VITA: 01

1. VITA: 01/16/10Lesson 12: Rental Income and K-1s Winter 2010 Kristina Shroyer

2. Lesson 12: K-1s and Rental Income Blank Forms for this Lesson As we go through this lesson you'll want to use some of the blank forms in Publication 4491-W for reference (blank forms start on Page 215) Form 1040 (page 215) Schedule E (page 244-245) We're also going to look at some K-1s which I suggest you download and take a look at from the IRS website

3. Lesson 12 – K-1's New this year – some K-1's are in scope for VITA This is an Advanced/International/Military Topic Certain entities: for example partnerships, S-Corporations, Trusts do not themselves pay taxes Instead taxes are passed through the shareholders or beneficiaries of these entities For example in a 50/50 partnership the income and expenses of the partnership would be reported 50/50 to each partner and each partner would report that income on their individual tax returns based on their own individual tax rules – This type of income is reported on Schedule K-1 Income reported to a shareholder or beneficiary on Schedule K-1 is included in various places on the shareholder's individual tax return depending on the type of income The only K-1 type income in scope for VITA is: Interest Income (goes to Schedule B) Dividend Income (goes to Schedule B) Net short term capital gains and losses (goes to Schedule D – line 5) Net long term capital gains and losses (goes to Schedule D – line 12) Tax Exempt Interest Income (Form 1040 line 8b) Taxwise will have a K-1 screen and the amounts should be transferred to the proper part of the tax return for you but again you should verify the amounts go to the proper schedule and are the right amount K-1's are slightly different depending on what type of entity they come from but the main idea is the same…let's look at a K-1 from each type of entity K-1 (Form 1041 – Trust) – received by fiduciaries/beneficiaries K-1 (Form 1065 – Partnership) – received by partners K-1 (Form 1120S – S Corporation) – received by shareholders Let's look at the K-1s and see where the income in the scope of VITA will show up on each one

4. Lesson 12 – K-1's Page 2 of Schedule K-1 Lists the appropriate forms and schedules where the taxpayer's income from each line should be reported – remember the VITA scope though You will be entering the K-1 in Taxwise You will notice the name and Identification of the Partnerships and S-Corps are required and they show up in Part II of Schedule E The name and identification numbers of Trusts/Estates show up in Part III of Schedule E Let's take a quick look at Part II of Schedule E

5. Lesson 12: Rental Income & Expenses Introduction – Rental Income and Expenses This lesson is going to show you how to report rental income and expenses for US Citizens and resident aliens This is for taxpayers that rent out their home or other property but renting is not their actual business This is not for taxpayers in the business of renting properties There are some parts in this lesson that are difficult and outside the VITA scope except in certain situations, I'll point them out as we go Let's look at the Schedule E for a second and line 17 of Form 1040 A lot of this is out of scope for VITA EXCEPT in the situations where you are assisting military and other international taxpayers living abroad with limited access to professional taxpayers and other resources Notice this topic is beyond advanced and is only for people International and Military Tests Where are rental income and expenses reported? Part I of Schedule E

6. Lesson 12: Rental Income & Expenses What is rental income? A taxpayer who rents out a home, a room or some other property is engaged in an income producing activity This type of income received by US citizens and resident aliens must be reported for property located in the US and/or for a foreign located property Gross rental income includes: Ordinary rent payments Advance rent Payments for breaking a lease Security deposits (in some cases – see the tip) If it's intended to serve as last month's rent report as income when it is received If it's intended to be returned at the end of the lease do not report in income unless it is not returned at the end of the lease Expenses paid by the tenant FMV for services received instead of rent payments Rental Income and Expenses may be reported using the cash method of accounting or the accrual method of accounting Cash Method of accounting (MOST INDIVIDUAL TAXPAYERS) Rental income is reported when received and expenses when paid Accrual Method of accounting Rental income is reported when earned and expenses when incurred Read tip on page 12-3 regarding Fair Rental Value If a taxpayer rents their property at less than Fair Rental Value (usually because they are renting to a friend or relative) they should be referred to a professional tax preparer (outside VITA scope) Note: Schedule E should only be used by taxpayers who are not in the BUSINESS fo renting property (so this is not their principal means of income)

7. Lesson 12: Rental Income & Expenses What qualifies as a Rental Expense Mortgage Interest and Property Taxes When a taxpayer rents out a home instead of living in it these are no longer itemized deductions but rental expenses If the taxpayer rents the home out part of the year and lives in it part of the year Mortgage Interest and Property taxes must be allocated between the Schedule E and the Schedule A The allocation can be based on time (say the property was a rental 5 months and a home 7 months) It also could be that the taxpayer only rents out part of the home In this case also mortgage interest and Property taxes must be allocated between the Sch E and Sch A This could be based on area (sq feet of rental vs sq feet of home part) Mortgage Interest is still reported on form 1098 Form 1098 may include property taxes or the taxpayer may need to provide other documentation (such as a property tax statement and canceled check) Example page 12-4, Exercise on page 12-4

