Publication 17
Your Federal Income Tax

For Individuals

For use in preparing 2002 Returns

Personal Use of
Dwelling Unit
(Including Vacation Home)

If you have any personal use of a dwelling unit (including vacation home) that you rent, you must divide your expenses between rental use and personal use. See Figuring Days of Personal Use and How To Divide Expenses, later.

If you used your dwelling unit for personal purposes long enough during 2002, it will be considered a dwelling unit used as home. If so, you cannot deduct rental expenses that exceed rental income for that property. See Dwelling Unit Used as Home and How To Figure Rental Income and Deductions, later. If your dwelling unit is not considered a dwelling unit used as home, you can deduct rental expenses that exceed rental income for that property subject to certain limits. See Limits on Rental Losses, later.

Exception for minimal rental use.   If you use the dwelling unit as a home and you rent it fewer than 15 days during the year, do not include any of the rent in your income and do not deduct any of the rental expenses. See Dwelling Unit Used as Home, later.

Dwelling unit.   A dwelling unit includes a house, apartment, condominium, mobile home, boat, vacation home, or similar property. A dwelling unit has basic living accommodations, such as sleeping space, a toilet, and cooking facilities. A dwelling unit does not include property used solely as a hotel, motel, inn, or similar establishment.

Property is used solely as a hotel, motel, inn, or similar establishment if it is regularly available for occupancy by paying customers and is not used by an owner as a home during the year.

Example.   You rent a room in your home that is always available for short-term occupancy by paying customers. You do not use the room yourself, and you allow only paying customers to use the room. The room is used solely as a hotel, motel, inn, or similar establishment and is not a dwelling unit.

Dwelling Unit
Used as Home

The tax treatment of rental income and expenses for a dwelling unit that you also use for personal purposes depends on whether you use it as a home. (See How To Figure Rental Income and Deductions, later.)

You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:

1. 14 days, or
2. 10% of the total days it is rented to others at a fair rental price.

See Figuring Days of Personal Use, later.

If a dwelling unit is used for personal purposes on a day it is rented at a fair rental price, do not count that day as a day of rental in applying (2) above. Instead, count it as a day of personal use in applying both (1) and (2) above. This rule does not apply when dividing expenses between rental and personal use.

Fair rental price.   A fair rental price for your property generally is an amount that a person who is not related to you would be willing to pay. The rent you charge is not a fair rental price if it is substantially less than the rents charged for other properties that are similar to your property.

Examples

The following examples show how to determine whether you used your rental property as a home.

Example 1.   You converted the basement of your home into an apartment with a bedroom, a bathroom, and a small kitchen. You rented the basement apartment at a fair rental price to college students during the regular school year. You rented to them on a 9-month lease (273 days).

Your basement apartment was used as a home because you used it for personal purposes for 30 days. Rent-free use by your brother is considered personal use. Your personal use (30 days) is more than the greater of 14 days or 10% of the total days it was rented (27 days).

Example 2.   You rented the guest bedroom in your home at a fair rental price during the local college's homecoming, commencement, and football weekends (a total of 27 days). Your sister-in-law stayed in the room, rent free, for the last 3 weeks (21 days) in July.

The room was used as a home because you used it for personal purposes for 21 days. That is more than the greater of 14 days or 10% of the 27 days it was rented (3 days).

Example 3.   You own a cottage in a resort area. You rented it at a fair rental price for a total of 170 days during the year. For 12 of those days, the tenant was not able to use the cottage and allowed you to use it even though you did not refund any of the rent. Your family actually used the cottage for 10 of those days. Therefore, the cottage is treated as having been rented for 160 (170 - 10) days. Your family also used the cottage for 7 other days during the year.

You used the cottage as a home because you used it for personal purposes for 17 days. That is more than the greater of 14 days or 10% of the 160 days it was rented (16 days).

Use As Main Home Before or After Renting

For purposes of determining whether a dwelling unit was used as a home, do not count as days of personal use the days you used the property as your main home before or after renting it or offering it for rent in either of the following circumstances.

1. You rented or tried to rent the property for 12 or more consecutive months.
2. You rented or tried to rent the property for a period of less than 12 consecutive months and the period ended because you sold or exchanged the property.

This special rule does not apply when dividing expenses between rental and personal use.

Figuring Days
of Personal Use

A day of personal use of a dwelling unit is any day that it is used by any of the following persons.

1. You or any other person who has an interest in it, unless you rent it to another owner as his or her main home under a shared equity financing agreement (defined later).
2. A member of your family or a member of the family of any other person who has a financial interest in it, unless the family member uses the dwelling unit as his or her main home and pays a fair rental price. Family includes only brothers and sisters, half-brothers and half-sisters, spouses, ancestors (parents, grandparents, etc.) and lineal descendants (children, grandchildren, etc.).
3. Anyone under an arrangement that lets you use some other dwelling unit.
4. Anyone at less than a fair rental price.

