Question

Please answer all the following questions.

When you rent out your home for more than 14 days per year, you have to declare your income and may have to pay taxes. However, it is not as bad as it sounds. This is because certain costs of running a home that would otherwise not be deductible, such as utilities and insurance, become partially deductible when the home is used to produce rental income. The textbook on page 14-18 (see PPTS below) gives an example of a home that generated 37,500 of rental income. As schedule E (exhibit 14-5, page 14-20, copied below) shows, the total income reported from these rents is only S972. It actually gcts even better. The taxpaycr can still itemize thousands of additional interest and real property tax deductions on Schedule A (almost as much as if the home was not used for rent) There are actually two allowable methods to calculate rental income. The method used here is the Tax Court Method. The other method is the IRS Method. The IRS Method actually results in zero rental income but allows less additional itemized deductions. The logic of the Tax Court method is that interest and real-estate taxes should be allocated based on the percentage of the whole year rather than the percentage of actual use. To understand the background: the IRS wanted to give a bigger deduction for interest and taxes, but the taxpayer successfully appealed to the tax court to lower the deduction. Why would the taxpayer do that? The answer is that the remainder of the interest and taxes would have been deducted anyway as an itemized deduction on schedule A. The advantage of the Tax Court Method is that it increases income before depreciation, therefore allowing a larger depreciation deduction (depreciation cannot be taken as an itemized deduction on schedule A). You do not need to know the details, but what you should understand is that the IRS method calculates the percentage of rental use based on the number of days the building is actually occupied. On the other hand, the Tax Court Method is based on 365 days. Therefore the IRS Mcthod applics a greater percentage of the costs to the rental revenuc. The result is that under the IRS method you report lower rental income (usually zero). However, you also have less itemized deductions than under the Tax Court Mcthod Questions: . If a property is available for rent 200 days and is used for personal purposes 30 days, what is the percentage used for rental under (a) IRS Mcthod and (b)Tax Court Method? 2. Which method will result in lower rental income on line 26 of schedule E, and why? 3. Which method will give you more itemized deductions, and why? 4. Which method will you likely use if you take the standard deduction, and why?

Answer 1

Question (1)

On rent = 200 days

Personal purpose = 30 days

(a) Under IRS method the percentage applied will be 200 / (200 + 30) = 200 / 230 on all the expenses

(b) Under Tax court method, for

• Tier I expenses such as interest and real estate taxes, percentage applied will be rental days / 365 = 200 / 365.
• Tier II expenses such as utilities, repairs, insurance, maintenance, percentage applied will be 200 / 230

Question 2

Allocated %age is higher for tier I expenses under IRS method. Hence, allocated Tier I expenses are more in case of IRS method and hence IRS method will result into lower net rental income.

Question 3

The allocated cost is higher in case of IRS method. So the itemized deductions ( in a way the balance cost not allocated to rental revenue) will be lower. Since allocated cost is lower in case of Tax Court method, the itemized deductions will be higher.

Question 4

IRS method should be used when one is making use of standard deduction. The standard deduction limit is much more under this method and the need to itemise deductions is lower here.

Question 5

TCJA restricts the deduction of local and state taxes to a maximum of $ 10,000 a year. Hence, amount paid in excess of $ 10,000 will be lost for deduction under IRS. One should therefore opt for Tax court method.