Publication 527
Residential Rental Property

(Including Rental of Vacation Homes)

For use in preparing 2002 Returns

Casualties and Thefts

As a result of a casualty or theft, you may have a loss related to your property. You may be able to deduct the loss on your income tax return. For information on casualty and theft losses (business and nonbusiness), see Publication 547.

Casualty.   Damage to, destruction of, or loss of property is a casualty if it results from an identifiable event that is sudden, unexpected, or unusual.

Theft.   The unlawful taking and removing of your money or property with the intent to deprive you of it is a theft.

Gain from casualty or theft.   When you have a casualty to, or theft of, your property and you receive money, including insurance, that is more than your adjusted basis in the property, you generally must report the gain. However, under certain circumstances, you may defer paying tax by choosing to postpone reporting the gain. To do this, you must generally buy replacement property within 2 years after the close of the first tax year in which any part of your gain is realized. The cost of the replacement property must be equal to or more than the net insurance or other payment you received. For more information, see Publication 547.

How to report.   If you had a casualty or theft that involved property used in your rental activity, you figure the net gain or loss in Section B of Form 4684, Casualties and Thefts. Also, you may have to report the net gain or loss from Form 4684 on Form 4797, Sales of Business Property. (Follow the instructions for Form 4684.)

Limits on
Rental Losses

Rental real estate activities are generally considered passive activities, and the amount of loss you can deduct is limited. Generally, you cannot deduct losses from rental real estate activities unless you have income from other passive activities. However, you may be able to deduct rental losses without regard to whether you have income from other passive activities if you materially or actively participated in your rental activity. See Passive Activity Limits, later.

Losses from passive activities are first subject to the at-risk rules. At-risk rules limit the amount of deductible losses from holding most real property placed in service after 1986.

Exception.   If your rental losses are less than $25,000, and you actively participated in the rental activity, the passive activity limits probably do not apply to you. See Losses From Rental Real Estate Activities, later.

Property used as a home.   If you used the rental property as a home during the year, the passive activity rules do not apply to that home. Instead, you must follow the rules explained under Personal Use of Dwelling Unit (Including Vacation Home), earlier.

At-Risk Rules

The at-risk rules place a limit on the amount you can deduct as losses from activities often described as tax shelters. Losses from holding real property (other than mineral property) placed in service before 1987 are not subject to the at-risk rules.

Generally, any loss from an activity subject to the at-risk rules is allowed only to the extent of the total amount you have at risk in the activity at the end of the tax year. You are considered at risk in an activity to the extent of cash and the adjusted basis of other property you contributed to the activity and certain amounts borrowed for use in the activity. See Publication 925 for more information.

Passive Activity Limits

In general, all rental activities (except those meeting the exception for real estate professionals, below) are passive activities. For this purpose, a rental activity is an activity from which you receive income mainly for the use of tangible property, rather than for services.

Limits on passive activity deductions and credits.   Deductions for losses from passive activities are limited. You generally cannot offset income, other than passive income, with losses from passive activities. Nor can you offset taxes on income, other than passive income, with credits resulting from passive activities. Any excess loss or credit is carried forward to the next tax year.

For a detailed discussion of these rules, see Publication 925.

You may have to complete Form 8582 to figure the amount of any passive activity loss for the current tax year for all activities and the amount of the passive activity loss allowed on your tax return. See Form 8582 not required under Losses From Rental Real Estate Activities, later, to determine whether you have to complete Form 8582.

Exception for Real Estate Professionals

Rental activities in which you materially participated during the year are not passive activities if for that year you were a real estate professional. Losses from these activities are not limited by the passive activity rules.

For this purpose, each interest you have in a rental real estate activity is a separate activity, unless you choose to treat all interests in rental real estate activities as one activity.

If you were a real estate professional for 2002, complete line 42 of Schedule E (Form 1040).

Real estate professional.   You qualified as a real estate professional for the tax year if you met both of the following requirements.