8. Lesson 12: Rental Income & Expenses What qualifies as a Rental Expense (continued) Property Insurance This is a deductible rental expenses for the time the property is considered a rental property If the property is only rented for a portion of the year only the property insurance allocable to that portion of the year is deductible If only a portion of the residence is rented an allocation must also be done Insurance premiums paid more than a year in advance cannot be deducted all in one year (EVEN IF CASH BASIS!) The only deductible portion in the current year is the amount that covers that year Other deductible rental expenses See list on page 12-5 Read tip on page 12-5

9. Lesson 12: Rental Income & Expenses What qualifies as a Rental Expense (continued) Auto and Travel Expenses These expenses can be deducted on Schedule E as long as they are attributable to the production of rental income Taxpayer must separate personal and business portions of the travel and be able to substantiate it with records If the taxpayers personal auto is used for the travel the rental-related portion of the expenses may be deducted using (MUST LOG MILEAGE) Standard Mileage method (same rules as with business travel – 55 cents per mile) Actual Expense method (we'll cover this more when we do Chapter 22 later) This lesson states the actual expense method is outside the scope of VITA, but this is only true if the taxpayer wants to take depreciation, if they are leasing a vehicle you may be able to use the actual expense method Repairs vs. Improvements Repairs keep the property in good working condition and is a current year deduction as a rental expense Improvements add to the life or material value of the property and the cost must be recorded as an asset and depreciated over the asset's useful life The total cost of an improvement includes labor, material and installation Look at the table on page 12-6 for a list of common repairs and improvements It's important NOT to deduct improvements as a current year expense Question 3 of the Exercises on page 12-6

10. Lesson 12: Rental Income & Expenses How to handle depreciation of rental property A property or improvement has a useful life of more than one year This means the cost of a property or improvement cannot be deducted as an expense all in one year Instead the cost of the property is expensed (depreciated) over the useful life of the asset (property or improvement) Depreciable property includes: buildings, equipment, machinery, furniture vehicles, improvements Land is NOT depreciable property, the taxpayer gets no expense deduction for land This means when a taxpayer busy a rental property the cost of land must be separated from the cost of the building since only the building can be depreciated – this is usually done with a property tax assessment When a property is depreciated each year (a year of expense is deducted), the taxpayer's basis in that property is reduced by the depreciation It is important that taxpayers claim the correct amount of depreciation each year Even if they don't claim all depreciation they are entitled to they must reduce their property's basis by the correct amount of depreciation What factors affect depreciation In calculating depreciation for an asset, three factors affect the calculation Depreciation Method (usually MACRS for tax) Basis of the property (usually purchase price plus any improvements or costs to bring the property to operating condition) Recovery Period for the property (What is its useful life…how long to depreciate)

11. Lesson 12: Rental Income & Expenses How to handle depreciation of rental property (continued) Depreciation Methods used in Tax (We focus only on MACRS) Exercises 12-7 (Question 4 and 5) Basis and Adjusted Basis of a Rental Property Basis is generally The purchase price of the property + any improvements but NOT including the value of the land on which the property sits So the purchase price needs allocated between land and building, this is usually done with a property tax assessment When a property is converted from personal use to a rental property the basis is: The lesser of the adjusted basis or FMV at the time of the conversion Total Depreciation Expense taken in all years can NEVER exceed the property's basis, stop taking depreciation when the property's basis is reduced to zero What is a Recovery Period? This is the number of years over which the taxpayer recovers (deducts as an expense) the cost or other basis of the property The MACRS method assigns specific recovery periods to different classes of property Exercise (Question 7) Page 12-9

12. Lesson 12: Rental Income & Expenses How to handle depreciation of rental property (continued) How to Figure out the MACRS Depreciation Deduction You need to know three things Placed in Service Date Recovery Period Depreciable Basis - We just went over how to calculate this (Purchase Price of Building (NOT LAND) plus improvements) Placed in Service Date When the asset (property or improvement) is a condition of readiness and used in the rental for the production of income Recovery Periods Under MACRS Depends on the class the property is in – basically classes of assets (such as "Machinery", "Residential Rental Property" etc) are assigned recovery periods by MACRS Publication 527 Page 12 has a table of MACRS recovery periods (the software may also have the information) Recovery Periods Under MACRS you'll likely use (see page 12-10 top of page) 27.5 years for a residential rental property converted to such in 1986 or later 5 years for a Stove or appliance used in a residential rental Property located outside the US has different rules and recovery periods (see page 12-10)

13. Lesson 12: Rental Income & Expenses When the Rental Property is a Portion of the Taxpayer's Residence Expenses must be allocated between the rental and the taxpayer's personal residence Expenses that apply only to the rental property are reported in full on the Schedule E Installing a second phone line in the rental Taxpayer cannot deduct any part of the cost of the first phone line in a partially rented property Repairing an appliance in the rental Painting the rental unit only Expenses that benefit the ENTIRE property (both the rental and the personal residence) Must be divided up and only the rental portion deducted on the Schedule E Mortgage interest and property taxes may be split up between the Sch E and the Sch A, so if the rental is 10% of the property 10% of Mortgage Interest and Prop taxes go on Sch E and 90% on Sch A The taxpayer can use any reasonable method to divide up the expenses Some expenses may be deductible only on Schedule E and not anywhere else Do Question 9 Exercise page 12-12

