When the IRS issued the latest version of Form 8825, Rental Real Estate Income and Expenses of a Partnership or an S Corporation, in December 2010, it added three new columns to the revised form, one to enter a code for the type of property being rented and two columns of significance for both practitioners and taxpayers: fair rental days and personal use days. Now that reporting the number of days each rental property is rented at fair rental value and the number days the property is used for personal purposes is required on Form 8825, practitioners must decipher Sec. 280A and Prop. Regs. Sec. 1.280A-1 as they apply to partnerships and S corporations owning dwelling units. Properly apportioning the expenses between personal and rental use presents several challenges. Experience shows that practitioners are not using consistent methods to calculate and prepare Form 8825 and the related Schedules K-1.
Some of the challenges result from insufficient congressional guidance and do not have legislatively defensible answers. This article summarizes the known rules and regulations related to use of dwelling units and identifies questions that practitioners must address in their own practice.
One common argument is that the determination of personal vs. rental use occurs at the owner level rather than the entity level. However, this approach is refuted in Prop. Regs. Sec. 1.280A-1(a), 1 and the addition of days of use information on Form 8825 confirms the IRS’s intent to pursue the issue.
Another proposal to have partners pay fair market rent to the partnership for days used also fails to defeat the calculation of personal use days. As discussed in Prop. Regs. Sec. 1.280A-1(d), the personal use rules supersede fair rental rules. 2
The only exceptions to the personal use allocation rules are where the partnership rents the property to a partner or related party for use as that person’s principal residence. The following discussion does not pertain to this type of rental arrangement.
Determining Personal Use Days
Once the total income and expenses have been calculated for a property, the next consideration is how to determine the number of personal use days. This can be challenging when there are multiple unrelated partners. Unrelated partners may rent their allocated time outside of the partnership, further complicating the reporting. Even in a close family relationship, obtaining data and tracking usage of “vacation” property can be hard for a practitioner to obtain. Basically, a “day” is counted when overnight accommodation is provided.
“Personal use days” as defined in Sec. 280A(d)(2) include:
- Use by “the taxpayer or any other person who has an interest in such unit, or by any member of the family (as defined by section 267(c)(4)) of the taxpayer or such other person.” The attribution rules referred to in Sec. 267(c)(4) include siblings, spouse, ancestors, and lineal descendants. According to Prop. Regs. Sec. 1.280A-1(e)(3), use by a person related to a partner or S corporation shareholder is considered to be personal use by the partner or S corporation shareholder. Even if the property is rented to a relative at fair rent, if the owner retains free access to the unit, those days will be considered personal use days. In the case of an S corporation, “any shareholder of the S corporation” is substituted for “the taxpayer.”
- Use under house-swapping arrangements, whether or not fair rental is charged.
- Use by any individual who does not pay fair market rent.
Since personal use days do not include days when repairs and maintenance are performed on a substantially full-time basis by the owner, even if other individuals are present who are not repairing or maintaining the property, it will be important to determine if any days of occupancy were maintenance days rather than personal use days. 3
Allocation of Expenses to Personal Use Days
The second challenge is calculating the amount of deductible rental expenses. Under Sec. 280A(e)(1), the number of personal use and fair rental days is used to determine the tax treatment of expenses incurred and the amount of depreciation allowed as a deduction. Sec. 280A(e)(2) carves out an exception for “deductions which would be allowable under this chapter for the taxable year whether or not such unit (or portion thereof) was rented.” Despite the seemingly clear language of Sec. 280A(e)(2), the IRS interprets Sec. 280A(e) to mean that all deductible expenses related to a property are allocated between fair rental and personal use days based on the ratio of fair rental days to the total number of days used, not just to those expenses that are deductible only in relation to the rental of the property.
When the issue was the deductibility of real estate taxes and mortgage interest (which are generally deductible by individual taxpayers whether or not the property is rented out as a vacation property), the Ninth 4 and Tenth 5 Circuits have disagreed with the IRS’s calculation of the ratio using the total number of days used and supported using 365/366 days in the denominator of the ratio. Obviously, the personal use percentage is decreased when a full year is used as the denominator. Practitioners in these circuits should consult with their clients regarding which position to follow when deducting items such as real estate taxes and mortgage interest.
Limitations on Deductions
The amount of expenses related to a property that may be deducted may be further limited depending on whether the property is classified as a personal residence or as a rental property.
Limitation on Deductions If Unit Is Considered a Personal Residence
If a taxpayer uses a property for personal purposes for the greater of 14 days or 10% of the days during the tax year it is rented at a fair rental, the property is treated as a personal residence. 6 If a property that qualifies as a personal residence is rented for more than 15 days, the deduction of expenses related to the property is limited to the amount of rental income received during the tax year, and there is an ordering of the allowable deductions. Excess rental losses are carried over to the next tax year. The personal use portion of mortgage interest and property taxes is passed through to the owners.
If the property qualifies as a residence and is rented for less than 15 days during the year, the rental income is not taxable. 7 Nor are any expenses deductible, other than property taxes and mortgage interest.
