Rental Property

A rental property is real property held out for rent to produce income. In ordinary speech that covers anything from a spare room to an apartment building, but federal tax law asks a narrower question about each dwelling unit: did the owner also use it personally, and how much? Section 280A of the Internal Revenue Code answers by counting days. A taxpayer is treated as using a dwelling unit as a residence if personal use for the year exceeds the greater of 14 days or 10 percent of the number of days the unit was rented to others at a fair rental. Below that line the unit is a rental and the ordinary rules apply. Above it, the unit is a residence that happens to be rented, and deductions attributable to the rental use are capped at the rental income.

Two things about that test surprise people. It is the greater of, not the lesser, so a unit rented for 300 days tolerates 30 days of personal use rather than 14. And a day counts as personal use if the unit is used for any part of it by the owner, by anyone else with an interest in it, or by a family member, whether or not rent is charged, unless the arrangement fits a narrow exception for renting to a family member at a fair rental as that person's principal residence.

The 15-day rule is the one worth knowing before anyone rents anything. Section 280A(g) says that if a dwelling unit is used by the taxpayer as a residence and is actually rented for fewer than 15 days in the taxable year, no deduction attributable to the rental is allowed and the income from that rental is not included in gross income at all. It is a complete exclusion rather than a deduction, so an owner who rents a home for a fortnight around a local event reports nothing. This is the provision widely known as the Augusta rule, and its two halves travel together: give up the deductions and the income disappears with them.

Depreciation is the deduction that makes a rental different from any other investment, and it starts earlier than owners expect. The clock begins when the property is ready and available for rent, which is the date it is listed and habitable rather than the date the first tenant signs. Residential rental property, meaning a building for which 80 percent or more of the gross rental income comes from dwelling units, is recovered over 27.5 years on the straight-line method with a mid-month convention, so the first and last years are prorated to the middle of the month. Land is never depreciated, which makes the allocation of the purchase price between land and building the single most consequential number recorded at closing. Appliances, carpeting and furniture used in the activity are a separate, much shorter class, so they are worth listing separately rather than folding into the building.

Depreciation is not free money. It reduces basis as it is claimed, and the reduction is measured by what was allowed or allowable rather than by what was actually taken, so declining to claim it does not preserve the basis. What happens at the sale, and the separate question of whether rental losses can be set against a salary, belong to the terms that own those subjects.

The repair-or-improvement line decides timing, and the timing is worth real money. A repair is deducted in the year it is paid. An improvement is capitalized and recovered over the building's life. The test in the tangible property regulations is whether the work results in a betterment of the property, a restoration of it, or an adaptation of it to a new or different use. Fixing a pre-existing defect, enlarging the property, or increasing its capacity or quality is a betterment. Replacing a substantial structural part, or rebuilding to a like-new condition, is a restoration. Converting a garage into a shop is an adaptation. Patching, painting and servicing are not. Two elections soften the edges: a de minimis safe harbor for small acquisitions and a safe harbor for routine maintenance performed more than once over a stated period.

Section 280A is a dwelling-unit rule, so it does not reach every rental. Bare land, commercial space and a purpose-built rental the owner never occupies sit outside it. What all of them share is the ordinary requirement that the activity be conducted for profit and documented as such: leases, bank records, invoices, mileage logs, and a basis schedule that survives every year the property is held.

The sequence for a new landlord is: allocate the purchase price between land and building, place the property in service by making it ready and available for rent, begin depreciation from that month, then each year separate repairs from improvements, and report the result on Schedule E.

A hypothetical classification example. Renata owns a beach condominium. During the year she rents it at a fair rental for 100 days and stays in it herself for 20 days. Her personal-use ceiling is the greater of 14 days or 10 percent of 100 days, which is 10 days, so the ceiling is 14 days. Her 20 days exceed it, so for the year the condominium is treated as a residence. Deductions attributable to the rental use are limited to the rental income; she cannot use the property to produce a loss. Had she stayed 12 days instead of 20, the same property in the same year would have been an ordinary rental.

A hypothetical depreciation example. Renata buys a single-family house to rent for $350,000. Her allocation, supported by the assessor's split between land and improvements, assigns $75,000 to the land and $275,000 to the building. Land is not depreciable, so only the building is recovered: $275,000 divided by 27.5 years is $10,000 a year of straight-line depreciation once the property is in service for a full year. If she had allocated $120,000 to the land instead, the annual deduction would have been $230,000 divided by 27.5, or about $8,364. Nothing about the house changed; only the number written down at closing did.

Pros

• Depreciation is a deduction that requires no cash outlay in the year it is claimed, so a property can produce positive cash flow and a taxable loss at the same time.
• Operating costs that would be personal on a home you live in, including insurance, repairs, management and the mortgage interest, become deductible against the rental income.
• The 15-day rule lets an owner rent a home briefly and report nothing at all, which is the rare case where doing less produces a better tax result.
• Rent and property values respond to different pressures than financial markets, so the income is not tied to a portfolio's behavior.

Cons

• The classification test is unforgiving and is counted in days, so a well-intentioned extra week at the property can change the year's tax result after the fact.
• Depreciation reduces basis whether or not it is claimed, so skipping it does not avoid the consequence at sale.
• Losses are frequently not deductible against wages in the year they arise, which is a common and expensive surprise for a first-year landlord.
• The activity is an operating business with vacancy, collections, repairs and regulation attached, and none of that appears in a projected yield.
• Poor records at purchase, especially a missing land allocation, are hard to reconstruct years later and can cost every subsequent year's deduction.