Taxation of Individuals and Business Entities, 11e by Brian C. Spilker

Author:Brian C. Spilker
Language: eng
Format: epub

Example 14-13

What if: Suppose that at the beginning of the year, the Jeffersons purchased a vacation home in Scottsdale, Arizona, for $400,000. They paid $100,000 down and financed the remaining $300,000 with a 6 percent mortgage secured by the home. During the year, the Jeffersons did not use the home for personal purposes and they rented the home for 200 days. They received $37,500 in gross rental revenue for the year and incurred $50,439 of expenses relating to the rental property. How much can the Jeffersons deduct in this situation?

Answer: The good news is that the deductions are not limited to gross income from the rental so they can tentatively deduct all $50,439, generating a $12,939 loss on the property ($37,500 − $50,439). The bad news is that, as we discuss below, the loss may not be immediately deductible due to the passive activity loss limitations.

Exhibit 14-6 summarizes the tax rules relating to a home used for rental purposes depending on the extent of rental (and personal use). Appendix B to this chapter provides a flowchart summarizing the implementation of these rules.

Losses on Rental Property A rental property can be a great investment that gets the best of all worlds. It could (1) appreciate in value, (2) produce annual positive cash flow (rental receipts exceed expenses other than depreciation), and (3) generate tax losses that reduce the taxes the owner is required to pay on other sources of income. Consider the Jeffersons’ second-home property, purchased for $400,000 and used primarily as a rental home (see Example 14-13), which we’ll assume has appreciated to $440,000 by the end of 2019. The property has appreciated by $40,000, produced a positive cash flow of $1,000 [$37,500 rental income minus expenses other than depreciation of $36,500 ($50,439 total expenses minus depreciation expense of $13,939)], and generated a net tax loss of $12,939. This loss apparently saves the Jeffersons $4,140 in taxes ($12,939 × 32% marginal tax rate).

Thus, the increase in the Jeffersons’ wealth from their second-home investment for the year appears to be $45,140 ($40,000 appreciation + $1,000 rental cash flow + $4,140 tax savings). But as noted elsewhere in this text, when a tax outcome seems too good to be true, it usually is. Read on.

Passive activity loss rules. In the Investments chapter, we introduced the passive activity loss rules that indicate taxpayers may only deduct passive losses for a year to the extent of their passive income. We also learned that, by definition, a rental activity Page 14-23(including a dwelling unit that falls in the nonresidence category) is considered to be a passive activity.24 Because they are passive losses, losses from rental properties are generally not allowed to offset other ordinary or investment type income. However, as we also discussed in the Investments chapter, a taxpayer who is an active participant in a rental activity may be allowed to deduct up to $25,000 of the rental loss against nonpassive income.25 Consistent with a number of tax benefits, the exception amount for active

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