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Tax return forms Publication 571 - Introductory Material Table of Contents Future Developments What's New for 2013 What's New for 2014 Reminder IntroductionOrdering forms and publications. Tax return forms Tax questions. Tax return forms Useful Items - You may want to see: Future Developments For the latest information about developments related to Publication 571 and its instructions, such as legislation enacted after they were published, go to www. Tax return forms irs. Tax return forms gov/pub571. Tax return forms What's New for 2013 Retirement savings contributions credit. Tax return forms  For 2013, the adjusted gross income limitations have increased from $57,500 to $59,000 for married filing jointly filers, from $43,125 to $44,250 for head of household filers, and from $28,750 to $29,500 for single, married filing separately, or qualifying widow(er) with dependent child filers. Tax return forms See chapter 10, Retirement Savings Contributions Credit (Saver's Credit), for additional information. Tax return forms Limit on elective deferrals. Tax return forms  For 2013, the limit on elective deferrals has increased from $17,000 to $17,500. Tax return forms Limit on annual additions. Tax return forms  For 2013, the limit on annual additions has increased from $50,000 to $51,000. Tax return forms What's New for 2014 Retirement savings contributions credit. Tax return forms  For 2014, the adjusted gross income limitations have increased from $59,000 to $60,000 for married filing jointly filers, from $44,250 to $45,000 for head of household filers, and from $29,500 to $30,000 for single, married filing separately, or qualifying widow(er) with dependent child filers. Tax return forms See chapter 10, Retirement Savings Contributions Credit (Saver's Credit), for additional information. Tax return forms Limit on elective deferrals. Tax return forms  For 2014, the limit on elective deferrals remains unchanged at $17,500. Tax return forms Limit on annual additions. Tax return forms  For 2014, the limit on annual additions has increased from $51,000 to $52,000. Tax return forms Reminder Photographs of missing children. Tax return forms  The Internal Revenue Service is a proud partner with the National Center for Missing and Exploited Children. Tax return forms Photographs of missing children selected by the Center may appear in this publication on pages that would otherwise be blank. Tax return forms You can help bring these children home by looking at the photographs and calling 1-800-THE-LOST (1-800-843-5678) if you recognize a child. Tax return forms Introduction This publication can help you better understand the tax rules that apply to your 403(b) (tax-sheltered annuity) plan. Tax return forms In this publication, you will find information to help you: Determine the maximum amount that can be contributed to your 403(b) account in 2014. Tax return forms Determine the maximum amount that could have been contributed to your 403(b) account in 2013. Tax return forms Identify excess contributions. Tax return forms Understand the basic rules for claiming the retirement savings contributions credit. Tax return forms Understand the basic rules for distributions and rollovers from 403(b) accounts. Tax return forms This publication does not provide specific information on the following topics. Tax return forms Distributions from 403(b) accounts. Tax return forms This is covered in Publication 575, Pension and Annuity Income. Tax return forms Rollovers. Tax return forms This is covered in Publication 590, Individual Retirement Arrangements (IRAs). Tax return forms How to use this publication. Tax return forms   This publication is organized into chapters to help you find information easily. Tax return forms    Chapter 1 answers questions frequently asked by 403(b) plan participants. Tax return forms    Chapters 2 through 6 explain the rules and terms you need to know to figure the maximum amount that could have been contributed to your 403(b) account for 2013 and the maximum amount that can be contributed to your 403(b) account in 2014. Tax return forms    Chapter 7 provides general information on the prevention and correction of excess contributions to your 403(b) account. Tax return forms    Chapter 8 provides general information on distributions, transfers, and rollovers. Tax return forms    Chapter 9 provides blank worksheets that you will need to accurately and actively participate in your 403(b) plan. Tax return forms Filled-in samples of most of these worksheets can be found throughout this publication. Tax return forms    Chapter 10 explains the rules for claiming the retirement savings contributions credit (saver's credit). Tax return forms Comments and suggestions. Tax return forms   We welcome your comments about this publication and your suggestions for future editions. Tax return forms   You can write to us at the following address: Internal Revenue Service Tax Forms and Publications Division 1111 Constitution Ave. Tax return forms NW, IR-6526 Washington, DC 20224   We respond to many letters by telephone. Tax return forms Therefore, it would be helpful if you would include your daytime phone number, including the area code, in your correspondence. Tax return forms   You can send your comments from www. Tax return forms irs. Tax return forms gov/formspubs/. Tax return forms Click on “More Information” and then on “Comment on Tax Forms and Publications. Tax return forms ”   Although we cannot respond individually to each comment received, we do appreciate your feedback and will consider your comments as we revise our tax products. Tax return forms Ordering forms and publications. Tax return forms   Visit www. Tax return forms irs. Tax return forms gov/formspubs/ to download forms and publications, call 1-800-TAX-FORM (1-800-829-3676), or write to the address below and receive a response within 10 days after your request is received. Tax return forms  Internal Revenue Service 1201 N. Tax return forms Mitsubishi Motorway Bloomington, IL 61705-6613 Tax questions. Tax return forms   If you have a tax question, check the information available on IRS. Tax return forms gov or call 1-800-829-1040. Tax return forms We cannot answer tax questions sent to either of the above addresses. Tax return forms Useful Items - You may want to see: Publication 517 Social Security and Other Information for Members of the Clergy and Religious Workers 575 Pension and Annuity Income 590 Individual Retirement Arrangements (IRAs) Form (and Instructions) W-2 Wage and Tax Statement 1099-R Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. Tax return forms 5329 Additional Taxes on Qualified Plans (Including IRAs) and Other Tax-Favored Accounts 5330 Return of Excise Taxes Related to Employee Benefit Plans Prev  Up  Next   Home   More Online Publications
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Sale of Assets Financed with Tax-Exempt Bonds by State and Local Governments and 501(c)(3) Organizations