1. More than half of the personal services you performed in all trades or businesses during the tax year were performed in real property trades or businesses in which you materially participated.
2. You performed more than 750 hours of services during the tax year in real property trades or businesses in which you materially participated.

Do not count personal services you performed as an employee in real property trades or businesses unless you were a 5% owner of your employer. You were a 5% owner if you owned (or are considered to have owned) more than 5% of your employer's outstanding stock, or capital or profits interest.

If you file a joint return, do not count your spouse's personal services to determine whether you met the preceding requirements. However, you can count your spouse's participation in an activity in determining if you materially participated.

Real property trades or businesses.   A real property trade or business is a trade or business that does any of the following with real property.

• Develops or redevelops it.
• Constructs or reconstructs it.
• Acquires it.
• Converts it.
• Rents or leases it.
• Operates or manages it.
• Brokers it.

Material participation.   Generally, you materially participated in an activity for the tax year if you were involved in its operations on a regular, continuous, and substantial basis during the year. For more information, see Publication 925.

Participating spouse.   If you are married, determine whether you materially participated in an activity by also counting any participation in the activity by your spouse during the year. Do this even if your spouse owns no interest in the activity or files a separate return for the year.

Choice to treat all interests as one activity.   If you were a real estate professional and had more than one rental real estate interest during the year, you can choose to treat all the interests as one activity. You can make this choice for any year that you qualify as a real estate professional. If you forgo making the choice for one year, you can still make it for a later year.

If you make the choice, it is binding for the tax year you make it and for any later year that you are a real estate professional. This is true even if you are not a real estate professional in any intervening year. (For that year, the exception for real estate professionals will not apply in determining whether your activity is subject to the passive activity rules.)

See the instructions for line 23 of Schedule E (Form 1040) for information about making this choice.

Losses From Rental
Real Estate Activities

If you or your spouse actively participated in a passive rental real estate activity, you can deduct up to $25,000 of loss from the activity from your nonpassive income. This special allowance is an exception to the general rule disallowing losses in excess of income from passive activities. Similarly, you can offset credits from the activity against the tax on up to $25,000 of nonpassive income after taking into account any losses allowed under this exception.

If you are married, filing a separate return, and lived apart from your spouse for the entire tax year, your special allowance cannot be more than $12,500. If you lived with your spouse at any time during the year and are filing a separate return, you cannot use the special allowance to reduce your nonpassive income or tax on nonpassive income.

The maximum amount of the special allowance is reduced if your modified adjusted gross income is more than $100,000 ($50,000 if married filing separately).

Example.   Jane is single and has $40,000 in wages, $2,000 of passive income from a limited partnership, and $3,500 of passive loss from a rental real estate activity in which she actively participated. $2,000 of Jane's $3,500 loss offsets her passive income. The remaining $1,500 loss can be deducted from her $40,000 wages.

Active participation.   You actively participated in a rental real estate activity if you (and your spouse) owned at least 10% of the rental property and you made management decisions in a significant and bona fide sense. Management decisions include approving new tenants, deciding on rental terms, approving expenditures, and similar decisions.

Example.   Mike is single and had the following income and losses during the tax year:

Even though the rental loss is a loss from a passive activity, because Mike actively participated in the rental property management, he can use the entire $4,000 loss to offset his other income.

Maximum special allowance.   If your modified adjusted gross income is $100,000 or less ($50,000 or less if married filing separately), you can deduct your loss up to $25,000 ($12,500 if married filing separately). If your modified adjusted gross income is more than $100,000 (more than $50,000 if married filing separately), this special allowance is limited to 50% of the difference between $150,000 ($75,000 if married filing separately) and your modified adjusted gross income.

Generally, there is no relief from the passive activity loss limits if your modified adjusted gross income is $150,000 or more ($75,000 or more if married filing separately).

