Rental Property:
Proper Classification and Reporting
Summer 2014
Developed by Timothy Dilworth EA, CPA
Presented by XXXX
Table of Contents
Table of Contents ...........................................................................................................................................i
Tax Rules for Mixed-Use Property .............................................................................................................. 2
Tax Court Method and Exceptions ............................................................................................................... 3
Rental Real Estate with Active Participation ............................................................................................... 3
Modified adjusted gross income (MAGI) .................................................................................................... 4
Basis Limitation example:........................................................................................................................ 5
At-Risk Rules ............................................................................................................................................... 5
Real estate professionals: ............................................................................................................................. 5
Real property trades or businesses................................................................................................................ 6
Material Participation ................................................................................................................................... 6
Material participation tests ....................................................................................................................... 7
Proof of participation ............................................................................................................................... 8
Rental Activities not automatically treated as Passive: ................................................................................ 8
Participation Rules........................................................................................................................................ 9
Work not usually performed by owners ................................................................................................... 9
Participation as an investor ...................................................................................................................... 9
Spouse's participation ............................................................................................................................. 10
Definition of a qualified joint venture ........................................................................................................ 10
Self Rental activity: .................................................................................................................................... 10
Sources: ...................................................................................................................................................... 11
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Tax Rules for Mixed-Use Property
Classification
Personal-Use
Rental Property
Vacation Home
Personal use
15 days or more of
personal use and rented
fewer than15 days.
No more than the greater
of (1) 14 days or (2) 10%
of the number of days
rented at fair rental value.
More than the greater of
(1) 14 days or (2) 10% of
the number of days
rented at fair rental value.
Rental
Not reported.
Report on Schedule E,
line 3.
Report on Schedule E,
line 3.
Mortgage
Report on
Interest
Schedule A, line
Amount allocated to
rental, report on Schedule
E, line 12. Personal-use
amount nondeductible.
Amount allocated to
rental, report on Schedule
E, line 12.
Amount allocated to
rental, report on Schedule
E, line 16.
Amount allocated to
rental, report on Schedule
E, line 16. Personal-use
amount report on
Schedule A, line 6.
Property
Days of
Income
10, if qualified home or
second home.
Property
Taxes
Report on Schedule A,
line 6.
Personal-use amount
report on Schedule A,
line 6.
Casualty / Theft Losses
Personal use subject to
limitations, report on
Schedule A, line 20.
Amount allocated to
rental report on Schedule
E. Personal-use report on
Personal-use amount
report on Schedule A,
line 10, if qualified
second home.
Amount allocated to
rental, report on Schedule
E. Personal-use amount
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Direct
Schedule A, line 20.
report on Schedule A,
line 20.
Nondeductible.
Report on Schedule E,
lines 5 -19.
Report on Schedule E,
lines 5 -19.
Nondeductible.
Amount allocated to
rental, report on Schedule
E. Personal-use amount
nondeductible.
Amount allocated to
rental, report on Schedule
E, but limited to gross
rental income, less the
expense items in the
preceding rows. Personaluse amount
nondeductible.
Expenses
Other Operating
Expenses
Tax Court Method and Exceptions
280A(e) Expenses attributable to rental
(1) In general
In any case where a taxpayer who is an individual or an S corporation uses a dwelling unit for
personal purposes on any day during the taxable year (whether or not he is treated under this
section as using such unit as a residence), the amount deductible under this chapter with respect
to expenses attributable to the rental of the unit (or portion thereof) for the taxable year shall not
exceed an amount which bears the same relationship to such expenses as the number of days
during each year that the unit (or portion thereof) is rented at a fair rental bears to the total
number of days during such year that the unit (or portion thereof) is used.*
(2) Exception for deductions otherwise allowable
This subsection shall not apply with respect to deductions which would be allowable under this
