©The McGraw-Hill Companies, Inc. 2008McGraw-Hill/Irwin Chapter 8 Rental Property, Royalties, and Income From Flow- Through Entities (Line 17, Form 1040 and Schedule E) “There is no simple tax, at least no simple tax that is also fair.” -- Joel Slemrod

8-2 LO #1: Rental Property Income and expense from rental property are generally reported on Schedule E. All ordinary and necessary expenses related to a rental property are deductible.

8-3 LO #1: Rental Property Rental property is depreciated using straight-line depreciation over 27.5 or 39 years. If a taxpayer’s rental property is considered a trade or a business, the related income and expense are reported on Schedule C.

8-4 LO #1: Rental Property Concept Check Rental income is generally reported on Schedule E. True 2. All expenses related to rental property are deductible in the current year, including capital improvements. False 3. Rental property structures must be depreciated using the straight-line method. True

8-5 LO #1: Rental Property Concept Check If a taxpayer’s rental property is considered a trade or a business, she or he reports the income on Schedule E. False 5. If a tenant provides a service in lieu of rent, the taxpayer is not required to report the value of that amount as rental income. False

8-6 LO #2: Rental of Vacation Homes A property that is for both personal use and rental activity falls into one of three categories for tax purposes: –(a) primarily rental, –(b) primarily personal, or –(c) personal/rental.

8-7 LO #2: Rental of Vacation Homes The three categories are based on the number of rental use days versus number of personal use days. If a rental property is primarily personal, no expenses are deductible other than deductions allowed as itemized deductions.

8-8 LO #2: Rental of Vacation Homes If a rental property is primarily rental or personal/rental, the expenses must be allocated between personal and rental. No net loss is allowed if a rental property is considered personal/rental.

8-9 LO #2: Rental of Vacation Homes – Concept Check 8-2 Indicate the correct letter that identifies whether the rental property in the following situations would be classified as (a) primarily rental, (b) primarily personal, or (c) personal/rental. 1. Jamie rented her lake home for $2,000 for 12 days, and she and her family used it for the rest of the year, usually on weekends and holidays. B – primarily personal

8-10 LO #2: Rental of Vacation Homes – Concept Check Julie rented her home in Seal Beach for 180 days for $12,000; she used it for 17 days. A – Primarily Rental 3. Darren rented his beach house for 45 days for $9,000 and stayed there on weekends with his family for a total of 16 days. During his stay, he rebuilt the deck while his family enjoyed the beach. A – Primarily Rental

8-11 LO #2: Rental of Vacation Homes – Concept Check Alex rented her mountain cabin for 90 days for $13,500, and she and her family used it for 50 days. C – Personal/Rental

8-12 LO #2: Rental of Vacation Homes Rental expenses are allocated to a personal/rental property using –The IRS method. Based on the number of days of rental use to the total days used –The Tax Court method. Interest and taxes allocated based on the number of rental days to the number of days in the year. Other expenses allocated using the IRS method.

8-13 LO #2: Rental of Vacation Homes – Concept Check 8-3 Lynn and Dave Wood own a vacation home in Utah. During the year, the Woods rented the home for 75 days and used it for personal use for 30 days. The following are income and expenses related to the property: Rental income$15,000 Mortgage interest$ 6,000 Insurance$ 1,400 Property taxes$ 1,000 Repairs and maintenance $ 800 Depreciation$ 2,000

8-14 LO #2: Rental of Vacation Homes – Concept Check 8-3 Answer the following questions about the Wood’s vacation home: 1. Which of the three categories of rental property would apply to this property and why? Personal/Rental 2. Using the IRS method, how much of the expenses can be allocated to the rental property? $8,571

8-15 LO #2: Rental of Vacation Homes – Concept Check Using the Tax Court method, how much of the expenses can be allocated to the rental property? $5, Using the IRS method, what is the net income or loss that should be reported for tax purposes from this rental property? $6,429

8-16 LO #3: Royalty Income A royalty is a payment for the right to use intangible property. Royalty income is reported on Schedule E.

8-17 LO #3: Royalty Income If a payment is received while performing a service related to the royalty-producing asset or the royalty is a result of a trade or a business, the royalty is reported on Schedule C.

8-18 LO #3: Royalty Income Concept Check 8-4 Indicate whether the following items would be reported on Schedule E (E) or Schedule C (C). 1. Royalty income received by Debra, a full-time author, for her mystery novel. Schedule C 2. Royalty income received by Mark, a professional baseball player, for coal mined on his land in Wyoming. Schedule E

8-19 LO #3: Royalty Income Concept Check Nathan recently wrote a book on proverbs. He received income for his readings at various bookstores throughout the country. Schedule C 4. Royalty income that Jane, a full-time professor at the University of San Diego, received for a textbook she wrote. Schedule E

8-20 LO#4: Flow-Through Entities Partnerships, LLCs, S corporations, trusts, and estates are flow-through entities. Flow-through entities file “informational returns” and provide its owners with Schedule K-1s.

8-21 LO#4: Flow-Through Entities The income and expense from K-1s are reported on the owner’s Schedule E.

8-22 LO#4: Flow-Through Entities Certain limited partnerships and rental activity are considered passive activities and as such, the amounts of net loss that are deductible are limited by the passive activity rules.

8-23 LO#4: Flow-Through Entities Concept Check Flow-through entities allocate an appropriate share of the entity’s income, expenses, or loss to their owners on a Schedule K-1. True 2. Trusts and estates are flow-through entities but the net income is not reported on Schedule E. False

8-24 LO#4: Flow-Through Entities Concept Check Ordinary income from all flow-through entities is considered self-employment income. False 4. Trusts and estates are considered to be flow- through entities and thus file “informational returns” only. False