Modified adjusted gross income.   This is your adjusted gross income from line 35, Form 1040, figured without taking into account:

1. Taxable social security or equivalent tier 1 railroad retirement benefits,
2. Deductible contributions to an IRA or certain other qualified retirement plans,
3. The exclusion allowed for qualified U.S. savings bond interest used to pay higher educational expenses,
4. The exclusion allowed for employer-provided adoption benefits,
5. Any passive activity income or loss included on Form 8582,
6. Any passive income or loss or any loss allowable by reason of the exception for real estate professionals discussed earlier,
7. Any overall loss from a publicly traded partnership (see Publicly Traded Partnerships (PTPs) in the instructions for Form 8582,
8. The deduction for one-half of self-employment tax,
9. The deduction allowed for interest on student loans, or
10. The deduction for qualified tuition and related expenses.

Form 8582 not required.   Do not complete Form 8582 if you meet all of the following conditions.

1. Your only passive activities were rental real estate activities in which you actively participated.
2. Your overall net loss from these activities is $25,000 or less ($12,500 or less if married filing separately).
3. You do not have any prior year unallowed losses from any passive activities.
4. If married filing separately, you lived apart from your spouse all year.
5. You have no current or prior year unallowed credits from passive activities.
6. Your modified adjusted gross income is $100,000 or less ($50,000 or less if married filing separately).
7. You do not hold any interest in a rental real estate activity as a limited partner or as a beneficiary of an estate or a trust.

If you meet all of the conditions listed above, your rental real estate activities are not limited by the passive activity rules and you do not have to complete Form 8582. Enter each rental real estate loss from line 22 of Schedule E (Form 1040) on line 23 of Schedule E.

If you do not meet all of the conditions listed above, see the instructions for Form 8582 to find out if you must complete and attach that form to your tax return.

How To Report
Rental Income
and Expenses

If you rent buildings, rooms, or apartments, and provide only heat and light, trash collection, etc., you normally report your rental income and expenses in Part I of Schedule E (Form 1040). However, do not use that schedule to report a not-for-profit activity. See Not Rented For Profit, earlier.

If you provide significant services that are primarily for your tenant's convenience, such as regular cleaning, changing linen, or maid service, you report your rental income and expenses on Schedule C (Form 1040), Profit or Loss From Business or Schedule C-EZ, Net Profit From Business. Significant services do not include the furnishing of heat and light, cleaning of public areas, trash collection, etc. For information, see Publication 334, Tax Guide for Small Business (For Individuals Who Use Schedule C or C-EZ). You also may have to pay self-employment tax on your rental income. See Publication 533, Self-Employment Tax.

Schedule E (Form 1040)

Use Part I of Schedule E (Form 1040) to report your rental income and expenses. List your total income, expenses, and depreciation for each rental property. Be sure to answer the question on line 2.

If you have more than three rental or royalty properties, complete and attach as many Schedules E as are needed to list the properties. Complete lines 1 and 2 for each property. However, fill in the Totals column on only one Schedule E. The figures in the Totals column on that Schedule E should be the combined totals of all Schedules E.

Page 2 of Schedule E is used to report income or loss from partnerships, S corporations, estates, trusts, and real estate mortgage investment conduits. If you need to use page 2 of Schedule E, use page 2 of the same Schedule E you used to enter the combined totals in Part I.

On page 1, line 20 of Schedule E, enter the depreciation you are claiming. You must complete and attach Form 4562 for rental activities only if you are claiming:

• Depreciation on property placed in service during 2002,
• Depreciation on listed property (such as a car), regardless of when it was placed in service, or
• Any car expenses reported on a form other than Schedule C or C-EZ (Form 1040) or Form 2106 or Form 2106-EZ.

Otherwise, figure your depreciation on your own worksheet. You do not have to attach these computations to your return.