chapter for the taxable year whether or not such unit (or portion thereof) was rented.
*Tax Court method allows allocation of taxes and interest based on entire year.
Rental Real Estate with Active Participation
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Example. Mike is single and had the following income and losses during the tax year:
Salary . . . . . . . . . . . . . . . . . . . . $42,300
Dividends . . . . . . . . . . . . . . . . . . . . . 300
Interest . . . . . . . . . . . . . . . . . . . . . . 1,400
Rental loss . . . . . . . . . . . . . . . . . . (4,000)
The rental loss was from the rental of a house Mike owned. Mike had advertised and rented the
house to the current tenant himself. He also collected the rents, which usually came by mail. All
repairs were either made or contracted out by Mike. Although the rental loss is from a passive
activity, because Mike actively participated in the rental property management he can use the
entire $4,000 loss to offset his other income.
Modified adjusted gross income (MAGI)
This is your adjusted gross income from Form 1040, U.S. Individual Income Tax Return, line 38,
or Form 1040NR, U.S. Nonresident Alien Income Tax Return, line 37, figured without taking
into account:
1. The taxable amount of social security or equivalent tier 1 railroad retirement benefits,
2. The deductible contributions to traditional individual retirement accounts (IRAs) and
section 501(c)(18) pension plans,
3. The exclusion from income of interest from Series EE and I U.S. savings bonds used to
pay higher educational expenses,
4. The exclusion of amounts received under an employer's adoption assistance program,
5. Any passive activity income or loss included on Form 8582,
6. Any rental real estate loss allowed to real estate professionals,
7. Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships
(PTPs) in the Instructions for Form 8582),
8. The deduction allowed for a portion of self-employment tax,
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9. The deduction allowed for interest paid on student loans,
10. The deduction for qualified tuition and related fees, and
11. The domestic production activities deduction (see the Instructions for Form 8903).
Basis Limitation example:
Doug buys a rental home with his daughter Kay. Doug supplies 70% of the capital and Kay
supplies 30%, but Kay is interviewing and approving the renters (with Doug’s final approval),
and doing the maintenance and paying the utilities (which are included in the rent). Doug and
Kay split the profits and losses 50/50. They advertised the rental for sale in January, but didn’t
acquire a renter until October. The utilities, repairs, advertising expenses, mortgage interest,
property taxes, snowplowing (in northern Montana!) and other expenses created a loss of
$35,000 the first year. Kay’s investment was only $15,000. Her share of the loss of $17,500 is
limited to her basis of 15,000. The remainder will carry over until her basis increases either by
her share of future profits or if she contributes more capital to the venture.
At-Risk Rules
You may be subject to the at-risk rules if you have:
1. A loss from an activity carried on as a trade or business or for the production of
income, and
2. Amounts invested in the activity for which you are not fully at risk.
Losses from holding real property (other than mineral property) placed in service before 1987
are not subject to the at-risk rules.
In most cases, any loss from an activity subject to the at-risk rules is allowed only to the extent of
the total amount you have at risk in the activity at the end of the tax year. You are considered at
risk in an activity to the extent of cash and the adjusted basis of other property you contributed to
the activity and certain amounts borrowed for use in the activity. Any loss that is disallowed
because of the at-risk limits is treated as a deduction from the same activity in the next tax year.
See IRC Section 465 and Publication 925 for a discussion of the at-risk rules.
Form 6198: If you are subject to the at-risk rules, file Form 6198, At-Risk Limitations, with
your tax return.
Real estate professionals:
If you are a real estate professional, complete line 43 of Schedule E.
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You qualify as a real estate professional for the tax year if you meet both of the following
requirements.
1. More than half of the personal services you perform in all trades or
businesses during the tax year are performed in real property trades or
businesses in which you materially participate.
2. You perform more than 750 hours of services during the tax year in real
property trades or businesses in which you materially participate.
If you qualify as a real estate professional, rental real estate activities in which you materially
participated are not passive activities. For purposes of determining whether you materially
participated in your rental real estate activities, each interest in rental real estate is a separate
activity unless you elect to treat all your interests in rental real estate as one activity.
Do not count personal services you perform as an employee in real property trades or businesses
unless you are a 5% owner of your employer. You are a 5% owner if you own (or are considered
to own) more than 5% of your employer's outstanding stock, or capital or profits interest.
Do not count your spouse's personal services to determine whether you met the requirements in
bullet points 1 and 2. However, you can count your spouse's participation in an activity in
determining if you materially participated.
Real property trades or businesses: A real property trade or business is a trade or
business that does any of the following with real property.

