Tax Schedule E Questions for Active Participation Loss

David Y M. · 2020-08-15T13:05:13-07:00

Current Situation - Trying to tax plan for 2020 tax year- househacking with SO and 3 other roommates, and planning to claim active participation and claim a deductible passive loss- Deductible expenses are based off formula Shared Living Space/ Total Living space = 3000/3250 = 92%.Seems to me it'd be super beneficial to use this to our advantage, and make some improvements on the house since likely we won't be able to take advantage of this tax rule if we get married and our combined income is over the threshold. Is my thinking correct or are there more nuances I am overlooking?Questions: Would these be allowed for schedule E? I plan to talk to a CPA later but want to at least try on my own first and see what might be able to fly.- If I own the house and make her pay me $1/month to live at the house is that technically allowed? What would be reasonable since we are not married.- What expenses are considered okay to not have explicit documentation for such as a receipt? - like for these under $50 home depot runs, supplies/tools that I buy on facebook marketplace/craigslist, or mileage runs that I don't have documentation for. Would IRS consider this okay if the expenses seemed reasonable?- For the safe harbor/de minimus tax rule of $2,500 --> does this only apply to personal property, or can it apply to contract labor such as painting the outside of the house?

David M.

Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes

6y

@David Y M.

You seem be mistaken in several areas...

What tax rule won't you be able to take advantage of when you are married?

By declaring 92% of the property as a rental, you can only roughly take 8% advantage of the Sec121 capital gains exclusion of $250k single and $500k married. You'll need to talk to a professional or two on how to do a mixed taxed return when it comes time to sell.

To qualify for active participation, you need to spend more than half your time on real estate. While your profile says you are consultant, lets just use a regular W2 type employee working 40hrs a week. That's 2000 hours a year. So, somehow you need to be claiming that you are doing 2001 hours of real estate activities making money... That is usually what trips people up to trying to claim this.

I'd have to read up again on the De Minimus tax rule, but I thought that was for tangible property for your investment, not personal property. So, I don't think its supposed to apply to labour. Other than not having a receipt, you don't have to capitalize the deduction and do the depreciation. Double check with a professional or two.

Other than the de minimus rule, I say keep everything. I scan and keep every receipt. I've never been audited, but I have the piece of mind knowing I have the backup info to support my deductions.

For trying to take losses on your return, first you need to figure out if you have any losses. If so, maybe you shouldn't be doing a rental. If the losses are mainly due to depreciation, then that's different. To take up to $25k of passive losses on your return (instead of having them carried over), your modified AGI has to be less than $100k (its phases out at $150k) and you need to have 500 hours of "work." For one house, that can be somewhat difficult to say that you spent 500 hours managing your rental. I think the material participation allows for looking for another rental (and the active has to be on an actual investment/rental, or its hte other way around). Either way, it can be tough to really justify with one property, especially when there is no turnover and you are just collecting rent...

If you make capital improvements on an investment property, you are supposed to depreciate those improvements over the appropriate time spans. Meanwhile, don't forget that you end up paying taxes on the depreciation unrecapture tax; basically, there is no free lunch.

Does this make any sense?

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John Teachout

Rental Property Investor · Concord, GA · Member since 2015 · 3k+ posts · 3k+ votes

6y

Keep records for everything, it will simplify your life in the long run. ie, keep mileage logs, keep all receipts for all real estate related purchases, etc.

Regarding "active participation" I think the above poster was confused on that when he referred to 50% of your time. That has to do with "real estate professional" which is a completely separate issue.

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David M.

Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes

6y

@John Teachout

Thanks for pointnthat our. Real Estate Professional require the 50%+ hours and allows deductions of all losses. The other deduction potential maxes at $25k with agi <$100k.

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Kory Reynolds

Accountant · NH · Member since 2019 · 269 posts · 288 votes

6y

There is a lot to say here, but since it's late I'll just toss out a few initial thoughts!