Illustrated Example

In January, Eileen Johnson bought a condominium apartment to live in. Instead of selling the house she had been living in, she decided to change it to rental property. Eileen selected a tenant and started renting the house on February 1. Eileen charges $550 a month for rent and collects it herself. Eileen received a $550 security deposit from her tenant. Because she plans to return it to her tenant at the end of the lease, she does not include it in her income. Her house expenses for the year are as follows:

Eileen must divide the real estate taxes, mortgage interest, and fire insurance between the personal use of the property and the rental use of the property. She can deduct eleven-twelfths of these expenses as rental expenses. She can include the balance of the allowable taxes and mortgage interest on Schedule A (Form 1040) if she itemizes. She cannot deduct the balance of the fire insurance because it is a personal expense.

Eileen bought this house in 1979 for $35,000. Her property tax was based on assessed values of $10,000 for the land and $25,000 for the house. Before changing it to rental property, Eileen added several improvements to the house. She figures her adjusted basis as follows:

On February 1, when Eileen changed her house to rental property, the property had a fair market value of $92,000. Of this amount, $20,000 was for the land and $72,000 was for the house.

Because Eileen's adjusted basis is less than the fair market value on the date of the change, Eileen uses $39,000 as her basis for depreciation.

Because the house is residential rental property, she must use the straight line method of depreciation using either the GDS recovery period or the ADS recovery period. She chooses the GDS recovery period of 27.5 years.

She uses Table 4-D to find her depreciation percentage. Because she placed the property in service in February, she finds the percentage to be 3.182%.

On April 1, Eileen bought a new dishwasher for the rental property at a cost of $425. The dishwasher is personal property used in a rental real estate activity, which has a 5-year recovery period. The dishwasher qualifies for the special depreciation allowance which she figures first. Next, she uses the percentage under Half-year convention in Table 4-A to figure her MACRS depreciation deduction for the dishwasher.

On May 1, Eileen paid $2,000 to have a furnace installed in the house. The furnace is residential rental property. Because she placed the property in service in May, she finds the percentage from Table 4-D to be 2.273%.

Eileen figures her net rental income or loss for the house as follows:

Eileen uses Part I of Schedule E (Form 1040) to report her rental income and expenses. She enters her income, expenses, and depreciation for the house in the column for Property A. She uses Form 4562 to figure and report her depreciation. Eileen's Schedule E (Form 1040) is shown next. Her Form 4562 is not shown. See Publication 946 for information on how to prepare Form 4562.

Johnson Schedule E (Form 1040)

How To Get Tax Help

You can get help with unresolved tax issues, order free publications and forms, ask tax questions, and get more information from the IRS in several ways. By selecting the method that is best for you, you will have quick and easy access to tax help.

Contacting your Taxpayer Advocate.   If you have attempted to deal with an IRS problem unsuccessfully, you should contact your Taxpayer Advocate.

The Taxpayer Advocate represents your interests and concerns within the IRS by protecting your rights and resolving problems that have not been fixed through normal channels. While Taxpayer Advocates cannot change the tax law or make a technical tax decision, they can clear up problems that resulted from previous contacts and ensure that your case is given a complete and impartial review.

To contact your Taxpayer Advocate:

• Call the Taxpayer Advocate at
  1-877-777-4778.
• Call, write, or fax the Taxpayer Advocate office in your area.
• Call 1-800-829-4059 if you are a
  TTY/TDD user.

For more information, see Publication 1546, The Taxpayer Advocate Service of the IRS.

Free tax services.   To find out what services are available, get Publication 910, Guide to Free Tax Services. It contains a list of free tax publications and an index of tax topics. It also describes other free tax information services, including tax education and assistance programs and a list of TeleTax topics.

Personal computer. With your personal computer and modem, you can access the IRS on the Internet at www.irs.gov. While visiting our web site, you can:

• See answers to frequently asked tax questions or request help by e-mail.
• Download forms and publications or search for forms and publications by topic or keyword.
• Order IRS products on-line.
• View forms that may be filled in electronically, print the completed form, and then save the form for recordkeeping.
• View Internal Revenue Bulletins published in the last few years.
• Search regulations and the Internal Revenue Code.
• Receive our electronic newsletters on hot tax issues and news.
• Learn about the benefits of filing electronically (IRS e-file).
• Get information on starting and operating a small business.

