The Internal Revenue Service imposes variable tax rates on income generated by real estate. Regardless of the type of use, all real property is considered a capital asset. When a capital asset is sold at a gain, the taxable portion is taxed at capital gains rates. Capital gains rates are lower than rates imposed on most taxpayer income.
When you sell your main residence at a profit, the IRS allows you to exclude a maximum of $250,000 of gain resulting from the sale if both the ownership and use tests are met, and you did not exclude any gain from the sale of another home in the two years immediately preceding the date of sale. The ownership and use tests will be met if during the five-year period immediately preceding the sale, you owned the home and used it as a main residence for at least two years.
When an owner sells a second home that does not meet the tests for personal use, the entire profit will be subject to taxation. The amount of use of the second home is irrelevant for any years in which the taxpayer owns another property that is deemed the main home.
The income generated by property used solely for rental purposes is included in the taxpayer’s gross income and taxed as ordinary income. However, the owner can deduct expenses related to the rental property from the rental income, including real estate taxes, mortgage interest, repairs and maintenance. When the property is sold, the entire profit is subject to capital gains tax.
Partial Rental Property
A taxpayer who rents part of a property in which he also lives must include the rental in personal income for tax purposes. To determine the correct amount of taxable rental income, the expenses to maintain the home must be allocated between the rental and personal portions of the house as if two separate pieces of property exist. Utilities, mortgage interest and property taxes are typical expenditures that must be paid on the home as a whole. The allocation of shared expenses can be calculated as the percentage of the total square footage encompassed by the rental unit or based on the number of people living in the rental unit. Expenses solely related to the rental unit of the home can be fully deducted against the rental income. The gain earned on the sale of this type of property must be allocated between the rental and personal use. The ownership and use tests must be applied separately to the rental and personal portion of the home to determine the amount subject to taxation.
Infrequent Property Rental
Taxpayers who rent out a personal residence less than 15 days per tax year are not required to report the rental income on a tax return. However, the rental-related expenses such as advertising, cleaning fees and the cost of utilities incurred during the rental period cannot be deducted on the tax return. A common example of this situation is a taxpayer who owns a vacation home and rents it out to friends for one or two weeks during the year.
Jeff Franco's professional writing career began in 2010. With expertise in federal taxation, law and accounting, he has published articles in various online publications. Franco holds a Master of Business Administration in accounting and a Master of Science in taxation from Fordham University. He also holds a Juris Doctor from Brooklyn Law School.