Rent-back (post-settlement) occupancy agreement

[aqeel_ca]

Hi, I purchased my home in May 2015. We ended up renting back to sellers for 59 days. I entered into a post-settlement occupancy agreement with the seller and related income was included in my HUD settlement statement. I researched some of the already answered questions on turbo tax and came across two different answers. One super user suggested this "The rent income received is reported on Line 21 of the Form 1040 due to the apparent not-for-profit determination". Other super user suggestion seems to report it in Rentals & Royalties section as "I converted this property to personal use in 2013".

I really need some guidance as to which approach should I use. If I have to use the Rentals & Royalties section and check "I converted this property to personal use ", then I have some questions and will appreciate the answers:

- I am not clear if I should click the option of "active participant" because it asks for management decisions for the property. I am 100% owner and just rented that property as part of the rent back. This question significantly changes my tax refund.
- I am using 0 days for "personal use". Is that correct? I am the first time home buyer and I purchased the home for my primary residence. After rent back of 59 days, I took possession of the property for my personal use.
- After the sellers left, they damaged the property and besides my dispute I wasn't able to recover the repair cost from them. I had to incur some amount for repairs. Is the screen "Did You Pay Anyone $600 or More for Work Related to This Property?" where I should click "yes" for such repair. I didn't issue any 1099s.
- On the screen of "Enter Escrow Fees", should I include the full amount of Title Insurance and Transfer taxes I paid to purchase this property? I only rented for 59 days.
- Similar question for all of the other expenses in this section on the following screens such as property tax, mortgage interest, I will include pro-rata here. Correct?

Thanks!

[Hal_Al]

You're not going to get a clear answer; as it's a matter of interpretation. I'll even give you a third option: it's not reportable income, it's just a reduction in the purchase price. But, my vote for the "correct" way is line 21 of form 1040.
If you do use sch E:
-You were an active participant
-yes, 0 days personal use
-answer no to Did You Pay Anyone $600 or More for Work Related to This Property (you didn't issue a 1099 and don't want or need to issue one)
-you add the purchase expenses to your purchase price to determine the appreciable basis
-yes, you will prorate  property tax & mortgage interest for the time it was rented

edited-removed comment about depreciation recapture and claiming a loss

[Critter]

I vote for reduction of purchase price since it was on your HUD statement, then line 21 and last the Sch E rated from least complicated to more.

[rehmanau]

Thanks guys!

[view2]

Depreciation is not allowed for property placed in service and retired from service in the same tax year. 

IRS states section 1.168(i)-4(c): 

(c) Conversion to personal use. The conversion of MACRS property from business or income-producing use to personal use during a taxable year is treated as a disposition of the property in that taxable year .

[rehmanau]

Thanks view2! One response I saw above suggests "you will have to recapture (pay tax on) the depreciation you took or should have taken". 1) If I am only claiming expenses and NOT depreciation, would I still have to recapture (pay tax on) the expenses claimed in loss calculations such as repair cost or this rule only applies to depreciation. 2) What's the period after which I wont have to pay recapture tax if sell the property.

3) Also, view2 would you agree if I consider that as a reduction in purchase price. If yes, can i still report the property tax for the 59 days rental period in my personal section of the tax return where i am reporting my first home purchase? 4) Initially i was splitting the property tax between 59 rental days (Schedule E) and my personal use based on a pro-rata basis.  Thank you.

[Critter]

If yes the entire property tax can be claimed as an Itemized deduction.

[Hal_Al]

You do not recapture expenses deducted.
The "recapture of depreciation" is just a different way of reporting the portion of the capital gain attributable to depreciation. The tax code taxes it differently than ordinary long term capital gains.

[view2]

@ rehmanau: Your welcome, unfortunately you were a victim of a common situation, Generally the best treatment is  withholding 20% of escrow payment until property is safety in your hands.
Your expenses can be deducted only up to  your rental income ,your rental expense deduction is limited.[Even a Schedule E reporting  will limit expenses due to vacation rental rules]
Your basis is not effected.
If repairs rises to the range of improvements  the amount above rental income are added to basis for when you sell.
Unfortunately the IRS states : that expenses for personal use are not deductible as rental expenses.
Personal property taxes and mortgage interest with reporting income on line 21 as a not for profit rental are fully deductible personal expenses.

[Opus 17]

I would also not report this as a rental at all.  Simply treat it as a reduction in the purchase price.  This will lower your cost basis and might get taxed when you sell, depending on the circumstances.  If you feel safer reporting the income as taxable, report it as other income on line 21 and don't deduct your expenses.

In addition to the issues outlined above, another factor is that you can't deduct a rental loss unless you renting with the intention of making a profit.  In the rent back arrangements I know about (including one where I was the seller), the rent back payment equals the monthly mortgage payment.  The utilities stay in the name of the seller until they move out.  The rent is not based on a market analysis and is probably below fair market value.  You aren't intending to make a profit, you are just holding in place until the sellers vacate.

With that in mind, you can only break even.  Which means you can deduct the proceeds you receive (mortgage payment) agains your expenses (mortgage payment).  You can't deduct other expenses like property taxes and mortgage interest--and why bother since you can fully deduct them as normal household expenses on schedule A.  You can't deduct repairs that would show a loss if you aren't renting for profit.  And any repairs you made during the 59 dat rental period were not really "so you could rent it to other tenants."  They were in preparation of you moving into the home.  It will look to the IRS (correctly) like you are trying to get an impermissible tax deduction on repairs made to your personal home.

So my suggestion is to skip all the paperwork entirely and just treat it as a price reduction on the sales transaction.

[aqeel_ca]

Great. Thanks a lot everyone!!!

[zhongjp058]

Can you share the IRS reference for option "Simply treat it as a reduction in the purchase price."? Searched around Publication 527 Residential Rental Property and only see the option to declare it as Other Income on Line 21 of Form 1040 (Not for profit).

[Opus 17]

@zhongjp058 If you are doing a short-term rent-back of a home you just purchased, and you want to treat it as a residential rental, you need to follow all the rules of a rental.  For all the reasons above, that is complicated, time-consuming, and won't save you anything on taxes in all likelihood.

As long as this is short term, our suggestion is to ignore the rental aspect; don't report the income as rental, don't use schedule E, and ignore publication 527.  Instead, you would treat the rental situation as part of the cost of buying the home, along with your inspections and other closing costs.  The money you get from the rental would be treated as a reduction in the price of the home, just as if you got a rebate of the real estate commission from the agent, or the buyer paid your closing costs.  Where the "sales price" is $100,000 for example, and the buyer gives you $1000 for any reason (rent back, paying your closing costs, etc.) then your selling price for capital gains purposes is $99,000.  This is in publication 523 selling your home.  It may also be in the publication on "basis of assets".

[VM1]

Reduction in cost basis is simple but not fair for the buyer: The buyer is doing the seller a favor by renting back and using the rent from the seller to cover her own rent payment. If there was no rent-back agreement there is no reduction in cost basis.

[Critter]

From where I stand you can't have your cake & eat it too ... either reduce the basis now so that you will pay long term capital gain taxes on later .....OR...   go thru the time consuming Sch E process which you will pay ordinary  taxes on now since you will not be able to depreciate the property on a short term lease.  @Opus 17  has explained your options  very well.