Taxes on rental activity losses
|  Dear
Tax Talk,
My question is about rental property. I have lived in my
residence for two and a half years and will be moving soon. Given that the market
is very soft, I want to rent it out for two to three years to see if the prices
in my area recover. Speculation about how the real estate market will fare aside,
I have determined that the amount I can rent it out for will cover the following:
mortgage interest, property tax and homeowners association fees, but just barely.
As I understand it, even if I sell, I will be "charged" with depreciation recapture.
As such, I think I should claim depreciation expense on my tax return. However,
that would mean that if I rent for three years, I will never show a profit. Will
I be subject to the for-profit/not-for-profit rule? I read on the IRS Web site
that if an activity does not show the for-profit intent by being profitable for
three out of five years, at the end of the period I will be taxed on my expense
deductions retroactively? As such, am I essentially being penalized for renting?
Thanks!
-- John
Dear John,
Losses from an activity are only deductible if entered into for
profit. The IRS presumes an activity is not-for-profit if it does
not show a profit in two of five years. However, real estate is
a special animal (horse racing losses are a breed apart, but that's
another question).
First, you're only showing a loss because of depreciation;
you're still economically in a good deal. What makes real estate distinct is that
it does not depreciate, but rather appreciates, and this is considered profit.
Even if you were to rent at an economic loss, if the value of your property is
appreciating each year, this is considered profit for the purpose of overcoming
the presumption.
 |
These factors overcome IRS' presumption of not-for-profit:
| |
|
| • |
You carry on the
activity in a businesslike manner. |
| • |
The time and effort
you put into the activity indicate you intend to make
it profitable. |
| • |
You depend on the
income for your livelihood. |
| • |
Your losses are
due to circumstances beyond your control (or are normal
in the startup phase of your type of business). |
| • |
You change your
methods of operation in an attempt to improve profitability. |
| • |
You (or your advisers)
have the knowledge needed to carry on the activity as
a successful business. |
| • |
You were successful
in making a profit in similar activities in the past. |
| • |
The activity makes
a profit in some years. |
| • |
You can expect to
make a future profit from the appreciation of the assets
used in the activity. |
| • | Personal
pleasure derived from the activity. | |
No
one factor is decisive. Even if property values don't increase as you expect,
it doesn't mean you lose your deductions retroactively. This would only happen
if the IRS examined your return and determined that the activity was not for profit. To
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