The chameleon character of interest expense during the rental of a residence.

• Author: Leaman, Richard S.

A significant tax savings opportunity can arise if a taxpayer rents out his personal residence (e.g., due to acceptance of a temporary work assignment away from home) while making payments on a mortgage on the property. The tax savings hinge on the classification and deductibility of the mortgage interest. Generally under Sec. 163(h)(3), "qualified residence interest" (QRI) is an itemized deduction on Schedule A. However, taxpayers have deducted interest expense incurred during a rental period in at least three different ways:

* As passive activity interest (PAI) on Schedule E.

* As QRI on Schedule A.

* As QRI on Schedule E.(1)

Methods of Reporting

Under the first method, the interest is treated as PAI from a rental activity, subject to the Sec. 469 passive activity loss (PAL) rules. Thus, the expenses are reported on Form 8582, Passive Activity Loss Limitations, and are deducted on Schedule E to the extent allowed by Sec. 469.

Some taxpayers have taken the position that Sec. 469(j)(7) excludes QRI from the PAL rules; thus, they deduct QRI in full on Schedule A, while reporting other expenses and income attributable to the rental as from a passive activity. This position significantly decreases the amount of PAL (or may create passive activity income) for each tax year the residence is rented. Such a position may allow formerly limited PALs to be currently deductible. Nevertheless, the QRI may be subject to the Sec. 68(a) 3% phaseout of itemized deductions.

The third position is reporting all rental income and expenses (other than interest) on Form 8582, and deducting the interest as QRI on Schedule E.(2) This position also decreases the tax-payer's PAL and/or increases passive activity income; however, the deduction of the interest on Schedule E reduces the taxpayer's adjusted gross income (AGI) for the current year and is not limited by the 3% phaseout.(3)

Assuming that a taxpayer has other PALs and/or high AGI, the treatment of mortgage interest on the rental of one's residence can significantly affect tax liability. See the comprehensive example on pages 392-395.

Which of the three reporting methods is correct? Under a strict reading of the Code and regulations, there appears to be more than one way of reporting such interest.(4) Depending on the facts and circumstances, there may be substantial authority to support the third or the first position--both of which allow the interest deduction to be taken on Schedule E. The third position is the most favorable from a taxpayer standpoint, because the interest expense reduces AGI and is deductible without regard to the PAL rules.(5)

The Origin of the Problem

In general, Sec. 469(c)(2) subjects any rental activity to the PAL rules. However, Sec. 469(j)(10) provides that if Sec. 280A(c)(5) applies to the rental of the taxpayer's residence, Sec. 469 does not apply, and Sec. 280A controls the deduction of all related expenses.

Sec. 280A(c)(5) generally limits deductions attributable to rental use when a taxpayer uses a residence for personal use and rents it during the same tax year. Thus, if a taxpayer uses a dwelling unit as a residence during the tax year and Sec. 280A(c)(5) limits the deductions attributable to rental use, Sec. 469 will not apply. If Sec. 280A(c)(5) applies, an allocation of expenses between rental and personal use is required, and any loss attributable to the rental use is disallowed and carried over to the next year.

However, Sec. 280A(d)(4) provides that if the dwelling unit was used as a residence for any day during the tax year that occurs before or after a "qualified rental period" (QRP), Sec. 280A(c)(5) does not apply; thus, under Sec. 469(c)(2), rental of the principal residence will be subject to the PAL rules. Sec. 469(j)(7) provides that PALs are computed without regard to QRI.

Sec. 280A(d)(4)(B) defines a QRP as a consecutive period of (1) 12 or more months that begins or ends in such tax year, or (2) less than 12 months that begins in such tax year and ends with the sale or exchange of the residence, for which the unit is rented, or held for rental, at fair market value (FMV).

Example: A's employer plans to transfer A to a new work location on Aug. 1, 1995, for 12 months. A rents out his principal residence under a one-year lease beginning Aug. 1, 1995. The rental period is a consecutive period of 12 or more months, so that it is a QRP under Sec. 280A(d)(4)(B)(i). Thus, A's personal use of the residence from Jan. 1-July 30, 1995 will not count as personal use under Sec. 280A(c)(5). Thus, Sec. 280A does not apply, and the rental income and expenses will be subject to Sec. 469.

QRI

The first issue, then, is whether interest paid on the rental is QRI. If QRI exists...