Mary and Charles have owned a beach cottage on the New Jersey shore for several
ID: 2344609 • Letter: M
Question
Mary and Charles have owned a beach cottage on the New Jersey shore for several years and have always used it as a family retreat. When they acquired the property they had no intention of renting it. Because family circumstances have changed, they are considering using the cottage for only 2 weeks a year and renting it for the reminder of the year. Their AGI is approx. $80,000 per year and they are in the 30% tax bracket (combined Federal and State). Interest and real estate taxes total $8,000 per year and are expected to continue at this level in the foreseeable future. If Mary and Charles rent the property their incremental revenue and expenses are projected to be:Rent Income $20,000
Rental Commission ($3,000)
Maintenance Expense ($8,000)
Depreciation Expense($10,000)
If the cottage is converted to rental property they plan to be actively involved in key rental and maintenance decisions. Given the tax effects of covering the property to rental use
Explanation / Answer
The incremental tax impact of renting the property would be that Mary and Charles would have a $1,000 deductible loss [$20,000 ($3,000 + $8,000 + $10,000)].
The total deductible loss, including the real estate tax and interest expenses, would be $9,000 ($1,000 + $8,000).
The real estate tax and interest expenses would be deductible whether or not Mary and Charles convert the cottage to rental status.
Even though the rental cottage would be considered a passive activity, it would qualify for the real estate rental exception.
This allows taxpayers to deduct up to $25,000 per year against active and portfolio income. Therefore, converting the property to rental status would produce an incremental $1,000
tax deduction and a tax benefit of $300 ($1,000 x 30%).
The cash flow position before the mortgage payments would be:
Net positive cash flow before mortgage payments = $ 9,300
Under the facts given, the cash flow from renting the cottage would not be sufficient to cover the $12,000 mortgage payment.
other relevant factors might be considered that could lead Mary and Charles to decide to rent the cottage.