Tax Exempt Bonds (“TEB”) focuses on providing participants in the municipal bond industry with quality service to assist issuers and conduit borrowers in understanding their tax responsibilities. TEB has initiated an outreach and educational services program to increase understanding and compliance with tax law applicable to tax-exempt bonds. As part of this service TEB is providing the following information with respect to the sale of property financed by tax-exempt bonds. Governmental issuers and 501(c)(3) organizations may use this information to establish practices to monitor tax compliance throughout the period that their bonds are outstanding. This information is not intended to be cited as an authoritative source. TEB recommends that issuers and 501(c)(3) organizations review this basic information concerning remedial actions in consultation with their counsel.

For remedial action with respect to exempt facility bonds, see section 1.142-2 of the Income Tax Regulations (the “Regulations”), and for build America bonds, see IRM 7.2.3.1.2.3.

Generally

To raise needed funds, state and local governments and 501(c)(3) organizations may plan to sell property financed with tax-exempt bonds. The sale of such property could cause the bond issue to become taxable. A timely remedial action, if necessary, will help ensure that the interest on the bond issue remains tax-exempt.

There are three basic remedial action options as generally described below:

  • Redemption or defeasance of nonqualified bonds
  • Alternative use of disposition proceeds
  • Alternative use of facility

Governmental Bonds Example

A governmental bond is one that is not a private activity bond. A bond is a private activity bond if both: (i) more than 10% of the proceeds of a bond issue are used for a private business use (the private business use test); and (ii) more than 10% of the debt service on the bonds is directly or indirectly secured by an interest in property or payments with respect to property used for a private business use or derived from payments in respect of property used for a private business use (the private security or payment test). The sale of bond-financed property, a “deliberate action,” may cause the bond issue to meet both of these tests.

Private business use, generally, is use directly or indirectly in a trade or business carried on by any person other than a governmental unit. The result of meeting both the private business use test and the private security or payment test (together, the private business tests) is that the tax-exempt bond issue becomes a taxable private activity bond.

An example of when governmental bonds are likely to meet the private business tests is the sale of a tax-exempt bond financed facility to a corporation. The sale is a deliberate action because the sale was within the issuer’s control. Depending on how much of the proceeds of the bond issue that the issuer used to construct or acquire the facility and how long after the bonds are issued that the sale occurs, the private business use test may be met since the purchaser is not a governmental entity. If the present value of the sales price is greater than 10% of the present value of the debt service on the bonds, the private security or payment test is met. If the revenues from the facility were pledged as security for the payment of debt service on the bonds and are expected to be more than 10% of the present value of the debt service, the private security or payment test is met (regardless of the sales price to the new purchaser). If the bond issue meets both the private business use test and the private security or payment test, the bonds are taxable unless remedial action is taken as described below.

Qualified 501(c)(3) Bonds Example

If the bonds financing the property are qualified 501(c)(3) bonds, the private business use test threshold of 10% is reduced to 5%. The 5% is further reduced by the percentage of proceeds of the bonds used to pay costs of issuance. (Up to 2% of the proceeds may be used for costs of issuance.) Additionally, use of tax-exempt bond financed property in an unrelated trade or business of any 501(c)(3) organization, as described in section 513 of the Internal Revenue Code (the “Code”), is considered private business use and counts toward the 5% limit.