Main home.   If the other person or member of the family in (1) or (2) above has more than one home, his or her main home is ordinarily the one lived in most of the time.

Shared equity financing agreement.   This is an agreement under which two or more persons acquire undivided interests for more than 50 years in an entire dwelling unit, including the land, and one or more of the co-owners is entitled to occupy the unit as his or her main home upon payment of rent to the other co-owner or owners.

Donation of use of property.   You use a dwelling unit for personal purposes if:

• You donate the use of the unit to a charitable organization,
• The organization sells the use of the unit at a fund-raising event, and
• The purchaser uses the unit.

Examples

The following examples show how to determine days of personal use.

Example 1.   You and your neighbor are co-owners of a condominium at the beach. You rent the unit to vacationers whenever possible. The unit is not used as a main home by anyone. Your neighbor uses the unit for two weeks every year.

Because your neighbor has an interest in the unit, both of you are considered to have used the unit for personal purposes during those 2 weeks.

Example 2.   You and your neighbors are co-owners of a house under a shared equity financing agreement. Your neighbors live in the house and pay you a fair rental price.

Even though your neighbors have an interest in the house, the days your neighbors live there are not counted as days of personal use by you. This is because your neighbors rent the house as their main home under a shared equity financing agreement.

Example 3.   You own a rental property that you rent to your son. Your son has no interest in this dwelling unit. He uses it as his main home. He pays you a fair rental price for the property.

Your son's use of the property is not personal use by you because your son is using it as his main home, he has no interest in the property, and he is paying you a fair rental price.

Example 4.   You rent your beach house to Joshua. Joshua rents his house in the mountains to you. You each pay a fair rental price.

You are using your house for personal purposes on the days that Joshua uses it because your house is used by Joshua under an arrangement that allows you to use his house.

Days Used for Repairs and Maintenance

Any day that you spend working substantially full time repairing and maintaining your property is not counted as a day of personal use. Do not count such a day as a day of personal use even if family members use the property for recreational purposes on the same day.

How To Divide Expenses

If you use a dwelling unit for both rental and personal purposes, divide your expenses between the rental use and the personal use based on the number of days used for each purpose. Expenses for the rental use of the unit are deductible under the rules explained in How To Figure Rental Income and Deductions, later.

When dividing your expenses follow these rules.

1. Any day that the unit is rented at a fair rental price is a day of rental use even if you used the unit for personal purposes that day. This rule does not apply when determining whether you used the unit as a home.
2. Any day that the unit is available for rent but not actually rented is not a day of rental use.

Example.   Your beach cottage was available for rent from June 1 through August 31 (92 days). Your family uses the cottage during the last 2 weeks in May (14 days). You were unable to find a renter for the first week in August (7 days). The person who rented the cottage for July allowed you to use it over a weekend (2 days) without any reduction in or refund of rent. The cottage was not used at all before May 17 or after August 31.

1. The cottage was used for rental a total of 85 days (92 - 7). The days it was available for rent but not rented (7 days) are not days of rental use. The July weekend (2 days) you used it is rental use because you received a fair rental price for the weekend.
2. You used the cottage for personal purposes for 14 days (the last 2 weeks in May).
3. The total use of the cottage was 99 days (14 days personal use + 85 days rental use).
4. Your rental expenses are 85/99 (86%) of the cottage expenses.

When determining whether you used the cottage as a home, the July weekend (2 days) you used it is personal use even though you received a fair rental price for the weekend. Therefore, you had 16 days of personal use and 83 days of rental use for this purpose. Because you used the cottage for personal purposes more than 14 days and more than 10% of the days of rental use, you used it as a home. If you have a net loss, you may not be able to deduct all of the rental expenses. See Property Used as a Home in the following discussion.

How To Figure Rental
Income and Deductions

How you figure your rental income and deductions depends on whether the dwelling unit was used as a home (see Dwelling Unit Used as Home, earlier) and, if used as a home, how many days the property was rented.

Property Not Used As a Home

If you do not use a dwelling unit as a home, report all the rental income and deduct all the rental expenses. See How To Report Rental Income and Expenses, later.

Your deductible rental expenses can be more than your gross rental income. However, see Limits on Rental Losses, later.

Table 10-1 Worksheet for figuring limit on rental deductions

Property Used As a Home

If you use a dwelling unit as a home during the year (see Dwelling Unit Used as Home, earlier), how you figure your rental income and deductions depends on how many days the unit was rented.

Rented fewer than 15 days.   If you use a dwelling unit as a home and you rent it fewer than 15 days during the year, do not include any rental income in your income. Also, you cannot deduct any expenses as rental expenses.

