Tax

When you use a home for both rental and personal use, regardless of that home’s location at the beach or in the city, you run into the tax code’s vacation home rules that make that home either a residence or a rental property. 

It’s a residence when you

• rent it for more than 14 days during the year and
• use it for personal purposes for more than the greater of 14 days or 10 percent of the days that you rent the home out at fair market rates.

Example. You own a beachfront vacation condo. During the year, you rent it out for 180 days. You and members of your family stay there for 90 days. The property is vacant the rest of the year except for seven days at the beginning of winter and seven days at the beginning of summer, which you spend maintaining the property. Your condo falls into the tax code–defined personal residence because

• you rented it out for 180 days, which is more than 14 days, and 
• you had 90 days of personal use, which is more than 14 days and more than 10 percent of the rental days. 

Disregard the 14 days you spent maintaining the place.

The fundamental principle that applies when your vacation home is a personal residence is that expenses other than mortgage interest and property taxes allocable to the rental use cannot exceed the gross rental income from the property. In other words, rental operating expenses and depreciation cannot cause a tax loss on Schedule E of your Form 1040 for the year in question.

If you have such a property and want to discuss some planning strategies for its use, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 4, 2022

Do you have a sideline activity that you think of as a business? 

From this sideline activity, are you claiming tax losses on your Form 1040?

Will the IRS consider your sideline a business and allow your loss deductions?

The IRS likes to claim that money-losing sideline activities are hobbies rather than businesses. The federal income tax rules for hobbies have been anti-taxpayer for years, and now an unfavorable change enacted in the Tax Cuts and Jobs Act (TCJA) made things even worse for 2018-2025. 

If you have such an activity, we should have your attention. 

Here’s the deal: if you can show a profit motive for your now-money-losing sideline activity, you can classify that activity as a business for tax purposes and deduct the losses. 

Factors that can prove (or disprove) such intent include:

• Conducting the activity in a business-like manner by keeping good records and searching for profit-making strategies.
• Having expertise in the activity or hiring advisors who do.
• Spending enough time to justify the notion that the activity is a business and not just a hobby.
• Expectation of asset appreciation: this is why the IRS will almost never claim that owning rental real estate is a hobby, even when tax losses are incurred year after year.
• Success in other ventures, which indicates that you have business acumen.
• The history and magnitude of income and losses from the activity: occasional large profits hold more weight than more frequent small profits, and losses caused by unusual events or just plain bad luck are more justifiable than ongoing losses that only a hobbyist would be willing to accept.
• Your financial status: “rich” folks can afford to absorb ongoing losses (which may indicate a hobby) while ordinary folks are usually trying to make a buck (which indicates a business).
• Elements of personal pleasure: breeding race horses is lots more fun than draining septic tanks, so the IRS is far more likely to claim the former is a hobby if losses start showing up on your tax returns.

If you would like to discuss the profit motive, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• February 1, 2022

Imagine this:

• Tax deduction for you
• Tax-free income for Mom and Dad

It doesn’t have to be Mom and Dad. The tax-free income can go to your brother or sister, or your best friend.

To make this work, you need to have a business reason to travel and stay overnight at the Mom and Dad Hotel.

Say you travel to a convention, rent your parents’ guest room for five days, and pay them $1,000 fair rent. You deduct the $1,000 as a business travel expense. Your parents have $1,000 of tax-free income.

Sound good? Great—let’s see how you can make this work for you by following three rules.

Rule 1: 14-Day Limit on Renting

Mom and Dad can rent out a room in their home or rent their entire house (tax-free) if they rent it out for no more than 14 days during the year. While the rules are generous in allowing your parents not to include this rental income as taxable income, they can’t offset that income with expenses associated with the rental. 

Rule 2: More Than 14-Day Personal Use Requirement

To obtain any tax-free rent, Mom and Dad must personally use the place they rent to you for more than 14 days during the year. For a primary residence, this isn’t a problem.

But for second homes or vacation homes, your rental from Mom and Dad or your brothers and sisters creates potential trouble. Why? Because the days of your rental (at fair value or not) count as days of personal use for Mom or Dad and for your brothers or sisters.

Rule 3: Fair Market Rental Rate

When you stay at a commercial hotel, you pay an established commercial rate. So when you stay with Mom and Dad, other family, or friends, you also need to pay a commercial rate, which the IRS refers to as a fair market rental rate. 

Form 1099

Tax law says that when you pay business rents that exceed $600 to an individual during a tax year, you must report the total of those business rents to the IRS. Hence, if you pay Mom and Dad more than $600 in rent during any calendar year, you have to give them (and the IRS) a Form 1099.

Mom and Dad’s Tax Return

Mom and Dad should report the rental income from the Form 1099 on their Schedule E for the year. 

Then, because the amount is not taxable, they should subtract that amount in the expense section of Schedule E and add a supporting statement such as the following:

Taxpayers rented their personal residence for fewer than 15 days during the taxable year. The rental income was reported on a 1099 and is thus reported as income on Schedule E. That rent is exempt from taxation under IRC Section 280A(g) and is thus removed with the offsetting expense entry on that same Schedule E.

If you want to discuss this strategy, please give me a call on my direct line at 408-778-9651.

• By Leon Clinton
• January 30, 2022