An example of qualified 501(c)(3) bonds likely to meet the private business tests is the sale of tax-exempt bond financed land to a taxable corporation. The sale is a deliberate action because the sale was within the issuer’s (or 501(c)(3) borrower’s) control. Depending on how much of the proceeds of the bond issue that the issuer or 501(c)(3) borrower used to construct or acquire the facility and how long after the bonds are issued that the sale occurs, the private business use test may be met since the purchaser is not a governmental entity or a 501(c)(3) organization. If the parcel of land sold was pledged as security for the payment of debt service on the bonds, the private security or payment test is met if the sales price is more than 5% of the present value of the debt service on the bonds. If the revenues from the facility were pledged as security for the payment of debt service on the bonds and are expected to be more than 5% of the present value of the debt service, the private security or payment test is met (regardless of the sales price to the new purchaser). If the bond issue meets both the private business use test and the private security or payment test, the bonds are taxable unless remedial action is taken as described below.

A qualified 501(c)(3) bond is one where, among other requirements, the tax-exempt bond financed property is owned by a 501(c)(3) organization or a governmental unit. An example of qualified 501(c)(3) bonds failing to meet this requirement is the sale of the tax-exempt bond financed land to a taxable corporation. Accordingly, the bonds are taxable unless remedial action is taken as described below.

Remedial Action under the Treasury Regulations

The Regulations permit an issuer to take remedial action to preclude the sale of tax-exempt bond financed assets from causing the bonds to become taxable bonds. There are five basic conditions that an issuer must meet to qualify to take a remedial action. The conditions are:

  • The issuer must have reasonably expected on the issue date that the bonds would not meet either the applicable private business tests (including the ownership test for qualified 501(c)(3) bonds) or the private loan financing test for the entire term of the bonds.
  • The term of the bonds must not be longer than reasonably necessary for the qualified purposes of the issue (as a guideline, the term is not greater than 120% of the average reasonably expected economic life of the financed property).
  • Generally, the terms of a sale must be a bona fide and arm’s-length arrangement for fair market value.
  • Disposition proceeds must be treated as gross proceeds for arbitrage and rebate purposes. Disposition proceeds are any amounts, including property, derived from the sale, exchange or other disposition of the tax-exempt bond financed property.
  • Except for a remedial action involving the redemption or defeasance of nonqualified bonds, the proceeds must have been spent on a qualified purpose before the date of the deliberate action, that is, the sale of the bond-financed assets.

Redemption or Defeasance of Nonqualified Bonds

Generally, in the case of a sale of bond-financed property, the nonqualified bonds are the portion of the outstanding bonds equal to the percentage of the proceeds of the bond issue that financed that property. For example, if 50% of the proceeds of a bond issue financed the sold property, the nonqualified bonds equal 50% of the outstanding bonds of the issue at the time of the sale.

The first type of remedial action available is the redemption or defeasance of all of the nonqualified bonds within 90 days of the deliberate action. (Generally, proceeds of another issue of tax-exempt bonds may not be used for this redemption.) If the disposition proceeds are all cash, the issuer need not redeem or defease all of the nonqualified bonds, but must use all of the disposition proceeds to redeem a pro rata portion of nonqualified bonds. The redemption must be on the earliest call date after the deliberate action, or if the earliest call date is more than 90 days after the deliberate action, the issuer must establish a defeasance escrow within 90 days of the deliberate action. Defeasance is only permitted as a remedial action if the first call date is no more than 10 ½ years from the issue date of the bonds. The issuer must provide written notice to the Commissioner of the escrow within 90 days of its establishment.

Alternative Use of Disposition Proceeds

The second type of remedial action, available when the seller receives only cash, allows the issuer to spend the disposition proceeds within two years of the date of the sale for an alternative qualifying use. The issuer must treat the disposition proceeds as proceeds of the bonds, and must not take any action after the date of the sale to cause either the applicable private business use tests or the private loan financing test to be met. (If the bonds are qualified 501(c)(3) bonds, the disposition proceeds must be used for a qualified purpose under section 145 of the Code.) If the issuer does not expect the full amount of the disposition proceeds to be spent for a qualifying purpose within the two year period, it must use the balance of disposition proceeds to redeem (or defease) nonqualified bonds as allowed for the first type of remedial action described above.