Rented 15 days or more.   If you use a dwelling unit as a home and rent it 15 days or more during the year, you include all your rental income in your income. See How To Report Rental Income and Expenses, later. If you had a net profit from the rental property for the year (that is, if your rental income is more than the total of your rental expenses, including depreciation), deduct all of your rental expenses. However, if you had a net loss, you may not be able to deduct all of your rental expenses.

Use Table 10-1 to figure your deductible expenses.

Depreciation

You recover your cost in income producing property through yearly tax deductions. You do this by depreciating the property; that is, by deducting some of your cost on your tax return each year.

Three basic factors determine how much depreciation you can deduct. They are: (1) your basis in the property, (2) the recovery period for the property, and (3) the depreciation method used. You cannot simply deduct your mortgage or principal payments, or the cost of furniture, fixtures and equipment, as an expense.

You can deduct depreciation only on the part of your property used for rental purposes. Depreciation reduces your basis for figuring gain or loss on a later sale or exchange.

You may have to use Form 4562 to figure and report your depreciation. See How To Report Rental Income and Expenses, later.

Claiming the correct amount of depreciation.   You should claim the correct amount of depreciation each tax year. Even if you did not claim depreciation that you were entitled to deduct, you must still reduce your basis in the property by the full amount of depreciation that you could have deducted. If you did not deduct the correct amount of depreciation for property in any year, you may be able to make a correction for that year by filing Form 1040X. If you are not allowed to make the correction on an amended return, you can change your accounting method to claim the correct amount of depreciation. See Claiming the correct amount of depreciation in Publication 527 for more information.

Changing your accounting method to deduct unclaimed depreciation.   If you claimed less depreciation than allowable in an earlier year, you can change your accounting method to take a deduction in the current year for the unclaimed depreciation. To change your accounting method, you must have the consent of the IRS. In some instances, you can receive automatic consent. For more information, see chapter 1 of Publication 946.

Land.   You can never depreciate the cost of land because land does not wear out, become obsolete, or get used up. The costs of clearing, grading, planting, and landscaping are usually all part of the cost of land and are not depreciable.

Depreciation Methods

There are three ways to figure depreciation. The depreciation method you use depends on the type of property and when the property was placed in service. For property used in rental activities you use one of the following.

• MACRS (Modified Accelerated Cost Recovery System) for property placed in service after 1986.
• ACRS (Accelerated Cost Recovery System) for property placed in service after 1980 but before 1987.
• Useful lives and either straight line or an accelerated method of depreciation, such as the declining balance method, if placed in service before 1981.

This chapter discusses MACRS only. If you need more information about depreciating property placed in service before 1987, see Publication 534.

If you placed property in service before 2002, continue to use the same method of figuring depreciation that you used in the past.

Section 179 election.   You cannot claim the section 179 deduction for property held to produce rental income. See chapter 2 of Publication 946.

No deduction greater than basis.   The total of all your yearly depreciation deductions cannot be more than the cost or other basis of the property. For this purpose, your yearly depreciation deductions include any depreciation that you were allowed to claim, even if you did not claim it.

Cooperative apartments.   If you are a tenant-stockholder in a cooperative housing corporation and rent your cooperative apartment to others, you can deduct depreciation for the apartment even though it is owned by the corporation. Your depreciation deduction is your share of the corporation's depreciation. See Cooperative apartments in Publication 527 for information on how to figure your depreciation deduction.

Special Depreciation Allowance

You can claim a special depreciation allowance for qualified property you placed in service after September 10, 2001. The allowance is a depreciation deduction equal to 30% of the property's depreciable basis. The special depreciation allowance is figured before you calculate your regular MACRS deduction.

You must claim the special depreciation allowance for all qualified property. However, you can elect not to claim the allowance. If you make this election for any property, it applies to all property in the same property class placed in service during the year. See Election Not To Claim the Allowance in Publication 946 for more information.

Qualified property.   To qualify for the special depreciation allowance, your property must meet the following requirements.

1. It must be new property that is depreciated under MACRS with a recovery period of 20 years or less.
2. It must meet the following tests.
   1. Acquisition date test.
   2. Placed in service date test.
   3. Original use test.

Acquisition date test.   Generally, you must have acquired the property after September 10, 2001.

Placed in service date test.   Generally, the property must be placed in service for use in your trade or business or for the production of income after September 10, 2001, and before January 1, 2005.

Original use test.   The original use of the property must have begun with you after September 10, 2001. Original use means the first use to which the property is put, whether or not by you.

Example.   Dave bought and placed in service a new refrigerator ($700) for one of his residential rental properties in June of 2002. Dave notes that the refrigerator has a 5-year recovery period (see Table 10-2.). Dave's refrigerator is qualifying property and he claims the special depreciation allowance.

