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Question from D.M. (on 1/27/2009)

This should be a common question among military, but I surprisingly have had difficulty finding an answer on the web:

I own a home (one home), but have been involuntarily moved from the home due to military orders.  I am currently renting where I now am (as I can't qualify nor afford two houses) and have a tenant in my home who meets part of the mortgage.  I'm pretty sure I have to count the rent as income (even though I collect $25,000 in rents and pay out $36,000 in rent where I am stationed).  In addition and here's the question:

Do I have to depreciate the house and deduct my mortgage interest as a property expense rather than under the standard home deductions?

I paid $29,000 in mortgage interest, $2,500 in property tax and $3,700 in insurance.  I also had $4,000 in repairs.  In addition, I had to replace the septic and the range which was "improvements" to the tune of $9,000 but with depreciation added minimally to the annual depreciation of the house of just under $12,000.  The bottom line was a net loss of $25,500.  This year, I got some from "passive activity loss" (PAL), though next year this will probably not be there as my AGI is approaching 150K.

On the flip side if I could count the $25,000 rent as pure income, and take the standard home deductions of $29,000 in mortgage interest, $2,500 in property tax and $3,700 in insurance, the net deduction would be 10,000.  (I would assume, even if this were legal, that I couldn't deduct repairs and other rental expenses from the rental income, but I could be wrong about that, too).

And in connection to the question above: If I can choose between the two, am I locked in from one year to the next do it a certain way...i.e. in 2009 when I get virtually no PAL deduction, can I do it the alternate way ("on the flip side..." paragraph) I described above?

Of course, this is military move has been a huge hit financially, as I've got a $11,000 difference in my housing cost, and loose a big chunk of the otherwise $35,000 mortgage deduction!

 

Answer from The Tax Dude®

 

D.M.,

When you rent a home (even temporarily), you are required to report the rental income Schedule E.  You are also entitled to deduct any expenses attributed to the property (including depreciation) on the same schedule.  Deducting the mortgage interest and real estate taxes for this property on Schedule A is not allowable.  You are only allowed itemized deductions for mortgage interest on your primary and secondary residences.  Even if you could shift these deductions to Schedule A, you probably run the risk of falling into the Alternative Minimum Tax.

Currently, your property is not considered a primary or secondary residence.  This means the only place to deduct these expenses on Schedule E.  Many times properties run at a loss during the first few years of rental activity.  The loss is typically caused by depreciation.  You have the option to claim the deduction for depreciation or not.  It doesn't make sense not to claim the depreciation because of what happens when you sell the property.

When you sell a depreciable asset, you are required to recapture the depreciation as income in the year of sale.  The rule requires recapture of depreciation allowed or allowable.  This means you would be recapturing depreciation as income even if you don't take the deduction.  Among the issues of depreciation recapture is this income does not capital gains treatment.  It is taxed at a 25% rate.

The next consideration is what happens to the rental losses you are incurring.  All rental real estate activities are considered passive activities and subject to the passive loss rules.  You seem to have a decent understanding about these rules.  I want to point out any losses which are not currently deductible are not lost.  They are suspended until you have passive income (from any source) to offset the losses or you dispose of the property.  In the year you sell the property, all of the unused suspended losses are released.  The losses are not considered capital losses and are fully deductible.

The release of the suspended losses may prove to be very valuable when you do sell the property.  There have been changes in the tax code for when you sell a residence.  Generally when you sell a primary residence you get to exclude $250,000 ($500,000 if married filing joint tax return) of capital gain.  The change in the law impacts this exclusion when the property has also been a rental.  Under the new law, you will need to allocate the capital gain between the rental use and primary residential use.  The capital gain allocated to the rental use does not qualify for the exclusion.

This means in the year of sale, you could have a taxable capital gain and depreciation recapture.  This is when the suspended passive losses become quite beneficial.  The suspended losses are considered ordinary losses.  This means it will offset taxable income from any source.

I hope this answers your questions and clarifies things for you.  As a side note, I really would like to see the new administration make some changes to the passive loss rules.  The AGI phase-out between $100,000 and $150,000 has not been adjusted since the passive activity rules went into effect with the Tax Reform Act of 1986.

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