Note: If the proceeds of a governmental bond issue are to be subsequently used by a 501(c)(3) organization, remediation by spending the disposition proceeds for an alternate use requires that the nonqualified bonds satisfy all the requirements for qualified 501(c)(3) bonds beginning on the date of the sale.

Alternative Use of Facility

The third type of remedial action available to the issuer is when the tax-exempt financed facility will be used after the sale for a purpose that is a qualifying purpose for another type of tax-exempt bonds (provided that the purchaser of the facility does not use tax-exempt bond proceeds for its purchase). The nonqualified bonds must satisfy all the requirements for the alternate type of tax-exempt bonds beginning on the date of the sale. The issuer must either apply any disposition proceeds resulting from the sale to pay the debt service on the bonds on the next available payment date or deposit the proceeds into an escrow within 90 days of their receipt. If the issuer must establish an escrow, the investment yield on the disposition proceeds must be restricted to the yield on the bonds and the escrow used to pay debt service on the next available payment date.

Allocation of Disposition Proceeds

For all three remedial actions, if the property was financed by different sources, the issuer must first allocate disposition proceeds to the outstanding bonds in proportion to the principal amounts of the outstanding bonds. If the disposition proceeds are not greater than the principal amount of outstanding bonds allocated to the sold property, the proceeds must first be allocated to the outstanding bonds before allocating to bonds no longer outstanding or to sources not derived from borrowing (such as revenues of the issuer).

Remedial Actions-Examples

The following examples assume that the above-described five conditions for remedial action are satisfied. Also, in these examples, no bond proceeds were used for costs of issuance or to fund a reserve fund.


Example 1. - Disposition proceeds are less than the principal amount of the outstanding bonds allocated to the sold property.

Issuer issues $10 million of bonds to finance the construction of a community center. Issuer later sells the center for $5 million, its fair market value. At this time, all $10 million of the bonds are still outstanding. The issuer may choose to remediate by using all $5 million of disposition proceeds to redeem within 90 days or establish a defeasance escrow for a pro rata portion of the $10 million of nonqualified bonds. The remaining outstanding $5 million of bonds would not be private activity bonds because the issuer has remediated as required by the Regulations.

Or, the issuer could remediate by using the alternative use of disposition proceeds option. Under this option, the issuer must apply the total amount of disposition proceeds, $5 million, to a qualifying alternative use within two years (or use a combination of the alternative use of disposition proceeds and redemption or defeasance options).

The disposition proceeds are considered gross proceeds of the bonds and as such are subject to the applicable yield restriction and arbitrage rebate rules pending their use as described above.

Example 2.- Disposition proceeds are greater than the principal amount of the outstanding bonds allocated to the sold property.

Issuer issues $10 million of bonds to finance a school and land. Issuer subsequently sells a portion of the land for $3 million. At this time, all $10 million of the bonds are still outstanding. The principal amount of outstanding bonds allocated to the sold property is $2 million. If the issuer chooses to remediate by redeeming bonds, it must redeem $2 million of outstanding bonds leaving the issuer with $1 million of gross proceeds.

Or, the issuer could remediate by using the alternative use of disposition proceeds option. If so, the Issuer must apply the total amount of the disposition proceeds, $3 million, to a qualifying use within two years (or use a combination of the alternative use of disposition proceeds and redemption or defeasance options).

The disposition proceeds are considered gross proceeds of the bonds and as such are subject to the applicable yield restriction and arbitrage rebate rules pending their use as described above.

Example 3. - Disposition proceeds are greater than the principal amount of the outstanding bonds allocated to the sold property and the conduit borrower finances the project in part with tax-exempt bond proceeds and in part with an equity contribution.

A 501(c)(3) conduit borrower contributed $4 million of cash from its revenues and used $6 million of tax-exempt bonds to finance a $10 million acquisition of a continuing care facility. Subsequently, the conduit borrower sells the facility for $12 million. At this time, all $6 million of the bonds are still outstanding. Thus the issuer has $6 million of nonqualified bonds. The issuer may remediate by either redeeming all of the $6 million nonqualified bonds or by requiring the conduit borrower to use $12 million of disposition proceeds for an alternative use within two years (provided all requirements of qualified 501(c)(3) bonds are met).

Of the $12 million of disposition proceeds, $6 million are considered gross proceeds of the bonds and as such are subject to the applicable yield restriction and arbitrage rebate rules pending their use as described above.

