We are going to rent our second home for three months, and on occasion afterwards. Does the property become 100% a rental property, or only the % of days we rent it?

[blattanzi111]

That is, if we rent 6 months a year, and use it the other 6, is it 50% a rental or 100% a rental?

[Carl]

The property is ONE HUNDRED PERCENT business use starting from the date you convert it to a rental, and ending on the date you convert it back to personal use.

Now if you use the property for any type of personal use while it is classified as a rental, then you will be asked for number of days rented, and number of days of personal use. This will change the percentage of business use "for you" and your rental deductions will be prorated accordingly.

Now, when dealing with the IRS, the general rule of thumb is, 'If it was easy, you did it wrong.' 🙂

If only renting for 3 months each year, you "may" have what is classified as a short term/vacation rental. In that case, any days of the entire 365 day tax year you live in the property "will" have an impact on your allowed expenses for the period of time it is classified as a vacation rental.

Things "can" get even more complicated if your state taxes personal income.

[blattanzi111]

Thanks, Carl. Very clear and helpful. Further into the weeds:  So I know how to deduct expenses proportinately each year. What happens when we sell the home? Is depreciation recapture and cap gains calculated at 100% or only the % of days we rented as a vacation home. So if we rented 25% of the time, do we only owe 25% of cap gains and (the deadly) recapture or 100%? Thanks!

[Carl]

When it comes to claiming expenses proportionally each year, I suggest you elect the option to do it manually. If you let the program do it for you, it just can't quite pro-rate everything correctly based on my limited testing with different scenarios. For example, since property insurance is not deductible for personal use time, the program doesn't prorate that in some cases. It fully deducts the amount you enter.

When classified as a vacation rental, manual proration gets complicated because personal use days count against you; including those days of personal use while it was not classified as a vacation rental. If you want an example of this complicated fiasco created by the IRS, take a look at IRS Publication 527 at https://www.irs.gov/pub/irs-pdf/p527.pdf on page 17 in the third column where it gives an "Example" scenario. Note that some of the personal use days are before the property was re-classified to rental. But those days still count against the taxpayer for figuring deductible expenses.

In the tax year you sell the property you're going to pay taxes on the recaptured depreciation no matter what you do. There is a cap on the tax rate for recaptured depreciation though. It will be taxed anywhere from 0% to a maximum of 25%.

For the capital gains, if the property was your primary residence for at least 2 years (731 days) of the last 5 years (1826 days) you owned it, then your gain is excluded from being taxed. Note also that the 731 days do not have to be consecutive. But all 731 days of the property being your primary residence must have occurred within the last 1826 days you owned it, counting backwards from the closing date of the sale.

It gets complicated when you go converting property back and forth between rental and personal use. That's because each time you convert to rental, you have to reduce your cost basis on the property and all other assets by the total amount of depreciation already taken, and start your depreciation anew again. Then for depreciation recapture, it's 100% up to you to keep track of depreciation outside of the program. There's no way the program can, when you're converting back and forth.

It might be easier to just leave the property classified as a rental and just claim/report personal use days for the days you actually live in it or use the property for any other personal use each year. The only issue I see with that, is that it may raise flags for all I know if you're claiming it was your "primary residence" for the days you lived in it while it was classified as a rental.  Most likely, if audited the IRS would want some type of proof for your claim of residence.

It's my impression that either way you go, you can do the manual work now, or do it later. But you're gonna do it sooner or later.

[Mike9241]

there is a tax rule when personal use days are more than 10% of days rented and it's rented more than 15 days.

then expenses are prorated between rental and personal use. the rental portion of interest and taxes is not limited to rental income. other rental deductions, including depreciation, are limited to the remaining net income and are subject to ordering rules.

[blattanzi111]

Thanks again, so helpful, and I see the issue with recalculating the base cost of the home each time a rental period ends. But I think that's doable as Redfin sends me an estimate every week in email, it seems :).  As I narrow it down, one more specific question and I'm set:  when I sell, if profit is10%.... do I owe cap gains and deprecation on the full 10% or taking the 10% and reducing it by the % of days rented... say 25% ... So (I'm hoping) if Cap Gains are 100,000, the tax would be on the 25,000 gain that would be the rental portion of the time. Another way of saying this is that I hope you can divide rental time the same way we divide rental spacein our two family home.

[blattanzi111]

Thanks so much, that all makes sense, very helpful!

[Carl]

I think that's doable as Redfin sends me an estimate every week in email, it seems

That has nothing to do with your cost basis. Once your original cost basis is established, it never changes. But wihen converting back and forth between rental and personal use, the cost bsais is adjusted for depreciation purposes only, each time you convert it back to a rental.

when I sell, if profit is10%.... do I owe cap gains and deprecation on the full 10% or taking the 10% and reducing it by the % of days rented

Unless you qualify for the "2 of last 5" capital gains tax exclusion, you pay taxes on the gain. Percentages of anything really don't matter. But your recaptured depreciation will be taxed anywhere from 0% to a maximum cap of 25% no patter what.