Your allocation of expenses as 100% rental use for shared square footage likely would not be considered reasonable. You are required to use a reasonable allocation - in reality you have control over the shared areas. The two most common methods is dividing by rooms (ie 4 bedroom house, 3 are rented, 75% rental allocation for expenses), or by square footage of the space that is solely the tenants - not the shared space. Depending on future plans you'll want to consider this heavily, as already alluded to, considering the 121 exclusion.

For you to be able to create losses on the portion rented to your significant other, one would need to be charging FMV rent - not something I have looked at in a while but I believe the IRS looks for around 80% or more of FMV rent. Thus $1 would not cut it. If you don't hit this threshhold, deductions allocated/apportioned to that unit would only be allowed to the extent of rental income.

Painting and that type of work is typically (emphasis on typically, the tangible property regs are a good read) considered routine maintenance and is deductible. The de minimis safe harbor is for tangible property, with installation/delivery costs, so it could potentially include labor.

1 Reply

Michael PlaksPro Member

Tax Accountant / Enrolled Agent · Houston, TX · Member since 2014 · 5k+ posts · 6k+ votes

6y

@David Y M.

I'll give you a few more ideas while you are on this "s.. the system" trip.

- Adopt your SO as a child and claim that "child" as a dependent and for all credits. Some millionaire dude whose assets were frozen by the court did adopt his adult GF to successfully cheat the system and gain access to his funds

- Have your SO and the other roommates not pay you and then claim the business losses

- Allow the house to be burned for a casualty loss on taxes and an insurance claim

That's all the advice I can give you for free.

1 Reply

Linda WeygantPro Member

Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes

6y

You need to stop reading whatever you're reading that has created these ideas or smoking whatever has brought these pipe dreams and actually consult with a qualified tax professional.

You're off the rails in so many different ways that just trying to organize my thoughts to address anything would require a complete re-education of pretty much everything you're thinking.

Quickly though...

Active participation in a home you're house hacking and currently living in does not create a deductible loss. At the most you can deduct your expenses down to zero, but not beyond. You'll need to move out of the property to create a deductible loss.

Your deductible percentage - when you're sharing common areas is based on the percentage of square footage that is solely rented (you have no rights to enter unless you are performing a landlord duty) vs the total percentage. You don't include the common/shared areas as "business usage"

What do you think you're accomplishing by charging $1 of rent? I don't follow the logic on this at all.

There is no such thing as a "deminimus" expense where you don't have to have receipts. In the event of an audit, every deduction will need to be substantiated. The deminimus type expense you're thinking of is a completely different concept used in a different type of business and is usually related to travel expenses.

The IRS has no concept of "this deduction is allowable because it seems reasonable". I actually laughed out loud for real reading this and spewed coffee.

The safe harbor rules are fairly complex and I'm not sure you're ready for the nuances of that discussion given your lack of knowledge in the fundamentals.

Podcast Guest on Show #244

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David Y M.

OP

Dallas, TX · Member since 2020 · 42 posts · 10 votes

6y

@Linda Weygant

I appreciate your feedback but my questions were posed as separate questions. Obviously you need to substantiate major expenses, but I was asking specifically for expenses under $50.

I know you can expense mileage without documentation if they occur at a regular cadence. For example, if you go to a rental property per month you can deduct that roundtrip mileage based off a history rather than pure documentation of every trip. I wasn’t sure what would be the case with small expenses for regular maintenance.

Second question - why wouldn’t I be able to claim the loss if I helped fill the house by getting all the tenants? The $1 was hypothetical and I assumed it wouldn’t fly since it’s not at arms length, but it was more a question of at what point would the IRS deem the rent to be reasonable. Think somebody else responded to that question.

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David Y M.

OP

Dallas, TX · Member since 2020 · 42 posts · 10 votes

6y

@Michael Plaks

I appreciate the sarcasm LOL. But would actually appreciate help if I could get more knowledge. I’m just reading the rules based off the IRS publications and made an excel spreadsheet for the P/L this year and it seems like we’d be in a minor paper loss situation based off of current projections. The reason why I went to this forum is to see if other people have had clients who have used this more aggressively. The $1 rent is purely hypothetical and not what I’m actually charging.