Gross Proceeds - Example 2 versus Example 3

When the tax-exempt bond financed property is sold for an amount in excess of the principal amount of the outstanding bonds allocated to that property, a different result occurs with respect to that excess amount depending on whether all the bonds of the issue have been redeemed. In Example 3, where the issuer redeemed all of the outstanding bonds, the remaining disposition proceeds are not gross proceeds of the bonds and, therefore, are no longer subject to the federal tax restrictions. This is because the amount of gross proceeds cannot exceed the amount of the outstanding bonds of the issue. Whereas in Example 2, although the issuer has redeemed the nonqualified bonds, the issuer still has bonds of the issue outstanding and thus the additional disposition proceeds are gross proceeds of the bonds and subject to the applicable yield restriction and arbitrage rebate rules pending their use.

Correction of Violations Using TEB Voluntary Closing Agreement Program (VCAP)

If an issuer or conduit borrower discovers that it has sold bond financed assets causing the applicable private business tests to be met but is ineligible to self-correct through a remedial action provision, TEB encourages the issuer to take advantage of its Voluntary Closing Agreement Program (TEB VCAP) to resolve federal tax violations relating to bonds as described in Notice 2008-31 and IRM section 7.2.3.

Page Last Reviewed or Updated: 04-Sep-2013

The Tax Return Forms

Tax return forms 4. Tax return forms   Special Situations Table of Contents Condominiums CooperativesDepreciation Property Changed to Rental UseBasis of Property Changed to Rental Use Figuring the Depreciation Deduction Renting Part of Property Not Rented for ProfitPostponing decision. Tax return forms Example—Property Changed to Rental Use This chapter discusses some rental real estate activities that are subject to additional rules. Tax return forms Condominiums A condominium is most often a dwelling unit in a multi-unit building, but can also take other forms, such as a townhouse or garden apartment. Tax return forms If you own a condominium, you also own a share of the common elements, such as land, lobbies, elevators, and service areas. Tax return forms You and the other condominium owners may pay dues or assessments to a special corporation that is organized to take care of the common elements. Tax return forms Special rules apply if you rent your condominium to others. Tax return forms You can deduct as rental expenses all the expenses discussed in chapters 1 and 2. Tax return forms In addition, you can deduct any dues or assessments paid for maintenance of the common elements. Tax return forms You cannot deduct special assessments you pay to a condominium management corporation for improvements. Tax return forms However, you may be able to recover your share of the cost of any improvement by taking depreciation. Tax return forms Cooperatives If you live in a cooperative, you do not own your apartment. Tax return forms Instead, a corporation owns the apartments and you are a tenant-stockholder in the cooperative housing corporation. Tax return forms If you rent your apartment to others, you usually can deduct, as a rental expense, all the maintenance fees you pay to the cooperative housing corporation. Tax return forms In addition to the maintenance fees paid to the cooperative housing corporation, you can deduct your direct payments for repairs, upkeep, and other rental expenses, including interest paid on a loan used to buy your stock in the corporation. Tax return forms Depreciation You will be depreciating your stock in the corporation rather than the apartment itself. Tax return forms Figure your depreciation deduction as follows. Tax return forms Figure the depreciation for all the depreciable real property owned by the corporation. Tax return forms (Depreciation methods are discussed in chapter 2 of this publication and Publication 946. Tax return forms ) If you bought your cooperative stock after its first offering, figure the depreciable basis of this property as follows. Tax return forms Multiply your cost per share by the total number of outstanding shares. Tax return forms Add to the amount figured in (a) any mortgage debt on the property on the date you bought the stock. Tax return forms Subtract from the amount figured in (b) any mortgage debt that is not for the depreciable real property, such as the part for the land. Tax return forms Subtract from the amount figured in (1) any depreciation for space owned by the corporation that can be rented but cannot be lived in by tenant-stockholders. Tax return forms Divide the number of your shares of stock by the total number of shares outstanding, including any shares held by the corporation. Tax return forms Multiply the result of (2) by the percentage you figured in (3). Tax return forms This is your depreciation on the stock. Tax return forms Your depreciation deduction for the year cannot be more than the part of your adjusted basis (defined in chapter 2) in the stock of the corporation that is allocable to your rental property. Tax return forms Payments added to capital account. Tax return forms   Payments earmarked for a capital asset or improvement, or otherwise charged to the corporation's capital account are added to the basis of your stock in the corporation. Tax return forms For example, you cannot deduct a payment used to pave a community parking lot, install a new roof, or pay the principal of the corporation's mortgage. Tax return