I’ve scanned threads, not found my answer but am impressed with the tone of this forum.
I’m a CA resident w/ a newly purchased rural OR vacation home. There is a shop on the far side of the OR property with a long term (2+ decade) sole-proprietor business tenant. The shop has separate electrical, phone, driveway, etc. but is not a residential dwelling by any legal standard. I will be using the vacation house for 2 months each summer and it will remain unoccupied otherwise.
I’ve read (and re-read) the applicable IRS docs but am still unclear how expenses and deductions are applied in this situation. The mortgage interest deduction issue started my quest and remains a murky subject in my mind. It’s probably time to hire a pro but I’d first like to have a solid grasp on a situation so I can ask intelligent questions and know if I’m getting BS answers.
Thanks in advance for any advice or pointers.
From your question, do we assume that the two structures are on a single lot and were purchased as a package on the same mortgage loan? How about hazard insurance? Is there a separate insurance policy for each structure or are both covered on the same policy?
The answer is easy – treat the property as two separate entities, a personal use dwelling and a rental unit.
The dwelling structure is your second/vacation home and a personal use property. You can take a Schedule A deduction for property taxes and mortgage interest. Repairs, maintenance, upkeep, and homeowners insurance premiums are personal expenses and not deductible.
The rental unit is an income producing property. All rental income and expenses are reported on Schedule E. You can expense anything it costs you to own and to maintain the rental property. Expenses would include property taxes, mortgage interest, repairs, maintenance, upkeep, management fees, utilities when and if paid for by the owner/landlord, advertising costs, legal fees, cleaning, and supplies.
You can take a depreciation expense for the rental unit, but not for the second home. Figuring out the depreciation basis for the rental unit may take a little work. If you have a single mortgage, then allocate mortgage interest between the rental and the dwelling using a defendable rationale. If you have a single insurance policy, ask the insurance company to tell you how much of the premium applies to each structure if it is not already itemized on the declarations page.
Thank you, Dave.
Yes, both structures are on the same lot, under the same loan and covered by the same hazard policy.
The hazard policy is already split but the “defendable rationale” for the other expenses/deductions is causing my stumbles. The house and the outbuilding have approximately the same square footage but they are far from equivalent on any other basis. The shop has no cooking facility, a wood stove for heat, and the only running water is an outdoor spigot (tenant pays for a porta-john service). Dividing total square footage does not appear defendable. I can think of logical alternatives but can also easily rationalize that my alternative approaches could be considered arbitrary by others, including the IRS. Unfortunately, I’m unable to find an IRS document that provides guidance so I have turned here for advice.
Beyond that, every trip to the property (750 miles one way) has involved some interaction with the tenant and maintenance to the outbuilding. I am assuming this will remain so for the life of our ownership or until the tenant leaves. Am I safe to assume I can deduct a portion of my travel expenses up to the passive loss limit? The IRS documents on this topic are still on my upcoming reading list.
I would give the rental place half the mortgage interest since the square footage is the same. Also half the property taxes for a deduction. It seems the only logical thing to do. The IRS isn’t going to drive out there and look at it, I don’t think.
The most defendable thing to do is pull the tax assessor’s records. Something the IRS auditors can do without leaving their office.
Surely the tax assessment will show assessed land value and assessed value for each building. Let’s say the assessor shows the land valuation at 25% of the value of the property. For the remaining 75%, let’s say the assessed value is split 80/20.
Let me illustrate this with an example. Let’s say the property is assessed at $200K. 25% of the property’s value is attributed to the land, so this leaves $150K for the dwelling structure and outbuilding. If the assessor further allocates the improvements between the dwelling and the outbuilding on an 80/20 ratio, then the dwelling structure’s assessed value is $120K and the outbuilding is $30K.
Now, in this example, $30K becomes the depreciation basis for the outbuilding. I would use the same 80/20 ratio for the mortgage interest and property taxes.
Any reasonable method of allocating your blanket expenses is acceptable to the IRS. I am just giving you one approach that I belive is reasonable and defendable. Splitting the mortgage interest 50/50 and property taxes 50/50 on the grounds that the square footage is equal seems logical, but is probably not defendable since the value of the two structures varies drastically.
The tax assessor will itemize the property taxes for you. The assessed value of the dwelling will be taxed a certain amount and the value of the outbuilding will be taxed another amount. Divide the tax amount for the dwelling by the total amount of tax for the outbuilding and dwelling structure. Apply this ratio to the total tax bill to determine the amount you put on Schedule A, and allocate the rest of the tax bill to the rental unit. This will, by default, allocate the property tax for the land between the two structures on the same ratio.
Use this same ratio to allocate the mortage interest between the dwelling structure and the outbuilding.
IRS will not challenge you on this approach. There may be other equally defendable approaches, but this seems the most logical to me.
Thanks again, Dave.
The thorough explanation and example are appreciated.