Is it considered a rental property?

[kspin1002]

We have a secondary property that we sold this year, it was a rental for just over 4 years. We never made a profit in any year it was being rented and it was underwater until the year we sold. We didn't get back anywhere near what we paid. We walked away with a small amount at closing, what taxes can we expect to pay on it in Illinois? 

[Critter]

I would sell it as a rental if that is what it has been last so you can capture the possible loss after the depreciation recapture. 

[tagteam]

I agree but, further, if you have to ask whether the property was a rental, then you might need professional tax guidance and/or return preparation.

Obviously, you should have been reporting rental income and expenses (including deductions for depreciation) for each of the last four years on Schedule E of your tax return. If you did not do so, consult with a tax professional as soon as practicable.

[Carl]

We never made a profit in any year it was being rented

Guess what? It's extremely rare for residential rental property to actually show a taxable profit on paper. But weather you made money or not really doesn't matter. The IRS looks at "intent". So if your "intent" was to make a profit, then it's classified as residential rental real estate and all income/expenses is reported on SCH E as a part of your personal tax return.

The reality is, rental property will practically always show a loss "on paper" every single year you rent it; especially if the property has a mortgage on it. That's because after deducting the mortgage interest, property taxes, rental dwelling insurance and the depreciation you're required to take by law, those four items alone will generally exceed any "profit" you may have actually made. Add to that the other rental expenses and you're practically guaranteed to show ever increasing losses each passing year that just get carried forward.

So weather you actually made a taxable profit or not is really irrelevant. If it was rented out then it can be rather difficult to prove to the IRS that your intent was "not" to make a profit. When you sell, you are required to recapture all prior year's deprecation on the property and it's included in the taxable income. But the taxability of most (if not all) of that recapture will be offset by the carry forward losses. In the year you sell you are allowed to actually "realized" all that carried forward loss first against any taxable gain on the sale. Then the remaining loss if any, is claimed against other "ordinary" income. (Such as W-2 income for example.)

Next, depending on your AGI (which will be higher if you sold at a gain) the losses you can actually "take" that year could be limited to as low as $3K. Then any remaining losses you couldn't claim are carried forward to future years and can be taken against other ordinary income in those future years.

[tagteam]

There actually is a definition of an "activity engaged in not for profit", or more precisely a set of relevant factors, and intent does not override those factors in any way. As the Regs specifically state:

In determining whether an activity is engaged in for profit, greater weight is given to objective facts than to the taxpayer's mere statement of his intent. Treas. Reg. §1.183-2(a)

The relevant factors from the Regs are:

(1) Manner in which the taxpayer carries on the activity.

(2) The expertise of the taxpayer or his advisors.

(3) The time and effort expended by the taxpayer in carrying on the activity.

(4) Expectation that assets used in activity may appreciate in value

(5) The success of the taxpayer in carrying on other similar or dissimilar activities.

(6) The taxpayer's history of income or losses with respect to the activity.

(7) The amount of occasional profits, if any, which are earned.

(8) The financial status of the taxpayer.

(9) Elements of personal pleasure or recreation.