forms   Treat as a capital cost the amount you were assessed for capital items. Tax return forms This cannot be more than the amount by which your payments to the corporation exceeded your share of the corporation's mortgage interest and real estate taxes. Tax return forms   Your share of interest and taxes is the amount the corporation elected to allocate to you, if it reasonably reflects those expenses for your apartment. Tax return forms Otherwise, figure your share in the following manner. Tax return forms Divide the number of your shares of stock by the total number of shares outstanding, including any shares held by the corporation. Tax return forms Multiply the corporation's deductible interest by the number you figured in (1). Tax return forms This is your share of the interest. Tax return forms Multiply the corporation's deductible taxes by the number you figured in (1). Tax return forms This is your share of the taxes. Tax return forms Property Changed to Rental Use If you change your home or other property (or a part of it) to rental use at any time other than the beginning of your tax year, you must divide yearly expenses, such as taxes and insurance, between rental use and personal use. Tax return forms You can deduct as rental expenses only the part of the expense that is for the part of the year the property was used or held for rental purposes. Tax return forms You cannot deduct depreciation or insurance for the part of the year the property was held for personal use. Tax return forms However, you can include the home mortgage interest, qualified mortgage insurance premiums, and real estate tax expenses for the part of the year the property was held for personal use as an itemized deduction on Schedule A (Form 1040). Tax return forms Example. Tax return forms Your tax year is the calendar year. Tax return forms You moved from your home in May and started renting it out on June 1. Tax return forms You can deduct as rental expenses seven-twelfths of your yearly expenses, such as taxes and insurance. Tax return forms Starting with June, you can deduct as rental expenses the amounts you pay for items generally billed monthly, such as utilities. Tax return forms When figuring depreciation, treat the property as placed in service on June 1. Tax return forms Basis of Property Changed to Rental Use When you change property you held for personal use to rental use (for example, you rent your former home), the basis for depreciation will be the lesser of fair market value or adjusted basis on the date of conversion. Tax return forms Fair market value. Tax return forms   This is the price at which the property would change hands between a willing buyer and a willing seller, neither having to buy or sell, and both having reasonable knowledge of all the relevant facts. Tax return forms Sales of similar property, on or about the same date, may be helpful in figuring the fair market value of the property. Tax return forms Figuring the basis. Tax return forms   The basis for depreciation is the lesser of: The fair market value of the property on the date you changed it to rental use, or Your adjusted basis on the date of the change—that is, your original cost or other basis of the property, plus the cost of permanent additions or improvements since you acquired it, minus deductions for any casualty or theft losses claimed on earlier years' income tax returns and other decreases to basis. Tax return forms For other increases and decreases to basis, see Adjusted Basis in chapter 2. Tax return forms Example. Tax return forms Several years ago you built your home for $140,000 on a lot that cost you $14,000. Tax return forms Before changing the property to rental use this year, you added $28,000 of permanent improvements to the house and claimed a $3,500 casualty loss deduction for damage to the house. Tax return forms Part of the improvements qualified for a $500 residential energy credit, which you claimed on your 2010 tax return. Tax return forms Because land is not depreciable, you can only include the cost of the house when figuring the basis for depreciation. Tax return forms The adjusted basis of the house at the time of the change in its use was $164,000 ($140,000 + $28,000 − $3,500 − $500). Tax return forms On the date of the change in use, your property had a fair market value of $168,000, of which $21,000 was for the land and $147,000 was for the house. Tax return forms The basis for depreciation on the house is the fair market value on the date of the change ($147,000), because it is less than your adjusted basis ($164,000). Tax return forms Cooperatives If you change your cooperative apartment to rental use, figure your allowable depreciation as explained earlier. Tax return forms (Depreciation methods are discussed in chapter 2 of this publication and Publication 946. Tax return forms ) The basis of all the depreciable real property owned by the cooperative housing corporation is the smaller of the following amounts. Tax return forms The fair market value of the property on the date you change your apartment to rental use. Tax return forms This is considered to be the same as the corporation's adjusted basis minus straight line depreciation, unless this value is unrealistic. Tax return forms The corporation's adjusted basis in the property on that date. Tax return forms Do not subtract depreciation when figuring the corporation's adjusted basis. Tax return forms If you bought the stock after its first offering, the corporation's adjusted basis in the property is the amount figured in (1) under Depreciation (under Cooperatives, near the beginning of this chapter). Tax return forms The fair market value of the property is considered to be the same as the corporation's adjusted basis figured in this way minus straight line depreciation, unless the value is unrealistic. Tax return forms Figuring the Depreciation Deduction To figure the deduction, use the depreciation system in effect when you convert your residence to rental use. Tax return forms Generally, that will be MACRS for any conversion after 1986. Tax return forms Treat the property as placed in service on the conversion date. Tax return forms Example. Tax return forms Your converted residence (see previous example under Figuring the basis) was available for rent on August 1. Tax return forms Using Table 2-2d (see chapter 2), the percentage for Year 1 beginning in August is 1. Tax return forms 364% and the depreciation deduction for Year 1 is $2,005 ($147,000 × . Tax return forms 01364). Tax return forms Renting Part of Property If you rent part of your property, you must divide certain expenses between the part of the property used for rental purposes and the part of the property used for personal purposes, as though you actually had two separate pieces of property. Tax return forms You can deduct the expenses related to the part of the property used for rental purposes, such as home mortgage interest, qualified mortgage insurance premiums, and real estate taxes, as rental expenses on Schedule E (Form 1040). Tax return forms You can also deduct as rental expenses a portion of other expenses that normally are nondeductible personal expenses, such as expenses for electricity, or painting the outside of the house. Tax return forms There is no change in the types of expenses deductible for the personal-use part of your property. Tax return forms Generally, these expenses may be deducted only if you itemize your deductions on Schedule A (Form 1040). Tax return forms You cannot deduct any part of the cost of the first phone line even if your tenants have unlimited use of it. Tax return forms You do not have to divide the expenses that belong only to the rental part of your property. Tax return forms For example, if you paint a room that you rent, or if you pay premiums for liability insurance in connection with renting a room in your home, your entire cost is a rental expense. Tax return forms If you install a second phone line strictly for your tenant's use, all of the cost of the second line is deductible as a rental expense. Tax return forms You can deduct depreciation on the part of the house used for rental purposes as well as on the furniture and equipment you use for rental purposes. Tax return forms How to divide expenses. Tax return forms   If an expense is for both rental use and personal use, such as mortgage interest or heat for the entire house, you must divide the expense between rental use and personal use. Tax return forms You can use any reasonable method for dividing the expense. Tax return forms It may be reasonable to divide the cost of some items (for example, water) based on the number of people using them. Tax return forms The two most common methods for dividing an expense are (1) the number of rooms in your home, and (2) the square footage of your home. Tax return forms Example. Tax return forms You rent a room in your house. Tax return forms The room is 12 × 15 feet, or 180 square feet. Tax return forms Your entire house has 1,800 square feet of floor space. Tax return forms You can deduct as a rental expense 10% of any expense that must be divided between rental use and personal use. Tax return forms If your heating bill for the year for the entire house was $600, $60 ($600 × . Tax return forms 10) is a rental expense. Tax return forms The balance, $540, is a personal expense that you cannot deduct. Tax return forms Duplex. Tax return forms   A common situation is the duplex where you live in one unit and rent out the other. Tax return forms Certain expenses apply to the entire property, such as mortgage interest and real estate taxes, and must be split to determine rental and personal expenses. Tax return forms Example. Tax return forms You own a duplex and live in one half, renting the other half. Tax return forms Both units are approximately the same size. Tax return forms Last year, you paid a total of $10,000 mortgage interest and $2,000 real estate taxes for the entire property. Tax return forms You can deduct $5,000 mortgage interest and $1,000 real estate taxes on Schedule E (Form 1040), and if you itemize your deductions, you can deduct the other $5,000 mortgage interest and $1,000 real estate taxes on Schedule A (Form 1040). Tax return forms Not Rented for Profit If you do not rent your property to make a profit, you can deduct your rental expenses only up to the amount of your rental income. Tax return forms You cannot deduct a loss or carry forward to the next year any rental expenses that are more than your rental income for the year. Tax return forms Where to report. Tax return forms   Report your not-for-profit rental income on Form 1040 or 1040NR, line 21. Tax return forms For example, if you are filing Form 1040, you can include your mortgage interest and any qualified mortgage insurance premiums (if you use the property as your main home or second home), real estate taxes, and casualty losses on the appropriate lines of Schedule A (Form 1040) if you itemize your deductions. Tax return forms   If you itemize your deductions, claim your other rental expenses, subject to the rules