If the rental property is not rented and there is no personal use, very little guidance is provided as to the deductibility of expenses. One can argue that all of the expenses are deductible since there is no personal use, especially if extensive efforts to rent the property were made. Alternatively, since there are no rental or personal use days, the allowance of deductions ratio computed as “0 days rented divided by 0 days used” equals an undefined number. In this argument, it appears that only otherwise deductible mortgage interest and property taxes could be passed through to the partners. Each practitioner should evaluate the facts of the particular situation to determine the correct treatment of expenses.
If the personal use days do not exceed the limits described above and the property is rented for more than 15 days, the unit is considered a rental property. In general, the rental of real property is considered a passive activity, and, as such, gains or losses from the activity can only be offset against gains or losses from other passive activities. However, if a taxpayer actively participates in a rental activity, losses of up to $25,000 from the activity may be used to offset nonpassive income. 8
An individual meets the active participation rules by:
- Owning at least a 10% interest in the activity; and
- Having significant participation in the activity, such as making management decisions regarding tenants or policies, and arranging for repairs or capital improvements.
Both conditions must be met for active participation. Hence, a determination of participation by each partner or shareholder owning more than 10% is required. The $25,000 offset is phased out by 50% of the amount by which the taxpayer’s adjusted gross income for the tax year exceeds $100,000. 9
Rental activities where the average rental period of the property is seven days or less are not considered a rental activity under the passive loss rules and thus do not qualify for the active participation exception. 10 Many vacation-type of properties have average use periods of seven days or less, so the period of use must be determined.
If the taxpayer is a real estate professional who meets the tests of material participation in partnership activities, any losses from the partnership’s rental property will be nonpassive to that partner. 11 A taxpayer is a real estate professional for a tax year if:
- More than one-half of the personal services performed in trades or businesses by the taxpayer during the taxable year are performed in real property trades or businesses in which the taxpayer materially participates, and
- The taxpayer performs more than 750 hours of services during the taxable year in real property trades or businesses in which the taxpayer materially participates.
Defending Clients Under Audit
Most of the time, the partnership or S corporation entity will come under IRS scrutiny as part of an individual taxpayer examination.
Documenting, during the return preparation phase, days of personal use, significant and material participation of each owner, and average duration of rental periods for each year, rather than trying to gather the information when notified of an audit, will ensure proper reporting and protect the practitioner from adverse claims.
IRS agents are now required to document basis in passthrough entities as part of their basic procedures. Consider providing each owner with an annual calculation of the owner’s tax basis in the entity. In a partnership, this may be the capital account and related debt, but not in all cases. Be sure to obtain a copy of the partnership or operating agreement and any agreements with property managers or other persons providing regular services to the entity in connection with the rental property. Scrutinize the ownership agreement and any management contracts for conflicts in asserting material participation by the owners.
If a client receives a Schedule K-1 from a partnership or S corporation where he or she personally used the property owned by the entity, ask the client to confirm with the Schedule K-1’s issuer that the K-1 addresses the allocation of expenses between personal and rental use. The taxpayer should also request a copy of the complete Form 1065, U.S. Return of Partnership Income, or 1120S, U.S. Income Tax Return for an S Corporation, or, at a minimum, a copy of Form 8825.
Electing Out of Partnership Provisions
Electing out of partnership tax provisions may be an option where co-owned investment property is shared ratably among the owners and the requirements of Sec. 761(a) are met. Benefits include being able to make tax elections independently for each owner and qualifying for Sec. 1031 exchange treatment at the individual partner/owner level, and, of course, not having to file Form 1065. Rev. Proc. 2002-22 addresses when an undivided fractional interest in rental real estate is not an interest in a business entity under Sec. 761(a).
The spectrum of issues with personal use of passthrough entity property is daunting, without even considering valuation and gifting issues. The IRS has identified the area of passthroughs and other related entities as a target of interest. 12 Taxpayers need tax practitioners’ professional expertise and assistance in avoiding the pitfalls of co-ownership of vacation property. Tax practitioners can also help each other by properly applying the personal use rules and documenting that the rules have been applied on all Schedules K-1 provided to owners of entities with personal use property. 13
1 “In the case of an individual, a partnership, a trust, an estate, or an electing small business corporation (as defined in section 1371(b)), no deductions which would otherwise be allowable under chapter 1 of the Code shall be allowed with respect to the use of a dwelling unit” (Prop. Regs. Sec. 1.280A-1(a)).
2 “For purposes of this determination, a unit shall not be treated as rented at fair rental for any calendar day on which it is used for personal purposes” (Prop. Regs. Sec. 1.280A-1(d)).
3 Prop. Regs. Sec. 1.280A-1(e)(4).
4 Bolton, 694 F.2d 556 (9th Cir. 1982).
5 McKinney, 732 F.2d 414 (10th Cir. 1983).
6 Sec. 280A(d)(1).
7 Sec. 280A(g).
8 Sec. 469(i)(2).
9 Sec. 469(i)(3).
10 Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A).
11 Sec. 469(c)(7).
12 Internal Revenue Manual, §220.127.116.11.
13 For more on this topic, see the IRS’s Partnership Audit Technique Guide, Ch. 5, “Loss Limitations,” and Passive Activity Loss Audit Technique Guide, Ch. 2, “Rental Losses: Vacation Rentals in a Nutshell.”
Janet Hagy is with Hagy & Associates PC in Austin, Texas. For information about this article, contact Ms. Hagy at email@example.com.