properties that produce positive taxable income).

Disallowed passive losses from a property are carried forward to future tax years and can be deducted when you have sufficient passive income or when you sell the loss-producing property.

“Small Landlord” Exception to PAL Rules

A favorable exception to the PAL rules currently allows you to deduct up to $25,000 of annual passive rental real estate losses if you “actively participate” and have adjusted gross income (AGI) under $100,000. The $25,000 exception is phased out between AGI of $100,000 and $150,000.

The Seven-Days-or-Less and Less-Than-30-Days Rules

The IRS says the $25,000 small landlord exception is not allowed

• when the average rental period for your property is seven days or less, or
• when the average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers.

“Real Estate Professional” Exception to PAL Rules

Another exception to the PAL rules currently allows qualifying individuals to deduct rental real estate losses even though they have little or no passive income. To be eligible for this exception,

1. you must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate, and
2. those hours must be more than half the time you spend delivering personal services (in other words, working) during the year. If you can clear those hurdles, you qualify as a real estate professional.

The second step is determining whether you have one or more rental real estate properties in which you materially participate. If you do, those properties are treated as non-passive and are therefore exempt from the PAL rules. That means you can generally deduct losses from those properties in the current year.

Meeting the Material Participation Standard

The three most likely ways to meet the material participation standard for a vacation home rental activity are when the following occur:

• You do substantially all the work related to the property.
• You spend more than 100 hours dealing with the property, and no other person spends more time on this property than you.
• You spend more than 500 hours dealing with the property.

In attempting to clear one of these hurdles, you can combine your time with your spouse’s time. But if you use a management company to handle your vacation home rental activity, you’re very unlikely to pass any of the material participation tests.

If you would like to discuss the tax implications of owning a property that you both use personally and rent out, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• April 27, 2022

When you own more than one business, you need to consider the grouping rules that apply for passive-loss purposes.

Should one of your businesses lose money, you may not deduct the losses from that business during the current tax year unless you

1. materially participate in the business or, if grouped, materially participate in the group; or
2. do not materially participate but have passive income from other sources against which to deduct your passive business losses.

Example. Sam Warren, MD, operates a medical practice and starts a new physical therapy business (his second business) in which he will not materially participate. The physical therapy business is going to lose money during its first years of operation. If Dr. Warren wants to deduct the losses from his physical therapy business, he has one choice: group that business with his medical practice.

Dr. Warren knows that he will have tax losses in his physical therapy business during its start-up years. Because he will not materially participate in the physical therapy business, the tax code deems his losses passive. He may deduct his passive losses

• against his passive income from other sources (excess passive losses are carried forward); and
• in total, when he sells or otherwise disposes of his entire interest in the passive activity.

This is ugly.

First, Dr. Warren has no other passive income. The medical practice, his only other business or activity, is an active business that produces active income.

Second, he does not plan on selling the physical therapy business anytime soon, so he would not realize any benefit from the accumulation of his carried-forward passive losses.

His solution: the group.

If Dr. Warren’s physical therapy business loses $175,000 as he projects, he can write off that $175,000 because the grouping makes him a material participant.

Without the grouping, he does not materially participate in the physical therapy business. Without material participation, his $175,000 loss is a passive-loss deductible against only passive income, of which he has none.

The medical practice income is active income, not passive income.

When he makes the grouping election, the law combines the two businesses for material participation purposes. Let’s say he works 2,000 hours a year in his medical practice. With grouping, he now works 2,000 hours a year in the combined activity, and that makes the loss from the physical therapy business deductible.

If you have multiple activities and want to discuss grouping, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• April 21, 2022

• By Leon Clinton
• April 16, 2022