Deductions When Turning a Personal Residence into a Rental

You may have a former personal residence that you’ve converted into a rental property. As you probably know, rental property owners are allowed to deduct costs to produce rental income, including depreciation. Deductions are allowed when a property is held out for rent, whether it is actually rented or not. One Tax Court case clarifies this important point.

Facts of the Case: Hattie Bonds moved to Minnesota in 1988 but she held onto her former principal residence in Kansas City. She did not use the property for personal purposes after the move to Minnesota. For approximately 15 years, Bonds was able to rent the house out. In 2006 and 2007 (the tax years in question in this case), it was available to be rented but was not rented due to various factors including a poor local economy and the property’s sub-optimal location. The taxpayer continued to own the property because a realtor told her she could still sell it for a profit.

On her federal income tax returns for the years in question, Bonds claimed rental losses from the property of about $13,000 and $12,700, respectively. These came from expenses including mortgage interest, property taxes, depreciation, cleaning, maintenance, utilities, insurance, advertising and auto travel to visit the property. The deductions were claimed on Schedule E of her tax return, which is used to report income and deductions from rental activities. There was no rental income in either year because the property remained unrented.

The IRS Position

The taxpayer’s 2006 and 2007 returns were audited, and the IRS completely disallowed her Schedule E losses. The government advanced three different arguments to support its position.

  1. Bonds continued to own the property for personal reasons (because her family and friends lived in the area, and she wanted to eventually retire there) and she had no intention to produce income by renting it out. No deductions or losses could be claimed on Schedule E unless there is an intention to produce rental income.
  2. The taxpayer could not currently deduct the losses she claimed on Schedule E, even if they were determined to be rental losses, because they were suspended by the passive activity loss rules.
  3. Bonds failed to substantiate some of her claimed Schedule E deductions. The IRS did allow write-offs for mortgage interest and property taxes, but argued they were itemized deductions that should have been reported on the taxpayer’s Schedule A rather than on Schedule E.

Bonds took her case to the U.S. Tax Court where she represented herself under the “small case” rules for disputes involving less than $50,000. For this type of case, the Court issues “Summary Opinions,” which cannot be appealed.

The Tax Court’s Decision

The Tax Court concluded that the taxpayer was indeed entitled to deduct Schedule E rental losses for 2006 and 2007, even though the property was not actually rented out in either of those years. The Court pointed out that the government’s own regulations say that holding property for the production of income can include holding property for the expected collection of income in future years. It can also include holding property for an anticipated gain on sale in a future year. In 2006 and 2007, the taxpayer had reason to believe she could sell the property for a gain because a realtor told her so.

Next, the Tax Court rejected the IRS claim that the taxpayer’s rental losses were suspended by the passive activity loss rules. Bonds met the active participation requirement and was therefore eligible for the exception that allows individuals to currently deduct up to $25,000 of annual losses from rental real estate (subject to phase-out at higher income levels).

However, the Tax Court agreed with the IRS assertion that some of the taxpayer’s claimed deductions were undocumented and should be disallowed or only partially allowed for that reason. When all was said and done, about half the taxpayer’s claimed Schedule E losses were allowed. The other half was lost due to inadequate recordkeeping. (Hattie M. Bonds, T.C. Summary Opinion 2011-122)

Bottom Line

Individuals are allowed to claim Schedule E rental losses even in years when there is no rental income, as long as their properties are held out for rent. However, if this is your situation, make sure you keep proof that you attempted to rent the property in case you get audited by the IRS. This might include copies of agreements with realtors and copies of “for rent” advertising. In addition, you must be prepared to prove your claimed rental expenses by keeping decent records.

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