Under U.S. tax laws, properties are primarily categorized as “principal residences” or “investment properties” or a “mixed-use property“. This is so because tax law for computing income from mixed-use (think of properties rented some time on Airbnb) properties and pure rental income or capital gains income on sale “principal residence” are entirely different.
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Distinctions between “principal residence” and investment properties
Whether you buy a property for earning rent, a commercial property for your business, or a residence for residing, there may be an appreciation over time. However, taxation rules differentiate the nature of investment with different tax relief for “personal residence”, “rental property”, and “mixed-use property”. Significant differences exist between a “principal residence” property and an “investment property” which is for earning rental income. Some of the differences from a taxation perspective are as follows:
- You can deduct only the mortgage interest and property taxes while computing income from the sale of a principal residence; you get a wide range of expenses -like maintenance, management fees, and depreciation deducted while calculating income from the investment properties.
- When selling a principal residence, taxpayers can exclude, as per RC §121 for the tax year 2023, up to $250,000 of gain ($500,000 for married couples filing jointly) if certain tax conditions are met. Investment properties do not qualify for this exclusion.
- Investors can claim depreciation as a deduction from the income earned from an investment property, but this is not possible in the case of a principal residence. However, note that if investment properties are sold, the depreciation recapture also occurs, which means paying tax on the depreciation claimed earlier.
- If you sell a principal residence at a loss, it’s not deductible. However, losses on the sale of an investment property can typically be deducted while computing your taxable income.
What are the five most important criteria for a principal residence?
The Internal Revenue Code (IRC) provides exemption only to ‘principal residence” .So it has also set what qualifies as “principal residence”. According to the IRC, a principal residence is the main home where an individual lives most of the time. This can be a house, condo, apartment, mobile home, or boat. The most important factors taken into account to consider a house as principal residence are :
- What was the duration of living in the house? -The time you’ve lived in the property during the year is a fundamental criterion.
- What is the property’s location?- this means examining if your residence is near your office, family members, banks, etc.
- Is the property address your mailing address? -Do you receive snail mail at your property address that you claim as “principal residence”?
- How distant is the location of religious organizations, recreational clubs, or other associations you’re a part of from your property?
- The subjective intent of the taxpayer plays a role, too.
All these criteria are the primary conditions to reach a conclusion on your claim of a house being a “personal residence” for exclusion benefits.
Exceptional situations in which residence can be of personal use
In certain situations, a house can still be regarded as “personal residence” for tax purposes even though not used for personal residence. These three situations are :
- A taxpayer also uses a dwelling for personal purposes if the taxpayer rents the home to a friend or family member for a less than market value. For example, Ms. Lily rents her residence to her brother and accepts half the fair rental price.
- It is also personal use if an owner rents out their residence for only a few days. So, if Ms. Lisa rents her home for 14 days to Ms Kavita, the residence will still be regarded as “personal residence”.
- The lax law states that it is still personal use when taxpayers rent their residence for less than 15 days during a tax year. The taxpayer must only report the rental income when the home is rented for 15 days at maximum. As per Code Sec.280A (g) (2), you may not deduct any rental expenses other than mortgage interest and property taxes as itemized deductions.
- A dwelling unit can have more than one owner. It is considered joint property ownership if two or more people invest in one dwelling unit. Even if only one of the owners uses the dwelling unit for personal use, it is regarded as personal use of the dwelling for the remaining joint owners.
What is a mixed-use property?
Let us first understand what is a mixed-use property. Properties that serve as primary residences, rentals, or investments pose a unique scenario. For example, you only have a vacation rental in the summer and rent for the remainder of the year. Or, you rent a portion of your property, such as an extra room or granny suite. Some examples of mixed homes are:
- A home office;
- A farm or ranch partially occupied by the owner.
- A property that has an owner-occupied residence as well as a separate unit that is rented, say on Airbnb or VBRO;
- a duplex with the owner residing in one unit and a tenant in the other
How do you determine if the house is a mixed-use property?
If the owner also rents out the residence for less than 14 days, the residence can not be claimed as “rental property”. Therefore, when you are going to determine if your residence is a “mixed-use” property, the first condition is that the property or part of the property was put to rent for more than 14 days.
Once that condition is satisfied, determine if the owner used the house for the greater of the following days
- 14 days; or
- 10% of total rental days
For example, say Richard uses the house for 20 days and puts the house on rent for 225 days; the house can not be a mixed-use residence because he did not stay for 22.5 (23 days ), which was greater than the two days in the above conditions.
Tax Implication on mixed-use property
Once your residence qualifies as a mixed-use property, you must allocate your expenses, including insurance, housekeeping, mortgage interest, HOA fees, etc., by business use and self-use and whether the mixed-use property expenses fall under “whole-home expenses” and direct rental expenses.
The “Whole-Home ” expense category applies to the entire property for personal and rental use. For example, mortgage interest, real estate taxes, and house insurance are whole-home expenses. These “whole-home expenses” should be apportioned in the personal-to-rental use ratio.
For example, if you rent a room in your house for the entire year, you can allocate your expenses based on the percentage of your house’s floor space. So, if your house rental room is 500 square feet and your house is 2,500 square feet, you can deduct 20% of your “whole-home expenses”.
Some expenses are specific to rental operations and, as such, are fully deductible because you wouldn’t normally incur these costs if you weren’t using the property as a rental.
For example, cleaning services, snacks for guests, and streaming service subscriptions dedicated to renter use also qualify as some of the expenses directly connected to a rental home operation.
Many expenses may relate to your personal as well as business. For example, broadband or streaming services that are shared in the room put on rent can be deducted as business-related.
Selling a mixed-use house
Selling a mixed-use property gives rise to capital gains regarding the portion of the personal residence. You can claim an exclusion benefit under IRC Section 121.
Regarding income on the sale of a portion used for business purposes, the capital gain has to be computed by adding “depreciation recapture,” and no exclusion u/s 121 is allowed. However, users can defer tax under IRC Section 1031 by “like-kind-Exchange”.
While the information on this site - Internal Revenue Code Simplified-is about legal issues, it is not legal advice or legal representation. Because of the rapidly changing nature of the law and our reliance upon outside sources, we make no warranty or guarantee of the accuracy or reliability of information contained herein.