[Cambridge50]

Thanks. I'm going to try to get the answer I want one more time :).  This is about capital gains only.  This is probably wrong, but I have a hard time giving it up.

 We bought the house in 2020. We have never rented it. Since 2020 it has increased in market value by 25% (crazy market in the pandemic). Up until now, it's been a personal property. So it seems to me that, to be fair,  the starting figure for capital gains purposes should be the value of the house on the day it becomes a vacation rental or pure rental property, not the price we originally paid for it.  That 25% gain in value occurred when the house was personal property. That's logic, but I'm not sure it's tax law.  I want to claim the value of the house at time of rental, not the price we paid. Regarding cap gains, is that wrong?

[Carl]

I myself don't really like the "legal requirement" to depreciate business property. However, the law is the law. Current tax law states that we are required to depreciate the property based on the "lesser" of what was originally paid for it upon initial qcquisition, or it's FMV on the date placed in service; whichever is "LOWER".  We don't really have a choice in that.

I myself can't understand why one would want to take as much depreciation as they can. I myself prefer to keep my depreciation deduction as low as I can legally get away with. Why?

Because, when you sell the property you are required to recapture all depreciation taken, in the year of the sale and pay taxes on that recaptured depreciation.  Three things about that:

1) Recaptured depreciation is added to and increases your AGI in the year of the sale.

2) The increased AGI has the potential to bump you into the next higher tax bracket.

Now recaptured depreciation is not necessarily taxed the same as your gain on the sale is. It just all depends on the numbers.  While you gain on the sale (which is the amount over the original purchase price) is taxed at the capital gains tax rate, recaptured depreciation is taxed at the ordinary income tax rate, with a maximum ceiling of 25%. Good if you're in the 32% bracket or higher. Of no help if you're in the 24% bracket or lower.

Now on top of all that deprecation stuff, if one does not take depreciation with the belief they won't have to recapture it, thus keeping their AGI out of the next higher tax bracket, not so fast. If you don't depreciate the property, then you are still required to recapture the depreciation you "should" have taken and pay taxes on it. So it still increases your AGI and still has the potential to bump one into that next higher tax bracket.

I want to claim the value of the house at time of rental, not the price we paid. Regarding cap gains, is that wrong?

Not just wrong, but not legal either. While you may get away with it while the property is a rental, years down the road when the property is sold or otherwise disposed of, the chances of it raising flags at the IRS may be on the high side for all we know. In a worst case scenario, the property owner dies, the estate sells it, and the numbers used in the sale raises flags at the IRS resulting in an IRS "claw back" to the estate from the beneficiaries of the estate to do things right. The costs incurred can be astronomical, leaving nothing for the beneficiaries when it's all said and done.

[blattanzi111]

Thanks so much, that really clarifies things for me. that 'whichever is lower' is a nasty piece of work, but as you say, it's the law. And thanks for the strategy of taking as little depreciation as possible. Good tip. What a wonderful resource this site is.I've had the experience of paying for an hour's time of a lawyer/tax accountant. I spent 55 minutes while he told me what I already knew, and then 5 minutes telling me he'd have to look into my question, and charge me for another session to get the answer. Here, it got resolved in three posts. Thank you sincerely! 

[Carl]

Just remember, this forum is a "PUBLIC" forum, and the validity of information is not always right, or complete. I myself have discovered "after the fact" that information I provided was either wrong, or incomplete. For rental property, the governing publication is IRS Publication 527 at https://www.irs.gov/pub/irs-pdf/p527.pdf

It covers residential, as well as short term rentals and vacation rentals. I'm of the impression that your situation has the potential to fall under the vacation rental rules based on your comment, "We are going to rent our second home for three months, and on occasion afterwards."  I suspect chapter 5 which starts on page 17 would come into play for you. Pay particular attention to the example in the 3rd column on that page, and take note how "ALL" personal use days during the tax year can count against you, regardless of weather or not it was a rental during those personal use days.

[tagteam]

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@Carl wrote:

In a worst case scenario, the property owner dies, the estate sells it, and the numbers used in the sale raises flags at the IRS resulting in an IRS "claw back" to the estate from the beneficiaries of the estate to do things right.

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There is no "clawback" after the death of the owner from the beneficiaries, however. 

Regardless of how the owner handled depreciation, the property is stepped up to its fair market value on the death of the owner and accumulated depreciation disappears. 

Further, although recapture is a requirement per the Code, depreciation deductions are not. Per Section 167, depreciation is "allowed".

Finally, care needs to be taken with respect to relying on IRS publications as they are not authoritative (as are the Code, Regulations, et al). There have been errors in prior publications so caution is warranted and the material should always be checked against the Code and Regs.