Employees often elect to rent their homes rather than sell them while on temporary domestic or international assignment. In the poor housing market that has existed in recent years, employees who are permanently relocated also increasingly are renting out their old home, either waiting for the market to improve or because they have negative equity or otherwise cannot afford to sell. There are a number of tax implications, which should be considered by companies when recruiting or relocating an employee who may choose to rent out the old home.
If the company pays fix-up costs so that the house can be rented, these must be included in gross income of the employee. Because the costs are not administratively difficult to account for, they do not qualify as de minimis fringes under Code §132 even if the fix-up costs are small amounts. The costs are subject to withholding and payroll taxes, and includable on the W-2. The same is true of property management services, if paid for by the employer.
Ordinarily, subject to the discussion below, the employee treats the house as a rental property and deducts associated expenses, such as interest, taxes, maintenance, upkeep, and depreciation. Rental income is taxable, and offset by the expenses. The employee files IRS Schedule E with the tax return. However, some companies will pay rental “make-up” payments to the employee for periods the home is not rented. Such payments are not rent, but are treated as additional wages for tax purposes.
The employee will have to determine whether any fix-up expenses are ordinary maintenance deductible as repairs, on whether those fix-up costs are in the nature of a capital expenditure—a new roof, for example-which would be treated as adding significantly to the useful life of the property and not currently deductible. Normally, costs treated as capital improvements would be deductible only over time through depreciation or cost recovery deductions.
Deductibility of rental property expenses by the employee also may be subject to the section 469 limitation on the deductibility of ‘‘passive activity losses.’’ Because any rental activity is deemed to be a passive activity, if the aggregate annual deductions from all passive activities exceed the aggregate income, the resulting loss (created by the deductions) may be disallowed. An exception is provided for $25,000 of losses from rental real estate activities in which the taxpayer was an active participant. This exception phases out, however, for taxpayers with adjusted gross income (AGI) between $100,000 and $150,000 and is eliminated if AGI exceeds $150,000. Generally, taxpayers who employ a rental management company will not be considered “active participants.”
In the Small Business Jobs Act of 2010 (H.R. 5297) Congress added section 6041(h), under which individuals who rent out their property are considered to be engaged in a trade or business for purposes of information reporting, and starting in 2011 must provide Forms 1099 to individuals who provide services to them aggregating over $600 during the year in connection with the rental. Beginning in 2012, Forms 1099 also must be provided to corporations, and for receipt of goods for which payments aggregate over $600. Consequently, employees renting out their home may be responsible for providing Forms 1099 to persons who perform maintenance, property management, repairs, and the like. However, the provision does not apply to individuals who are temporarily renting out their principal residence (within the meaning of section 121), and the Treasury also is given authority to establish a minimal amount of rental income that may be received without triggering the reporting requirement, and to exempt individuals for whom the requirement would be a hardship. Worldwide ERC® has filed comments with Treasury and IRS asking them to exempt rentals by employees of their principal residence while they are on an assignment from which they intend to return to the home, or during any period after their relocation during which they could still exclude gain if the home were sold.
When the employee does eventually sell the residence, the applicability of the homesale capital gains exclusion of section 121 also will have to be considered. Fortunately, rental has no immediate effect on the availability of the full homesale capital gains exclusion. Section 121(a) requires only that the home have been owned and used as the principal residence for periods aggregating two years during the five years preceding sale. Consequently, if an employee owns and uses a home for two years as the principal residence, and then decides to rent it out after a relocation, the employee will still be entitled to the full $250,000 exclusion ($500,000 married filing jointly) if the home is sold during the first three years of rental. The fact that the home has been turned into a rental property is not relevant. See section 1.121-1(c)(4), Example 1, of the regulations.
The only impact of rental is that any depreciation claimed during the rental period will reduce the excludable capital gain, and will be subject to tax.
