Losses from rental property are normally deductible, even though they're limited by various phase-out and carry-over provisions.
However, losses from the rental of what the IRS calls a "vacation home" are subject to additional restrictions.It's defined as a rental property that has been used by the taxpayer for personal purposes for more than 14 days during the tax year, or for more than 10 percent of the number of days that the home is rented at a fair rental value - whichever is greater.
In computing the deduction, the IRS uses a formula that's based on the percentage relationship between the number of days the property is rented and the total number of days the property is used. That includes personal-use days.
However, the Tax Court has partially rejected this "days-of-use" formula and divides the vacation home expenses into two categories:
Real estate taxes and home mortgage interest.
Repairs, maintenance, depreciation and all other rent-related expenses.
The court's formula computes the deduction for taxes and interest using a "total-year" formula, based upon the number of days the property is rented as a percentage of 365 days, regardless of the number of days of personal use.
The deduction for all other expenses is computed using the IRS "days-of-use" formula.
(The Tax Court's decision has been affirmed on appeals by the Ninth and Tenth Circuit Courts of Appeals.)
During the year, Gloria Kelly rents out her vacation home for 91 days and uses it herself for 30 days.
The gross rental income is $3,700 for the year. She pays $4,000 in real property taxes and mortgage interest for the year. Additional expenses - for maintenance, repairs and utilities - total $3,000.
The IRS "days-of-use" allocation of all expenses would be based on 75 percent (91 days rented, 121 days used).
However, the Tax Court would allocate 25 percent of taxes and interest (91 days rented, divided by 365 days) and use the IRS 75 percent allocation for the additional expenses for maintenance, repairs and so on.
Under either method, the entire $4,000 in interest and taxes is in effect allowed as a deduction.
The IRS method allows $3,000 to be deducted as a rent-related expense and the remaining $1,000 as an itemized deduction.
The Tax Court formula allows $1,000 as a rent-related expense and $3,000 as an itemized deduction.
However, it is with respect to the maintenance, repairs and other expenses that the two methods arrive at dramatically different results.
The IRS method only allows $750 (25 percent of the $3,000) as a deduction, $700 in the current year and $50 as a carry-over.
In contrast, the Tax Court would allow $2,250 (75 percent of the $3,000) as a deduction in the current year.
Accordingly, in all federal court circuits other than the Ninth (California, Arizona, Oregon, Washington, Nevada, Idaho and Montana) and the Tenth (New Mexico, Utah, Colorado, Wyoming, Kansas and Oklahoma) the IRS applies the "days-of-use" allocation formula.
In the Ninth and Tenth circuits, the IRS must follow the more liberal Tax Court formula.
In contrast, when rental property is not classified as a vacation home, a net loss deduction is allowable.
However, losses from rental property (other than vacation homes) are subject to the following two passive loss provisions:
If a taxpayer actively participates in rental activities, up to $25,000 of losses generated by the rental activity can be deducted as an "ordinary loss."
Losses in excess of the $25,000 limit are treated as "passive losses" - subject to the passive loss provisions.
If the taxpayer-owner does not actively participate in rental activities, losses will be treated as "passive losses."
Passive losses may be used only to offset income from other passive activities.