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David M.

Morris County, NJ · Member since 2020 · 5k+ posts · 2k+ votes

6y

@David Y Mei

Send me a direct message if you want to chat and we can set up time

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David Y M.

OP

Dallas, TX · Member since 2020 · 42 posts · 10 votes

6y

@Kory Reynolds

I appreciate the help as you were the one person who gave me a real response.

The FMV rent makes sense. I assumed there would be some sort of threshold for the IRS to deem it an arms length transaction. I just didn't know what that threshold would be. RIght now all rents are slightly below FMV.

I also appreciate the clarity on the allocation for deductible expenses. Other people on the forum I saw did a percentage based off of square footage, but I can see how that’s not technically true since I control the shared space.

Based off that metric would the following allocation be more reasonable? 3.5/4 since my SO shares a room with me? I mean that’s still 87.5%.... Would like to know thoughts on that.

What about small expenses? I assume there needs to be explicit documentation but have you seen circumstances where the IRS deemed them okay based off a reasonableness perspective? I know mileage can be done this way but wasn’t sure about expenses like like when you buy tools on Craigslist. I bought a lawnmower on Facebook marketplace so was wondering about that.

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Kory Reynolds

Accountant · NH · Member since 2019 · 269 posts · 288 votes

6y

Originally posted by @David Y M.:

@Kory Reynolds

I appreciate the help as you were the one person who gave me a real response.

The FMV rent makes sense. I assumed there would be some sort of threshold for the IRS to deem it an arms length transaction. I just didn't know what that threshold would be. RIght now all rents are slightly below FMV.

I also appreciate the clarity on the allocation for deductible expenses. Other people on the forum I saw did a percentage based off of square footage, but I can see how that’s not technically true since I control the shared space.

Based off that metric would the following allocation be more reasonable? 3.5/4 since my SO shares a room with me? I mean that’s still 87.5%.... Would like to know thoughts on that.

What about small expenses? I assume there needs to be explicit documentation but have you seen circumstances where the IRS deemed them okay based off a reasonableness perspective? I know mileage can be done this way but wasn’t sure about expenses like like when you buy tools on Craigslist. I bought a lawnmower on Facebook marketplace so was wondering about that.

David - in regards to your significant other, I would just call it what it is - personal use unless they are going to pay FMV rent. The way I like to think about some of these scenarios is play it to the extreme. IE, what if you gift your SO , $1000/month, and she turns around and pays that to you as rent and you claim deductions. You could claim all you wanted it is rental income, but the IRS is going to look at the substance. Even with a live in SO (exclude all the roommates) - given the relationship they are more likely to look at is as a cost sharing initiative and you wouldn't be able to create a loss. I just wouldn't go there, call it 3/4 / 75% rental use and let the SO part go. Even if it was all above the table with your SO, you would want to consider your 121 exclusion - that could be worth MUCH more than the minimal losses it may create. Ie say you could and did claim those losses and it amounts to $1,000 per year of allowed losses, saving you $150-$220/year in federal tax.but then you lost out on another 12.5% of the property eligible for up to a $500k exclusion on capital gains. Say it was a a $200k capital gain...treating SO it as personal shelters $50k from capital gains ($7500 fed tax saved), where if you treated that as rental you pay another 3,750 in tax. To save $150-220/year you paid $3750. Of course, all very hypothetical numbers.

The other slightly below FMV rents are not a problem, it is a facts and circumstances consideration - all third parties, and you may have reasons for agreeing to below FMV - good tenant, payment history, neat, etc.

For all expenses, some amount of substantiation should be maintained. I have sold stuff on Craigslist for cash and they just asked me for a handwritten receipt. That said, while receipts would be the best, especially when we have a mix of personal and rental use. The IRS has excepted cancelled checks, credit card statements, bank statements etc - all of these show the expense was actually incurred, but not necessarily exactly what it was for, thus if you actually get audited receipts are best to minimize the risk of anything being disallowed. Even with mileage, when you claim it on a tax return you are agreeing that contemporaneous records (in real time) are kept. If you don't have these records, especially with the personal/rental use you should at least have a good method to back into and support it - a day calendar or something has been used.

1 Reply

Eamonn McElroy

Accountant · Atlanta, GA · Member since 2015 · 1k+ posts · 1k+ votes

6y

@David Y M.

You really should re-read Linda's post. There is some bad advice on this thread. Although harsh, she's spot on regarding inability to take losses regardless of whether the rents are fair market or not if you're renting rooms in your residence. Active participation does not matter. Expenses are limited to gross income and expenses cannot create a loss, the excess is suspended and carried over, except those expressly allowable under a different section of the code (i.e. mortgage interest and property taxes). IRC Sec 280A controls this situation, not IRC Sec 469.

Also, it appears to me that you're more than ready to expense 90% or 87.5% of everything. You cannot expense items directly allocable to shared areas. i.e. you cannot expense lawncare and landscaping, or your new lawnmower, even a proportional amount. This is your residence.

In these situations I expect to see depreciation for the rooms being rented, depreciation for personal property inside of the rooms if applicable, a proration of utilities, and a proration of mortgage interest, property taxes, etc. Maybe a few more things if they affect the structure as a whole.

Very rarely do I see a rental like this create a loss for tax purposes.

Make sure rents are approximately fair market, or else none of the above matters. If not none of the above matters because, in general, you would have a not for profit rental, gross rents of which are reported on Sch 1 of your 1040, and all expenses are disallowed except for those already expressly allowable by the code (i.e. mortgage interest and property taxes).

You said you are eventually going to "talk to" a CPA. Hopefully you do more than that and engage a knowledgeable CPA based on your understanding of the issue. Best of luck.

1 Reply

David Y M.

OP

Dallas, TX · Member since 2020 · 42 posts · 10 votes

6y

Originally posted by @Eamonn McElroy:

@David Y M.

You really should re-read Linda's post. There is some bad advice on this thread. Although harsh, she's spot on regarding inability to take losses regardless of whether the rents are fair market or not if you're renting rooms in your residence. Active participation does not matter. Expenses are limited to gross income and expenses cannot create a loss, the excess is suspended and carried over, except those expressly allowable under a different section of the code (i.e. mortgage interest and property taxes). IRC Sec 280A controls this situation, not IRC Sec 469.

Also, it appears to me that you're more than ready to expense 90% or 87.5% of everything. You cannot expense items directly allocable to shared areas. i.e. you cannot expense lawncare and landscaping, or your new lawnmower, even a proportional amount. This is your residence.

In these situations I expect to see depreciation for the rooms being rented, depreciation for personal property inside of the rooms if applicable, a proration of utilities, and a proration of mortgage interest, property taxes, etc. Maybe a few more things if they affect the structure as a whole.

Very rarely do I see a rental like this create a loss for tax purposes.

Make sure rents are approximately fair market, or else none of the above matters. If not none of the above matters because, in general, you would have a not for profit rental, gross rents of which are reported on Sch 1 of your 1040, and all expenses are disallowed except for those already expressly allowable by the code (i.e. mortgage interest and property taxes).

You said you are eventually going to "talk to" a CPA. Hopefully you do more than that and engage a knowledgeable CPA based on your understanding of the issue. Best of luck.

"(5)Limitation on deductions In the case of a use described in paragraph (1), (2), or (4), and in the case of a use described in paragraph (3) where the dwelling unit is used by the taxpayer during the taxable year as a residence, the deductions allowed under this chapter for the taxable year by reason of being attributed to such use shall not exceed the excess of—(A)the gross income derived from such use for the taxable year, over" -

Found it

Thank you for the advice, and referencing the relevant IRC sections.There isn't a lot of guidance, and I was using the guidance given from the biggerpockets blog to calculate those expense ratios - so seems to me there isn't great consensus or just a lack of knowledge on this issue in general.

Blog link: https://www.biggerpockets.com/blog/2016-02-21-tax-implications-house-hacking

"If you have a single family home, you can either divide the room you occupy by the total number of rooms (rooms include beds, baths, kitchen, living room, dining room, etc.) or the square footage you occupy by the total square footage.

You will now have a percentage of the home that you occupy and a percentage of the home that you rent."

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Linda WeygantPro Member

Investor and CPA · Arvada, CO · Member since 2015 · 2k+ posts · 3k+ votes

6y

Originally posted by @David Y M.:

@Linda Weygant

I appreciate your feedback but my questions were posed as separate questions. Obviously you need to substantiate major expenses, but I was asking specifically for expenses under $50.

I know you can expense mileage without documentation if they occur at a regular cadence. For example, if you go to a rental property per month you can deduct that roundtrip mileage based off a history rather than pure documentation of every trip. I wasn’t sure what would be the case with small expenses for regular maintenance.

Second question - why wouldn’t I be able to claim the loss if I helped fill the house by getting all the tenants? The $1 was hypothetical and I assumed it wouldn’t fly since it’s not at arms length, but it was more a question of at what point would the IRS deem the rent to be reasonable. Think somebody else responded to that question.

Stop. You're killing me.

"but I was asking specifically for expenses under $50."

Under $50, Under $10, Under $5. Doesn't matter. You need the receipts.

"I know you can expense mileage without documentation if they occur at a regular cadence. "

Good luck with that. This is completely not true. The IRS requires a contemporaneous record of mileage. No exceptions.

"why wouldn’t I be able to claim the loss if I helped fill the house by getting all the tenants?"

Because as long as you are living in the property, this is not a business. You have what is called "Business Use of the Home" and it is a much different tax scenario. I advise you to read the following:

https://www.irs.gov/taxtopics/tc509

https://www.irs.gov/publications/p587

And stop believing all these things you claim to know as a fact. You have been seriously miseducated somewhere along the way and you really need to come off of that, wipe away all these things you "know as a fact" and start over.

Podcast Guest on Show #244

1 Reply

David Y M.

OP

Dallas, TX · Member since 2020 · 42 posts · 10 votes

6y

@Linda Weygant:

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Dan Schwartz

Real Estate Investor · Tempe, AZ · Member since 2012 · 874 posts · 648 votes

6y

@David Y M. look at the relatively small amount of time you spend recordkeeping as the labor cost of your audit-proof-as-possible tax deduction. Get MileIQ, which is also included in Microsoft 365 (or whatever they're calling it now) subscriptions. Get Scannable or ScanBot or whatever app you like best and scan your receipts as soon as you get them. I have an iPhone and I put them right in a "Receipts" folder in iCloud since iCloud Drive is a standard share destination in all apps. The Microsoft suite subscription comes with OfficeLens, which I didn't care for, but maybe they've improved it. That saves easily to a sharepoint in the included OneDrive space. These tasks take moments, not minutes. Mentioning "a Home Depot run" and asking "do I need receipts?" suggests that you are being lazy about both what you are buying at HD (whatever interests me vs. exactly what I need) and documenting it for both business analysis and tax preparation purposes.

It's great that you are trying to maximize you knowledge and implementation of tax breaks available to real estate investors. I personally think that house hacking is less about maximizing tax benefits and more about low capital commitments (for OO conforming loans), forced appreciation, help with principal paydown, and ultimately, unlocked equity on sale or refinance. You'll see that the tax benefits flow much more easily when you have a dedicated rental property.

So, house hack now, ask questions, build good habits, build equity, internalize the great advice many talented accountants have offered free of charge in this thread....and then go crush it when you expand your portfolio.

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Tax Schedule E Questions for Active Participation Loss

Tax Schedule E Questions for Active Participation Loss

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