Personal residence then brother lived there and paid the mortgage. Sold in 2018.

[tamurack]

A client bought a townhome in 4/2013 and lived there until December 2016.  In 2017 his brother lived in the house and paid the mortgage. Last year preparer reported it as a rental.  The townhome sold in May of 2018.  So the owner used it as his personal residence for two of the last 5 years but not for 17 months.  How do I report an exclusion for the part of the time it was used as a personal residence in 2018?

[rbynaker]

Was it rented at fair rental value?  I'm not convinced this should have been a rental property for 2017.

[tamurack]

That is what I was thinking but I hate to question someone else's work.  Especially when the new wife of the client used the CPA for many years.  Can I just file an amended and take off the rental property?  Wouldn't that look suspicious?

[rbynaker]

I'm also not convinced that it shouldn't have been a rental property either. 🙂  See if you can figure out what a comparable place would have rented for.  I'm assuming "paid the mortgage" probably also included escrow which would have covered taxes and insurance.  In some areas that might be comparable.  Have the client consult with a realtor (i.e. the one who just made commission on selling their house).  I think it's fairly easy for them to come up with some comps.

[tamurack]

Been having difficulty with comps of the same size.  Smaller places are renting for 1100/mo and brother paid the mortgage, interest, taxes,HOA, insurance for a total of 835/mo

[Skylane · Accepted solution]

if the brother lived in the house for a year and just covered the mortgage (and maybe insurance and taxes) it doesn't sound like there's any kind of profit motivation. You should check on the points that Rick made.... I assume depreciation was established last year and the sch e resulted in a loss. Personally, I'd amend the 2017 and take the sale of primary exclusion in 2018. I don't think it looks suspicious. It does have to be realistic.

[tamurack]

The schedule E did not result in a loss but they did not take deductions for insurance, HOA   Probably because it was a related party.

[rbynaker]

The related party rules are negated if it's a fair rental amount and the related party uses the property as their principal residence.  So either way seems like amending 2017 is probably in order.  See 280A(d)(3):

https://www.law.cornell.edu/uscode/text/26/280A#d_3

"(3) Rental to family member, etc., for use as principal residence
(A) In general
A taxpayer shall not be treated as using a dwelling unit for personal purposes by reason of a rental arrangement for any period if for such period such dwelling unit is rented, at a fair rental, to any person for use as such person’s principal residence."

The hinge really is fair rental.  Don't try to figure this out yourself, get a third party (realtor) to run some comps.  This gives you the basis for a tax return position, one way or the other.  I'm comfortable with a rental number that's 10% lower than the comp rate.  It's easy to argue that rental to a relative comes with a lower risk and justifiably a lower rent.  In the 10 - 20% discount range we have a conversation about why, and document things, but it's not out of the question.  Beyond 20% discount IMO is a hard sell.

Rick

[tamurack]

Just to clarify.  If it is not a fair rental amount, then he would need to declare the income but not take any of the expenses except as a second home and not do a schedule E?  If it is a fair rental amount, then he should be able to take the other expenses other than taxes and interest such as mileage, HOA, insurance, etc?  Thank you again for your assistance!  

[tamurack]

And should it have been depreciated at all if not at a fair rental amount?

[Skylane]

Did you ask the client if he intended to rent to his brother (for profit) and keep the property long term for the purpose a rental property then and into the future? Or was something else going on? Bro could have needed a place to stay while client was getting it ready to sell or fix up the place for sale or whatever..... lot's of possible situations that wouldn't necessitate setting the property up as a rental and yeah, 'my bro can cover some expenses "(mortgage and maybe insurance and taxes)" while he's staying there instead of having to rent an apartment (or live with owner.... yada yada.... Just because the last preparer decided to treat this as a rental; put an asset in service, etc. doesn't make him/her/it correct.... find out.  If this or something similar was the situation then I've no problem amending the 17 to show as second home and then, if you're within the time frame and the other rules are satisfied, take the sale home exclusion.

[tamurack]

Skylane, thank you for your assistance.  I hope this gives you all the detail you need. Client never intended to keep or rent long term.  The client was married in May of 2017 and moved into wife's house.  The brother lived in the house to save money to follow through with his plan to move out of state.  He set a date to move in early 2018 and the house was put on the market and sold quickly for a gain. If it is shown as a second home, there would be no depreciation and the income received from the brother for "rent" that was used to pay the mortgage, taxes, insurance, and HOA would have to be shown as income? If this is not a rental, there would be no capital gain since it would be client's residence for two of the last 5 years?  If considered a rental, the depreciation would have to be recaptured which would trigger some gain. We are having difficulty finding comps because so many of the places within a close distance are much smaller.  The smaller properties have been renting for about $1100/mo and the brother paid about $835 per month.  

[rbynaker]

Doesn't sound like a fair rental value to me.  How much does it matter?  Depreciation is just a timing difference.  Interest and taxes are probably deductible either way (moved from E to A).  Sounds like the 2 of 5 year rule is met and no non-qualified use.

[Skylane]

i'd amend 2017 as if there rental never occurred with explanation that family member was paying the mortgage. Not a rental situation

[tamurack]

Thank you!  With your help, I have everything I need.

[TaxGuyBill]

Use the "Home Sale Worksheet".

If it was still a rental in 2018, you can 'link' the Asset Entry Worksheet to the Home Sale Worksheet (it is in the disposition section of the Asset Entry Worksheet).

However, you said it was a personal residence in 2018?  Did the client move back into the home?  Did he use it as his Principal Residence in 2018?  Using it as his Principal Residence would trigger the Nonqualified Use rules.

[tamurack]

He did not move back into the home.