THE FOREIGN SERVICE JOURNAL | JANUARY-FEBRUARY 2024 51 (including popular HELOCs) is no longer deductible unless the proceeds from the loan are used to substantially improve the property on which the HELOC is taken, and the total mortgage loan balance (including home equity loans) stays within the permitted mortgage limits. Scenario 2: Vacation Home. A vacation home is a home that may be used by you and is rented out at times during the year. If you use the vacation home without renting it out, you may deduct the mortgage interest and property taxes on Schedule A, subject to limits as described in Scenario 1. If you rent out your vacation home for less than 15 days during the year, you are not required to report the rental income on your tax return and you may still deduct the mortgage interest and real estate taxes on Schedule A. If you rent the vacation home out more than 14 days, but use it personally for the greater of 14 days or 10 percent of the number of days rented, it is considered a personal residence and you may not deduct 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 requirements for calculating depreciation during the rental period and for capital gain or loss calculations upon sale. During periods when the property is rented, the taxpayer must report the gross rental income received and deductible expenses paid on Schedule E. The rules requiring expensing or capitalization/depreciation of expenditures made for a rental property are complex. Readers should refer to the FAQs for the Tangible Property Regulations (https://irs.gov/businesses/small-businesses-self-employed/ tangible-property-final-regulations) for information on expensing and capitalization requirements. Consultation with a tax professional is also recommended. 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 recommends 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 if the rental activity meets material participation requirements (though most readers won’t meet the threshold for material participation). Consult Treasury Regulation 1.469-1T for 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 recovery 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 depreciable 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 depreciation 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 purposes should contact a tax professional to properly set up the property for tax reporting purposes, calculate deductible 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 depreciation 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 (adjustments to basis); associated basis and depreciation regulations; and Publications 527 and 946.
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