Even if the employee has not already met the two year ownership and use rule at the time rental begins, the employee still may be entitled to a partial exclusion. For example, suppose an employee bought a house in June 2008, lived in it until June 2009, was then relocated and decided to rent out the old residence. Section 121(c)(2) allows a partial exclusion if failure to meet the two-year ownership and use rule is by reason of a change in place of employment, health, or unforeseen circumstances. The regulations expand on this requirement. Section 1.121-3(b) says that the “primary reason” for the sale or exchange must be one of the enumerated circumstances, and that the issue is one of facts and circumstances unless one of the “safe harbors” set forth in the regulations is met. Section 1.121-3(c)(2) provides a “distance safe harbor” under which the primary reason for the sale is considered to be by reason of a change in place of employment if the change in place of employment occurs while the taxpayer owns and uses the property as the principal residence and the new place of employment meets the moving expense deduction 50-mile rule.
Under this test, the fact that the sale of the home occurs some time after the change in place of employment does not appear to be relevant. That is, if the taxpayer leaves the principal residence as a result of an employment-related move that meets the section 217 distance requirement, under the safe harbor the eventual sale is apparently deemed to be primarily as a result of the move even if the sale takes place later.
The same reasoning would appear to apply in the case of an employee who meets the two-year ownership and use rule at the time of the move, but then rents out the home for more than three years before sale. The employee will at most qualify for a partial exclusion, and only if the employee meets the “change in place of employment rules” discussed above. The change in place of employment “safe harbor” would literally apply (the employee was using the home as the principal residence at the time of the move, and the move met the 50-mile rule), so there is a good case for a partial exclusion.
Nevertheless, it is not clear whether IRS would agree that a sale after some four years of rental following a permanent move is automatically considered to be due “primarily” to the move, particularly if an employee has purchased a new home in the new location and has no obvious intention ever to re-occupy the original home. For example, section 1.121-3(be)(1) of the regulations recites the proximity in time of the sale or exchange and the circumstances giving rise to it as a factor in determining whether the circumstances were the primary reason for sale. It could be argued that although the cessation of use of the home as the principal residence was due to the move, the sale itself was motivated by factors that arose subsequently. Consequently, employees who choose to rent out their home following a permanent move should be careful to document the reasons they did not sell it at the time of the move, and why long-term rental was an appropriate or necessary alternative for the period during which the home was rented. As the period of rental lengthens, the argument for the capital gain exclusion may grow more difficult unless the employee still satisfies the two-year ownership and use rule.
Finally, any employee who received a homebuyer credit when the home was purchased will have to pay it back with their first tax return after the home becomes a rental property. Section 36(of) of the Code requires that the entire credit, which may be as much as $8,000, must be repaid under certain circumstances. These circumstances include the taxpayer ceasing to use the home as the taxpayer’s principal residence at any time within three years of its purchase. See section 36(f)(4)(D)(ii). When the home is rented out, it is no longer the employee’s principal residence, and the homebuyer credit must be repaid.
This article deals only with the tax issues faced by those who choose to rent. There are also non-tax considerations that would need to be addressed. For example, homeowner insurance usually does not cover a home that is used as a rental property, and generally will need to be changed to cover rental. This will add expense. In addition, some mortgages specify that the property must be owner-occupied. In such cases, the employee will have to deal with the lender to seek a modification or other accommodation. And of course there are policy issues that must be addressed, including the extent to which the company is willing to subsidize the rental activity, whether a homesale benefit eventually will be offered, and whether the employee is one who will deal effectively with the distraction of having a home that constantly requires attention in the old location.
In summary, there are a host of tax and other considerations that come into play when a transferee or recruit decides to rent out the old home instead of selling. Companies would be well advised to make sure that such employees receive appropriate advice before deciding to become landlords.
Peter K. Scott is tax counsel for Worldwide ERC®, Arlington, VA. He can be reached at +1 703 893 8566 or e-mail
pscott@worldwideerc.org.
Richard Mansfield is general counsel for Worldwide ERC®, Arlington, VA. He can be reached at +1 703 842 3428 or
e-mail rmansfield@worldwideerc.org.