Develops or redevelops it.

Constructs or reconstructs it.

Acquires it.

Converts it.

Rents or leases it.

Operates or manages it.

Brokers it.
Material Participation: A trade or business activity is not a passive activity if you
materially participated in the activity.
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Material participation tests. You materially participated in a trade or business activity for a tax
year if you satisfy any of the following tests:

You participated in the activity for more than 500 hours.

Your participation was substantially all the participation in the activity of all individuals
for the tax year, including the participation of individuals who did not own any interest in
the activity.

You participated in the activity for more than 100 hours during the tax year, and you
participated at least as much as any other individual (including individuals who did not
own any interest in the activity) for the year.

The activity is a significant participation activity, and you participated in all significant
participation activities for more than 500 hours. A significant participation activity is any
trade or business activity in which you participated for more than 100 hours during the
year and in which you did not materially participate under any of the material
participation tests, other than this test.

You materially participated in the activity for any 5 (whether or not consecutive) of the
10 immediately preceding tax years.

The activity is a personal service activity in which you materially participated for any 3
(whether or not consecutive) preceding tax years. An activity is a personal service
activity if it involves the performance of personal services in the fields of health
(including veterinary services), law, engineering, architecture, accounting, actuarial
science, performing arts, consulting, or any other trade or business in which capital is not
a material income-producing factor.

Based on all the facts and circumstances, you participated in the activity on a regular,
continuous, and substantial basis during the year.
You did not materially participate in the activity under the last test if you participated in the
activity for 100 hours or less during the year. Your participation in managing the activity does
not count in determining whether you materially participated under this test if:

Any person other than you received compensation for managing the activity, or

Any individual spent more hours during the tax year managing the activity than you did
(regardless of whether the individual was compensated for the management services).
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Proof of participation: You can use any reasonable method to prove your participation in an
activity for the year. You do not have to keep contemporaneous daily time reports, logs, or
similar documents if you can establish your participation in some other way. For example, you
can show the services you performed and the approximate number of hours spent by using an
appointment book, calendar, or narrative summary.
Rental Activities not automatically treated as Passive:

The average period of customer use of the property is 7 days or less. You figure the
average period of customer use by dividing the total number of days in all rental periods
by the number of rentals during the tax year. If the activity involves renting more than
one class of property, multiply the average period of customer use of each class by a
fraction. The numerator of the fraction is the gross rental income from that class of
property and the denominator is the activity's total gross rental income. The activity's
average period of customer use will equal the sum of the amounts for each class.

The average period of customer use of the property, as figured above, is 30 days or less
and you provide significant personal services with the rentals. Significant personal
services include only services performed by individuals. To determine if personal
services are significant, all relevant facts and circumstances are taken into consideration,
including the frequency of the services, the type and amount of labor required to perform
the services, and the value of the services relative to the amount charged for use of the
property. Significant personal services do not include the following:

Services needed to permit the lawful use of the property,

Services to repair or improve property that would extend its useful life for a
period substantially longer than the average rental, and

Services that are similar to those commonly provided with long-term rentals of
real estate, such as cleaning and maintenance of common areas or routine repairs

You provide extraordinary personal services in making the rental property available for
customer use. Services are extraordinary personal services if they are per-formed by
individuals and the customers' use of the property is incidental to their receipt of the
services.

The rental is incidental to a non-rental activity. The rental of property is incidental to an
activity of holding property for investment if the main purpose of holding the property is
to realize a gain from its appreciation and the gross rental income from the property is less
than 2% of the smaller of the property's unadjusted basis or fair market value. The
unadjusted basis of property is its cost not reduced by depreciation or any other basis
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adjustment. The rental of property is incidental to a trade or business activity if all of the
following apply:

You own an interest in the trade or business activity during the year.

The rental property was used mainly in that trade or business activity
during the current year, or during at least 2 of the 5 preceding tax years.

Your gross rental income from the property is less than 2% of the smaller
of its unadjusted basis or fair market value. Lodging provided to an
employee or the employee's spouse or dependents is incidental to the
activity or activities in which the employee performs services if the
lodging is furnished for the employer's convenience.

