Generally, a person is not entitled to deduct the cost of maintaining a personal residence. There are certain exceptions, allowing a deduction for items such as qualified mortgage interest and real estate taxes. With the advent of Airbnb and other home sharing services, more and more people may become rental property owners and be entitled to take these tax deductions on rental property.
Common Tax Deductions for Rental Property
If the property qualifies as a residence and is rented for fewer than 15 days, the owner is not permitted to claim expenses associated with rental. However, expenses associated with a personal residence that are allowed irrespective of whether the home is rented are permitted.
If the property qualifies as a residence and is rented for 15 days or more, the owner may claim expenses associated with rental. He or she may claim expenses only to the extent the gross income exceeds deductions otherwise allowable with respect to the property. Such otherwise allowable deductions include qualified home mortgage interest or real estate taxes.
What happens when expenses exceed income?
To the extent the expenses exceed rental income, they must be carried forward to the next year. Expenses associated with a personal residence that are allowed irrespective of whether the home is rented are not limited to income received from the rental.
To determine the correct amount of allowable expenses associated with rental of the vacation/second home, expenses must be allocated. Expenses are allocated between rental and personal use of the property.
How to Determine if Rental Expenses are Deductible?
When determining the deductibility of costs associated with rental of a vacation/second home, the costs will fall into one of the three following categories:
- Deductible in full in the year paid.
- Deductible over time (depreciable or amortizable).
- Neither currently deductible or nor deductible over time.
Currently Deductible Expenses
Currently deductible expenses are those that are ordinary and necessary expenses of renting the property, including the cost of repairs. A “repair” is the cost of keeping an asset in ordinary operating condition. It does not materially add to the value of the property or substantially prolong its life. Examples of repairs include:
- Cleaning and maintenance.
What Capital Expenses for Rental Property are Deductible?
Capital expenditures are amounts spent for an item that lasts more than one year or has a benefit that lasts more than one year. If the asset does not wear out over time, the cost cannot be recovered through depreciation. If the asset does wear out, the cost may be recovered over time through depreciation deductions. An improvement is treated as a capital expenditure. An “improvement” is an expenditure that puts an asset in normal operating condition. It materially adds to the value of the property, substantially prolongs its life, or adapts the property to a new or different use. Examples of improvements include:
- Updating wiring.
- Replacing the roof.
- Installing a new washer and dryer.
- Repairs made as part of an extensive remodeling or restoration of the property.
The cost of real property (not including the cost of land) used for rental purposes is recovered ratably over 27.5 years.
IRS Classes of Property Life
The IRS has provided charts setting forth the class life of property, which is the number of years over which the cost must be recovered. The property class lives are:
- 3-year property;
- 5-year property.
- 7-year property.
- 10-year property.
- 15-year property.
- 20-year property.
- 27.5 years for nonresidential real property.
- 39 years for residential real property.
Most property used for rental purposes will be classified as five-, seven-, or 15-year property. Five-year property includes items such as appliances, carpeting, some furniture, computers, office machines, and automobiles. Seven-year property includes items such as some furniture and desks. Roads and shrubbery are examples of 15-year property.
MACRS and Rental Property
Under MACRS, the cost of tangible personal property is recovered in an accelerated manner. More depreciation is allocated to the earlier years and less to the later years. In addition, for the first year the asset is placed in service, the owner is entitled to only one-half the year’s depreciation.
The correct prorated amounts have been converted into percentages and organized on charts. By locating the correct year on the chart for the correct class life, it is easy to calculate the amount of allowable depreciation for the year. Simply multiply the cost of the property by the percentage from the chart
It is possible to elect out of MACRS and recover the cost using the straight-line method. In essence, if the election is made, the cost of the property is recovered over 40 years rather than 27.5 years.
Placing MACRS Property Into Service
For the year the person places the property in service, she is not entitled to a full year of depreciation. Rather, for the month the owner begins using the property in a rental business, she gets one-half a month of deprecation. The owner receives a full month’s worth of depreciation for the remaining months of the year.
The correct prorated amounts have been converted into percentages and placed on charts. By locating the correct year and month, an individual can easily calculate the amount of allowable depreciation for the year. Simply multiply the cost of the building by the percentage from the chart. The cost of property used for rental purposes is recovered using the following percentages: