Sale or trade of business, depreciation, rentals

In general, if you receive income from the rental of a dwelling unit, such as a house, apartment, or duplex, you can deduct certain expenses.

Besides knowing which expenses may be deductible, it's important to understand potential limitations on the amounts of rental expenses that you can deduct in a tax year.

There are several types of limitations that may apply.

Not-for-profit activities:

• If you don't rent your property to make a profit, you can deduct your rental expenses only up to the amount of your rental income, and you can't carry forward rental expenses in excess of rental income to the next year. However, deductions that are allowed regardless of whether an activity is for-profit (e.g., certain real property taxes and mortgage interest) are not subject to this limitation.
• Refer to Publication 527, Residential Rental Property.

Rental of a dwelling unit (for profit):

• The tax treatment of rental income and expenses for a dwelling unit that you also use for personal purposes depends on how many days you used the unit for personal purposes.
• Renting to relatives may be considered personal use even if they're paying you rent, unless the family member uses the dwelling unit as his or her main home and pays rent equivalent to the fair rental value.
• Refer to Publication 527.

Passive activity losses:

• In general, you can deduct passive activity losses to the extent of passive activity income (a limit on loss deductions).
• You carry any excess loss forward to the following year or years until used, or you carry any excess loss forward until the year you dispose of your entire interest in the activity in a fully taxable transaction.
• There are several exceptions that may apply to the passive activity limitations. Refer to Publication 527 and Publication 925, Passive Activity and At-Risk Rules.

At-risk rules:

The at-risk rules limit your losses from most activities to your amount at risk in the activity.

• You treat any loss disallowed because of the at-risk limits as a deduction from the same activity in the next tax year.
• If your losses from an at-risk activity are allowed in a previous taxable year and your amount at risk drops below zero at the close of any later taxable year, then you must include a recapture amount in your income from the activity for such later taxable year.

• Is my residential rental income taxable and/or are my expenses deductible?
• Tax Topic 414 - Rental income and expenses
• Tax Topic 415 - Renting residential and vacation property

Report the gain or loss on the sale of rental property on Form 4797, Sales of Business Property or on Form 8949, Sales and Other Dispositions of Capital Assets depending on the purpose of the rental activity. Individuals typically use Schedule D (Form 1040), Capital Gains and Losses together with Form 4797 or Form 8949.

For further information, refer to:

• Publication 544, Sales and Other Dispositions of Assets,
• Publication 550, Investment Income and Expenses,
• Instructions for Form 4797, Sales of Business Property, and
• Instructions for Schedule D, Capital Gains and Losses.

Under section 121 of the Internal Revenue Code, you may be able to exclude much of the gain from the sale of your main home that you also used for business or to produce rental income, if you meet the ownership and use tests. However, you may not exclude gain from the sale or exchange of your main home if it's allocable to periods of nonqualified use; refer to Publication 523, Selling Your Home.

If you were entitled to take depreciation deductions because you used your home for business purposes or as rental property, you may not exclude the part of your gain equal to any depreciation allowed (actually deducted) or allowable (legally expected to be deducted) as a deduction for periods after May 6, 1997. If you can show by adequate records or other evidence that the depreciation deduction allowed was less than the amount of depreciation allowable, you may limit the recognized gain attributable to depreciation to the amount of the depreciation allowed. A simplified method of computing the deduction for the business use of a home that sets depreciation to zero may apply. Refer to Simplified option for home office deduction for details.

Reporting the sale of your home

Rental property is income-producing property and, if you're in the trade or business of renting real property, report the loss on the sale of rental property on Form 4797, Sales of Business Property. Normally, you transfer the loss as an ordinary loss to line 4 of Schedule 1 and attach it to Form 1040, U.S. Individual Income Tax Return or Form 1040-SR, U.S. Tax Return for Seniors. If your rental activity doesn't rise to the level of a trade or business, but instead is held for investment or for use in a not-for-profit activity, the loss is a capital loss. Report the loss on Form 8949, Sales and Other Dispositions of Capital Assets in Part I (if the transaction is short term) or Part II (if the transaction is long term). If your capital losses are more than your capital gains, you can deduct the difference as a capital loss deduction even if you don’t have ordinary income to offset it. The yearly limit on the amount of the capital loss you can deduct is $3,000 ($1,500 if you are married and file a separate return). Normally, you transfer the capital loss to line 7 of Form 1040 or 1040-SR. See the Instructions for Form 8949 PDF, the Instructions for Form 4797 PDF and the Instructions for Schedule D (Form 1040) PDF.

• Publication 544, Sales and Other Dispositions of Assets

Generally, deductible closing costs are those for interest, certain mortgage points and deductible real estate taxes.

Many other settlement fees and closing costs for buying the property become additions to your basis in the property and part of your depreciation deduction, including:

• Abstract fees
• Charges for installing utility services
• Legal fees
• Recording fees
• Surveys
• Transfer taxes
• Title insurance
• Any amounts the seller owes that you agree to pay (such as back taxes or interest, recording or mortgage fees, sales commissions and charges for improvements or repairs).

• Publication 527, Residential Rental Property (Including Rental of Vacation Homes)

Many taxpayers find using the standard mileage rate an easier way to expense their vehicle. You can't depreciate the vehicle if you use the standard mileage rate. Instead of the standard mileage rate, you can use the actual expense method. If you use this method, you need to figure depreciation for the vehicle.

You can claim business use of an automobile on:

• Schedule C (Form 1040), Profit or Loss From Business (Sole Proprietorship), if you're a sole proprietor. You may also need to use Form 4562, Depreciation and Amortization. If a farmer, use Schedule F (Form 1040), Profit or Loss From Farming and Form 4562.

• Form 2106, Employee Business Expenses, if you’re an Armed Forces reservist, state or local government official paid on a fee basis, or a qualified performing artist.

• Publication 463, Travel, Entertainment, Gift, and Car Expenses
• Publication 544, Sales and Other Dispositions of Assets
• Publication 946, How to Depreciate Property

Regular Method - No. The greater of allowed (claimed on your return) or allowable (what is required under the Code) depreciation must be considered at the time of sale. You can generally figure depreciation on the business use portion of your home up to the gross income limitation, over a 39-year recovery period and using the mid-month convention and the straight-line method of depreciation. Regardless of whether you determine actual expenses and the correct amount of depreciation, you must reduce your basis in your home by the greater of the allowed or allowable depreciation. Simplified Method - There's a simpler option where qualifying taxpayers may use a prescribed rate ($5 per square foot limited to 300 square feet) to compute the business-use-of-the-home deduction. This option, used instead of determining actual expenses, has the advantage of reducing your recordkeeping burden. Under this option, depreciation is treated as zero and the basis of your home won’t be reduced. For more information, visit Simplified option for home office deduction and FAQs – Simplified method for home office deduction. In addition, under this optional method, you can still deduct business expenses unrelated to qualified business use of the home for that taxable year, such as advertising, wages and supplies.

• Publication 946, How to Depreciate Property
• Publication 587, Business Use of Your Home (Including Use by Daycare Providers)
• Publication 544, Sales and Other Dispositions of Assets

Yes. What you've heard about is a transaction commonly known as a nontaxable exchange or like-kind exchange. A like-kind exchange, when properly executed, can postpone the recognition of gain (and resulting current tax) by shifting the basis of property sold to like-kind replacement property. You do this by acquiring a like-kind property, which may be of lesser or greater value. If the replacement property is of a lesser value than the value of the property you transfer, you may also receive non-like property such as cash, equal to the difference in values, when you receive your replacement property. If so, you must recognize the gain on the transfer of your rental property, but only to the extent of the non-like-kind property you receive.

To successfully defer gain in a like-kind exchange, you must comply with certain requirements under section 1031 of the Internal Revenue Code and the Income Tax Regulations thereunder. For example, when you sell your rental property, you can't take actual or constructive receipt of the sale proceeds. You can avoid actual or constructive receipt of the proceeds if you comply with one of the safe harbors, such as using a qualified intermediary or a qualified trust to hold and use the sale proceeds to acquire the replacement property, as set forth in the Income Tax Regulations or certain other publications of the IRS.

The basis of the property you acquire in a like-kind exchange is generally the same as the basis of the property you transferred. However, if you transfer money or other property (not like-kind) in addition to like-kind property, your basis in the property acquired is the basis of the property given up, increased by the amount of money or other property transferred. Also, if you recognize gain on the exchange because you received cash or other non-like-kind property in the exchange, your basis in the property acquired is the basis of the property given up, reduced by the amount of cash and fair market value of any property received, and increased by gain you recognized.

• Publication 544, Sales and Other Dispositions of Assets
• Form 8824, Like-Kind Exchanges (and section 1043 conflict-of-interest sales)

Replacements of the entire roof and all the gutters, and all windows and doors of your residential rental property:

• Are generally restorations to your building property because they're replacements of major components or substantial structural parts of the building structure. As a result, these replacements are capital improvements to the residential rental property.
• Are a separate asset with a new placed-in-service date and are in the same class of property as the residential rental property to which they're attached.
• Are generally depreciated over a recovery period of 27.5 years using the straight line method of depreciation and a mid-month convention as residential rental property.

Repainting the exterior of your residential rental property:

• By itself, the cost of painting the exterior of a building is generally a currently deductible repair expense because merely painting isn't an improvement under the capitalization rules.
• However, if the painting directly benefits or is incurred as part of a larger project that's a capital improvement to the building structure, then the cost of the painting is considered part of the capital improvement and is subject to capitalization.
• In this case, the painting is incurred as part of the overall restoration of the building structure. Therefore, the repainting costs are part of the capital improvements and should be capitalized and depreciated as the same class of property that was restored, as discussed above.

Replacement of the furnace in your residential rental property:

• Is generally a restoration to your building property because it's for the replacement of a major component or substantial structural part of the building's HVAC system. Therefore, the furnace replacement is a capital improvement to your residential rental property.
• As with the restoration costs discussed above, these costs are a separate asset with a new placed-in-service date and are in the same class of property as the residential rental property to which the furnace is attached.
• Is generally depreciated over a recovery period of 27.5 years using the straight line method of depreciation and a mid-month convention as residential rental property.

Note: A taxpayer whose average annual gross receipts is less than or equal to $10,000,000 may elect to not capitalize amounts paid for repairs, maintenance, or improvements of certain eligible building property if the total amounts paid during the taxable year for such activities don't exceed certain dollar limitations. For more information, see Safe Harbor Election for Small Taxpayers in Tangible Property Regulations - Frequently Asked Questions.

• Publication 527, Residential Rental Property (Including Rental of Vacation Homes)
• Publication 946, How to Depreciate Property