You customarily make the rental property available during defined business hours for
nonexclusive use by various customers.

You provide the property for use in a non-rental activity in your capacity as an owner of
an interest in the partnership, S corporation, or joint venture conducting that activity.
Participation Rules: In general, any work you do in connection with an activity in which
you own an interest is treated as participation in the activity.
Work not usually performed by owners: You do not treat the work you do in connection with
an activity as participation in the activity if both of the following are true.

The work is not work that is customarily done by the owner of that type of activity.

One of your main reasons for doing the work is to avoid the disallowance of any loss or
credit from the activity under the passive activity rules.
Participation as an investor: You do not treat the work you do in your capacity as an
investor in an activity as participation unless you are directly involved in the day-to-day
management or operations of the activity. Work you do as an investor includes:
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
Studying and reviewing financial statements or reports on operations of the activity,

Preparing or compiling summaries or analyses of the finances or operations of the
activity for your own use, and

Monitoring the finances or operations of the activity in a non-managerial capacity.
Spouse's participation: Your participation in an activity includes your spouse's participation.
This applies even if your spouse did not own any interest in the activity and you and your spouse
do not file a joint return for the year. (Remember, however, that the spouse’s activity does not
count towards meeting the >50% of personal services, and >750 hours tests for real estate
professionals.)
Definition of a qualified joint venture
A qualified joint venture is a joint venture that conducts a trade or business where (1) the only
members of the joint venture are a husband and wife who file a joint return, (2) both spouses
materially participate in the trade or business, and (3) both spouses elect not to be treated as a
partnership. A qualified joint venture, for purposes of this provision, includes only businesses
that are owned and operated by spouses as co-owners, and not in the name of a state law entity
(including a limited partnership or limited liability company) (See below). Note also that mere
joint ownership of property that is not a trade or business does not qualify for the election. The
spouses must share the items of income, gain, loss, deduction, and credit in accordance with each
spouse's interest in the business.
Self Rental activity:
Under Reg. § 1.469-2(f)(6), if a taxpayer rents property to a business in which he materially
participates, net rental income is non-passive. Stated differently, rental income from self-rented
property cannot be used to trigger allowance of passive losses on Form 8582. This rule does not
apply if there is a written binding contract entered into before 2/19/1988.
Income is still reportable on Schedule E, but cannot be entered as passive income on Form 8582,
line 1a. Remove self-rented income from Form 8582 and recompute. For every dollar of income
removed from Form 8582, allowable passive losses generally are reduced a dollar. Passive losses
are deductible only up to passive income reported on the return PLUS $25,000 in rental real
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estate losses. The difference between Form 8582, line 16 per return and as corrected is your
adjustment. The MAGI on Form 8582 will be increased by the amount of self-rented income
determined to be non-passive. Thus, the taxpayer also may lose part of his $25,000 offset under
IRC § 469(i).
Sources:
•
•
•
•
•
•
•
•
•
•
Publication 527
Publication 925
IRC Section 280A
IRC Section 465
IRC Section 469
Reg 1.469
Temp. Regs. Sec. 1.469
Instructions for Forms 8582 and 6198
Carlos, 123 TC 275 (2004)
Bolton, 51 AFTR 2d 83-305 (9th Cir. 1982)
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Timothy Dilworth, EA, CPA and a NTPI Fellow, has been the tax manager at a CPA firm in
Michigan for the past 7 years. He has been teaching tax classes in Michigan for 10 years and
served as Education chair for the Michigan Society of Enrolled Agents for 4 years. Dilworth
served on the NTPI Planning Committee for the past two years, is the Immediate Past President
of MiSEA, and is currently serving on the NAEA Board of Directors.
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NAEA created this educational program as part of its firm commitment to providing up-to-date,
convenient continuing education that focuses on the issues that members identify as top
priorities. Members are invited to suggest further areas of study or to submit presentations by
contacting hjones@naea.org. .
National Association of Enrolled Agents
1730 Rhode Island Ave, NW Ste 400
Washington, DC 20036
www.naea.org
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