You can also reach us with your computer using File Transfer Protocol at ftp.irs.gov.

TaxFax Service. Using the phone attached to your fax machine, you can receive forms and instructions by calling 703-368-9694. Follow the directions from the prompts. When you order forms, enter the catalog number for the form you need. The items you request will be faxed to you.

For help with transmission problems, call the FedWorld Help Desk at 703-487-4608.

Phone. Many services are available by phone.
 

• Ordering forms, instructions, and publications. Call 1-800-829-3676 to order current and prior year forms, instructions, and publications.
• Asking tax questions. Call the IRS with your tax questions at 1-800-829-1040.
• Solving problems. Take advantage of Everyday Tax Solutions service by calling your local IRS office to set up an in-person appointment at your convenience. Check your local directory assistance or www.irs.gov for the numbers.
• TTY/TDD equipment. If you have access to TTY/TDD equipment, call 1-800-829- 4059 to ask tax questions or to order forms and publications.
• TeleTax topics. Call 1-800-829-4477 to listen to pre-recorded messages covering various tax topics.

Evaluating the quality of our telephone services. To ensure that IRS representatives give accurate, courteous, and professional answers, we use several methods to evaluate the quality of our telephone services. One method is for a second IRS representative to sometimes listen in on or record telephone calls. Another is to ask some callers to complete a short survey at the end of the call.

Walk-in. Many products and services are available on a walk-in basis.
 

• Products. You can walk in to many post offices, libraries, and IRS offices to pick up certain forms, instructions, and publications. Some IRS offices, libraries, grocery stores, copy centers, city and county governments, credit unions, and office supply stores have an extensive collection of products available to print from a CD-ROM or photocopy from reproducible proofs. Also, some IRS offices and libraries have the Internal Revenue Code, regulations, Internal Revenue Bulletins, and Cumulative Bulletins available for research purposes.
• Services. You can walk in to your local IRS office to ask tax questions or get help with a tax problem. Now you can set up an appointment by calling your local IRS office number and, at the prompt, leaving a message requesting Everyday Tax Solutions help. A representative will call you back within 2 business days to schedule an in-person appointment at your convenience.

Mail. You can send your order for forms, instructions, and publications to the Distribution Center nearest to you and receive a response within 10 workdays after your request is received. Find the address that applies to your part of the country.

• Western part of U.S.:
  Western Area Distribution Center
  Rancho Cordova, CA 95743-0001
• Central part of U.S.:
  Central Area Distribution Center
  P.O. Box 8903
  Bloomington, IL 61702-8903
• Eastern part of U.S. and foreign addresses:
  Eastern Area Distribution Center
  P.O. Box 85074
  Richmond, VA 23261-5074

CD-ROM for tax products. You can order IRS Publication 1796, Federal Tax Products on CD-ROM, and obtain:

• Current tax forms, instructions, and publications.
• Prior-year tax forms and instructions.
• Popular tax forms that may be filled in electronically, printed out for submission, and saved for recordkeeping.
• Internal Revenue Bulletins.

The CD-ROM can be purchased from National Technical Information Service (NTIS) by calling 1-877-233-6767 or on the Internet at http://www.irs.gov/cdorders. The first release is available in early January and the final release is available in late February.

CD-ROM for small businesses. IRS Publication 3207, Small Business Resource Guide, is a must for every small business owner or any taxpayer about to start a business. This handy, interactive CD contains all the business tax forms, instructions and publications needed to successfully manage a business. In addition, the CD provides an abundance of other helpful information, such as how to prepare a business plan, finding financing for your business, and much more. The design of the CD makes finding information easy and quick and incorporates file formats and browsers that can be run on virtually any desktop or laptop computer.

It is available in March. You can get a free copy by calling 1-800-829-3676 or by visiting the website at www.irs.gov/smallbiz.