The Foreign Service Journal, January-February 2023

AFSA NEWS 62 JANUARY-FEBRUARY 2023 | THE FOREIGN SERVICE JOURNAL rental expenses greater than rental income. Mortgage interest and real estate taxes allocated to personal use are reported on Schedule A, subject to limitations. Mortgage interest, real estate taxes, and other deductible expenses (including depreciation) allocated to rental use are reported on Schedule E using the vacation home rules. Note that in cases when there is fractional ownership of a vacation home, a taxpayer must include the personal use of all co-owners of the vacation home in determining whether it is considered a personal residence. Scenarios 3 and 4: Rental Property. Real estate that you purchase as a personal use home and then convert to rental status (or vice versa) or real estate that you purchase for immediate rental to a third party both have similar require- ments for calculating depreciation during the rental period and for capital gain or loss calculations upon sale. During peri- ods when the property is rented, the taxpayer must report the gross rental income received and deductible expenses paid on Schedule E. Please review the annual Foreign Service Institute Tax Seminar presented each February (contact the FSI Transi- tion Center for a link to view the most recent seminar) for complications to consider when deciding which expenses are immediately deductible and which expenses must be capital- ized and depreciated during rental use. Scenario 5: Short-Term Rental. Real estate that you rent on a short-term basis may be treated differently on your tax return from long-term rentals. Income and expenses could be reported on Schedule C or Schedule E, depending on whether substantial services are provided to renters. AFSA recom- mends Publication 527 for examples of substantial services. In addition, readers need to consider the average period of customer (renter) use, which can change the treatment of the rental activity from a passive activity (requiring Form 8582) to a nonpassive activity. Consult Treasury Regulation 1.469-1T for the exceptions to the passive activity rules related to short- term rentals. Finally, the depreciable life of a short-term rental property may be 39 years rather than the usual 27.5 years for residential rental property if the property is being rented on a transient basis (and thus considered nonresidential real property for these purposes). Readers are referred to IRC Section 168. Depreciating Real Property Used to Produce Income During periods when real estate is rented, the IRS requires the taxpayer to depreciate the property over the IRS-defined recov- ery period. To calculate annual depreciation, a taxpayer must know: (1) the property’s adjusted cost basis and fair market value at time of rental conversion (the taxpayer must use the lower of the fair market value or adjusted basis as the depre- ciable basis); (2) adjustments to basis (tracked throughout the life of the property); (3) the date the property was placed in service as income-producing; and (4) the IRS-mandated depre- ciation method and convention. The IRS requires a taxpayer to depreciate buildings, certain land improvements, and other types of capital assets—all annually. The IRS, however, prohibits a taxpayer from depreciating land, including the land on which a depreciable asset sits. So, land values must be accounted for separately. Property used for personal purposes may not be depreciated and claimed for tax purposes. Taxpayers who believe they have sufficiently documented their property to begin using it for income-producing pur- poses should contact a tax professional to properly set up the property for tax reporting purposes, calculate deduct- ible expenses (including depreciation), account for income derived from the property, and file correct tax forms on time each year. Readers should note that the depreciable basis of the property must be adjusted for prior mandatory deprecia- tion deductions when a previously rented property converts back to rental use after a period of personal use. Failure to include the proper amount of depreciation on Schedule E can result in an incorrect accounting method, which may require a change in accounting method (Form 3115) or an amended return, depending on the mistake made and/or the number of years depreciation was improperly reported on Schedule E. AFSA recommends also reading Tax Topics 703 (basis), 704 (depreciation), and 414 (rental property); the Schedule E and Form 1040 instructions; IRC Sections 167 (depreciation), 1012 (cost basis), 1011 (adjusted basis), and 1016 (adjust- ments to basis); associated basis and depreciation regula- tions; and Publications 527 and 946. Selling a Principal Residence—IRC Section 121 Taxpayers who sell real estate used as a principal residence at some time during the taxpayer’s ownership may qualify to exclude all or a portion of their net taxable capital gain under the provisions of IRC Section 121. A taxpayer who used the property as a principal residence and also rented out the property at any time during ownership can only exclude the qualifying IRC Section 121 capital gain, which is the capital gain other than the gain created under IRC Section 1250 (see below for a discussion of IRC Section 1250). IRC Section 121 allows an exclusion of qualifying capital gain up to $500,000 MFJ or $250,000 for all other filing statuses. To qualify for the full IRC Section 121 exclusion, the taxpayer(s): (1) must have owned the home and lived there at any time for at least two of the last five years before the date of the sale (but see Military Families Relief Act, below); (2) cannot have acquired the home in a 1031 exchange within the five years before the date of the sale; and (3) cannot have claimed this exclusion during the two years before the date of the sale.