Dave determines the total depreciable basis of the property to be $700. Next, he multiplies this amount by 30% to figure his special depreciation allowance deduction of $210 ($700 × 30%). This leaves an adjusted basis of $490 ($700 - $210), which he will use to figure his MACRS deduction.

For more information, see Special Depreciation Allowance in Publication 946.

MACRS

Most business and investment property placed in service after 1986 is depreciated using MACRS.

MACRS consists of two systems that determine how you depreciate your property. The main system is called the General Depreciation System (GDS). The second system is called the Alternative Depreciation System (ADS). GDS is used to figure your depreciation deduction for property used in most rental activities, unless you elect ADS.

To figure your MACRS deduction, you need to know the following information about your property:

1. Its recovery period,
2. Its placed-in-service date, and
3. Its depreciable basis.

Personal home changed to rental use.   You must use MACRS to figure the depreciation on property you used as your home and changed to rental property in 2002.

Excluded property.   You cannot use MACRS for certain personal property placed in service in your rental property in 2002 if it had been previously placed in service before MACRS became effective in 1987 (before August 1, 1986, if election made).

In addition, you may elect to exclude certain property from the application of MACRS. See Publication 946 for more information.

Recovery Periods Under GDS

Each item of property that can be depreciated is assigned to a property class. The recovery period of the property depends on the class the property is in. Under GDS, the recovery period of an asset is generally the same as its property class. The property classes under GDS are:

• 3-year property,
• 5-year property,
• 7-year property,
• 10-year property,
• 15-year property,
• 20-year property,
• Nonresidential real property, and
• Residential rental property.

Recovery periods for property used in rental activities are shown in Table 10-2.

The class to which property is assigned is determined by its class life. Class lives and recovery periods for most assets are listed in Appendix B in Publication 946.

Additions or improvements to property.   Treat depreciable additions or improvements you make to any property as separate property items for depreciation purposes. The recovery period for an addition or improvement to property begins on the later of:

1. The date the addition or improvement is placed in service, or
2. The date the property to which the addition or improvement was made is placed in service.

The class and recovery period of the addition or improvement is the one that would apply to the original property if it were placed in service at the same time as the addition or improvement.

Example.   You own a residential rental house that you have been renting since 1986 and are depreciating under ACRS. You put an addition onto the house and you placed it in service in 2002. You must use MACRS for the addition. Under MACRS, the addition would be depreciated as residential rental property over 27.5 years.

Placed-in-Service Date

You can begin to depreciate property when you place it in service in your trade or business or for the production of income. Property is considered placed in service in a rental activity when it is ready and available for a specific use in that activity.

Cost Basis

To deduct the proper amount of depreciation each year, you must first determine your basis in the property you intend to depreciate. The basis used for figuring depreciation is your original basis in the property increased by any additions or improvements made to the property. Your original basis is usually your cost. However, if you acquire the property in some other way, such as by inheriting it, getting it as a gift, or building it yourself, you may have to figure your original basis in another way. Other adjustments could also affect your basis. See chapter 14.

Conventions

Under MACRS, conventions establish when the recovery period begins and ends. The convention you use determines the number of months for which you can claim depreciation in the year you place property in service and in the year you dispose of the property.

Mid-month convention.   A mid-month convention is used for all residential rental property and nonresidential real property. Under this convention, you treat all property placed in service, or disposed of, during any month as placed in service, or disposed of, at the midpoint of that month.

Half-year convention.   The half-year convention is used if neither the mid-quarter convention nor the mid-month convention applies. Under this convention, you treat all property placed in service, or disposed of, during a tax year as placed in service, or disposed of, at the midpoint of that tax year.

If this convention applies, you deduct a half-year of depreciation for the first year and the last year that you depreciate the property. You deduct a full year of depreciation for any other year during the recovery period.

Mid-quarter convention.   A mid-quarter convention must be used if the mid-month convention does not apply and the total depreciable basis of MACRS property you placed in service in the last 3 months of a tax year (excluding nonresidential real property, residential rental property, and property placed in service and disposed of in the same year) is more than 40% of the total basis of all such property you place in service during the tax year.

Table 10-2. MACRS Recovery Periods for Property Used in Rental Activities

Under this convention, you treat all property placed in service, or disposed of, during any quarter of a tax year as placed in service, or disposed of, at the midpoint of the quarter.

Example.   During the tax year, Jordan Gregory purchased the following items to use in his rental property.

• A dishwasher for $400, that he placed in service in January.
• Used furniture for $100, that he placed in service in September.
• A refrigerator for $500, that he placed in service in October.

Jordan uses the calendar year as his tax year. He elects not to claim the special depreciation allowance, discussed earlier. The total basis of all property placed in service in that year is $1,000. The $500 basis of the refrigerator placed in service during the last 3 months of his tax year exceeds $400 (40% × $1,000). Jordan must use the mid-quarter convention instead of the half-year convention for all three items.

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