14. Lesson 12: Rental Income & Expenses Reporting Rental Expenses that Exceed Income (ie Net Losses) How rental expenses are reported depends on how much the taxpayer uses the rental property personally How taxpayers report rental expenses that exceed income (losses) depends on how much the taxpayer uses the property personally Situation 1: Taxpayers do NOT use their rental home has their residence Include the rent received as income Deduct all rental expenses even if those expenses exceed income (they may or may not be deductible as a loss in the current year as we will see due to other rules/limitations) Situation 2: Taxpayers who rent out their personal residence 15 days or more during the year Include the rent received as income Expenses that exceed rental income may not be deductible – this means expenses may be deducted only to the extent of rental income in certain cases…see below, this is called the vacation home rule See Line 2 on part I of Schedule E Situation 3: Taxpayers who rent out their personal residence fewer than 15 days during the year may NOT include the rent as income or deduct the rental expenses Los Angeles Olympic Games~ Limitations on deducting rental expenses (situation 2 above) Deductibility limitations apply to rental expenses for a dwelling the taxpayer uses as a home for the greater of 14 days OR 10% of the number of days during the year the property is rented at FAIR MARKET VALUE Read the example page 12-13

15. Lesson 12: Rental Income & Expenses How to handle rental losses? Rental losses are not always fully deductible Just because the last set of rules allowed the taxpayer to deduct all their rental expenses (even if they exceeded income – Situation I) does NOT mean that the resulting loss will be deductible A deductible loss would be recorded on line 17 of Form 1040 and could be used to offset other income Two restrictions on how much a rental loss can offset other income At-risk rule Passive Activity Rule (book says law) At-risk Rule Basically this says a taxpayer can only deduct a loss up to they amount they have at risk in an activity So how much has the taxpayer put into the rental that they could lose? They can only deduct losses up to this amount Amounts at risk: A taxpayer's risk in any activity equals the following (add these two items together): The money and adjusted basis (cost + improvements – accumulated depreciation) of any property the taxpayer contributed to the activity PLUS: Amounts borrowed for use in the activity if the taxpayer is either personally liable for the loan for pledges personal assets as a security for the loan

16. Lesson 12: Rental Income & Expenses How to handle rental losses? (continued) Passive Activity Rule (Law) Basically this says that passive losses can only be used to offset passive income There are three types of income: active, investment and passive Some common sources of active/investment income are wages, dividends and investments…so passive losses can NOT be used to offset these types of income So let's say a taxpayer made $60,000 in wages and his only other income was a $5000 loss on a rental property, he cannot deduct the $5000 in the current year but may carry it forward to future years in which he may have passive income – or he will get to deduct it when he sells the rental property Basically it's saying any passive loss that exceeds passive income are not deductible in the current year Rentals in most cases are passive activities and therefore there losses are considered passive Passive losses that exceed passive income are not deductible There are other sources of passive income than rental income though (from K-1s – out of VITA scope) Passive vs. Active The limits on deducting rental losses have to do with How much of the rental activity is considered a passive activity If the activity involves active participation (then losses may be less limited) Passive Rental Activity One where income is received mainly from the use of the property rather than the services Most rentals are this Passive Rental Activity with Active Participation (Exception allows less limited losses) Active participation means making significant management decisions, such as approving tenants, approving rental terms, approving repairs and expenses…etc There is an AGI income limitation

17. Lesson 12: Rental Income & Expenses How to handle rental losses? (continued) Passive Activity Rule (Law) (continued) Why do we care about active participation? because there is an exception to the passive activity rule for this Exception Remember we said rental income is usually passive and therefore losses are usually not deductible (can only be used to offset other passive income) However there is an Exception Taxpayers who actively participate in the rental company can use up to $25,000 of their rental expenses to offset non-passive income (up to $12,500 for MFS) This exception can be limited by AGI More non-passive income examples on page 12-15 Active Participation Defined It is considered active participation when taxpayers own at least 10% of the rental property and make significant management decisions as defined earlier Phase out The $25,000 exception may be reduced or completely gone depending on the taxpayers AGI See Phase-Out offset on page 12-15 Example on page 12-15 (at top)

18. Lesson 12: Rental Income & Expenses How to handle rental losses? (continued) How are Passive Rental Losses Reported Disallowed passive losses are carried forward to future years (in case future years have passive income that can be offset by them) Also once the rental is sold all passive losses for that property can be deducted Form 8582 is used to figure the amount of any passive losses for the current tax year as well as carry forwards See rules for when Form 8582 is not required on page 12-15 TaxWise will automatically generate and complete the Form 8582 for you if required However you should check the taxpayers prior year return for any passive loss carry forwards from prior years and enter them in the appropriate place