explained in chapter 1 of Publication 535, as miscellaneous itemized deductions on Schedule A (Form 1040), line 23, or Schedule A (Form 1040NR), line 9. Tax return forms You can deduct these expenses only if they, together with certain other miscellaneous itemized deductions, total more than 2% of your adjusted gross income. Tax return forms Presumption of profit. Tax return forms   If your rental income is more than your rental expenses for at least 3 years out of a period of 5 consecutive years, you are presumed to be renting your property to make a profit. Tax return forms Postponing decision. Tax return forms   If you are starting your rental activity and do not have 3 years showing a profit, you can elect to have the presumption made after you have the 5 years of experience required by the test. Tax return forms You may choose to postpone the decision of whether the rental is for profit by filing Form 5213. Tax return forms You must file Form 5213 within 3 years after the due date of your return (determined without extensions) for the year in which you first carried on the activity or, if earlier, within 60 days after receiving written notice from the Internal Revenue Service proposing to disallow deductions attributable to the activity. Tax return forms More information. Tax return forms   For more information about the rules for an activity not engaged in for profit, see Not-for-Profit Activities in chapter 1 of Publication 535. Tax return forms Example—Property Changed to Rental Use In January, Eileen Johnson bought a condominium apartment to live in. Tax return forms Instead of selling the house she had been living in, she decided to change it to rental property. Tax return forms Eileen selected a tenant and started renting the house on February 1. Tax return forms Eileen charges $750 a month for rent and collects it herself. Tax return forms Eileen also received a $750 security deposit from her tenant. Tax return forms Because she plans to return it to her tenant at the end of the lease, she does not include it in her income. Tax return forms Her rental expenses for the year are as follows. Tax return forms   Mortgage interest $1,800     Fire insurance (1-year policy) 100     Miscellaneous repairs (after renting) 297     Real estate taxes imposed and paid 1,200   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. Tax return forms She can deduct eleven-twelfths of these expenses as rental expenses. Tax return forms She can include the balance of the allowable taxes and mortgage interest on Schedule A (Form 1040) if she itemizes. Tax return forms She cannot deduct the balance of the fire insurance because it is a personal expense. Tax return forms Eileen bought this house in 1984 for $35,000. Tax return forms Her property tax was based on assessed values of $10,000 for the land and $25,000 for the house. Tax return forms Before changing it to rental property, Eileen added several improvements to the house. Tax return forms She figures her adjusted basis as follows:   Improvements Cost     House $25,000     Remodeled kitchen 4,200     Recreation room 5,800     New roof 1,600     Patio and deck 2,400     Adjusted basis $39,000   On February 1, when Eileen changed her house to rental property, the property had a fair market value of $152,000. Tax return forms Of this amount, $35,000 was for the land and $117,000 was for the house. Tax return forms 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. Tax return forms As specified for residential rental property, Eileen must use the straight line method of depreciation over the GDS or ADS recovery period. Tax return forms She chooses the GDS recovery period of 27. Tax return forms 5 years. Tax return forms She uses Table 2-2d to find her depreciation percentage. Tax return forms Since she placed the property in service in February, the percentage is 3. Tax return forms 182%. Tax return forms On April 1, Eileen bought a new dishwasher for the rental property at a cost of $425. Tax return forms The dishwasher is personal property used in a rental real estate activity, which has a 5-year recovery period. Tax return forms She uses Table 2-2a to find the percentage for Year 1 under “Half-year convention” (20%) to figure her depreciation deduction. Tax return forms On May 1, Eileen paid $4,000 to have a furnace installed in the house. Tax return forms The furnace is residential rental property. Tax return forms Because she placed the property in service in May, the percentage from Table 2-2d is 2. Tax return forms 273%. Tax return forms Eileen figures her net rental income or loss for the house as follows: Total rental income received  ($750 × 11) $8,250 Minus: Expenses     Mortgage interest ($1,800 × 11/12) $1,650   Fire insurance ($100 × 11/12) 92   Miscellaneous repairs 297   Real estate taxes ($1,200 × 11/12) 1,100   Total expenses 3,139 Balance $5,111 Minus: Depreciation     House ($39,000 × . Tax return forms 03182) $1,241   Dishwasher ($425 × . Tax return forms 20) 85   Furnace ($4,000 × . Tax return forms 02273) 91   Total depreciation 1,417 Net rental income for house   $3,694       Eileen uses Schedule E, Part I, to report her rental income and expenses. Tax return forms She enters her income, expenses, and depreciation for the house in the column for Property A. Tax return forms Since all property was placed in service this year, Eileen must use Form 4562 to figure the depreciation. Tax return forms See the Instructions for Form 4562 for more information on preparing the form. 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