If you own real estate, you know your rental income needs to be reported on your federal income tax return. However, you can usually deduct associated expenses from that rental income. But did you know there is a legal way to earn tax-free rental income?
When is rental income taxable?
If you've ever considered renting out your home for a short period, you should know about a tax rule allowing homeowners to earn rental income tax-free if their property is rented only for up to 14 days in a tax year. (According to the IRS, rental income is "any payment you receive for the use or occupation of property.")
The provision allowing homeowners to exclude rental income earned from renting their personal residence for less than 15 days is in Section 280(A) of the Internal Revenue Code. It got its nickname, “the Masters Rule,” from the annual Augusta National Golf Club tournament in Georgia.
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- Residents rented their properties for the Augusta National Golf Club tournament due to the high demand for accommodations.
- The IRS recognized these temporary rentals as exceptions from regular business activities if they stayed within the 14-day limit, regardless of the amount of rental earnings.
- However, the rise of short-term rental platforms like Airbnb has highlighted the exception in recent years.
The IRS 'Masters rule'
Here’s how it works: You can rent out your personal residence (e.g., primary, secondary, or vacation home) during a significant event, for example, and any money earned from the short-term rental isn’t subject to income tax if the rental period doesn’t exceed 14 days in the tax year. That applies to any amount you charge for the rental.
However, the income generated becomes taxable if you rent your personal residence for more than 14 days in a tax year. As a result, keeping track of your rental days with good documentation is crucial.
If you need clarification on whether your rental situation qualifies for tax-free rental income, it's best to seek advice from a tax professional or an accountant. Ensuring compliance with tax laws is even more critical, given a recent United States Tax Court ruling involving the Masters rule.
Masters rule Tax Court case
A recent (August 2023) U.S. Tax Court case, Sinopoli v. Commissioner, has brought renewed attention to the Masters rule. In this case, a couple rented their homes to their S corporation, attempting to leverage the rule to claim rental deductions while excluding the same income from personal tax.
- The taxpayers claimed substantial deductions of about $290,000, stating that their company held monthly meetings in different residences.
- The Tax Court found insufficient evidence to support the claimed frequency and rental amounts.
- As a result, the court ruled against the taxpayers, ultimately allowing only about $16,500 in deductions.
Why does this matter? The Sinopoli case is a reminder of the importance of following tax laws and regulations. Yes, generally, rental expenses can be deducted, and some rental income isn't taxable under the Master’s rule. However, deductions claimed must always be ordinary, necessary, and reasonable for your business.
In addition, third-party transactions, like those in this case, must be conducted at "arm's length," meaning they should be similar to a market transaction between unrelated parties. The Tax Court determined that the taxpayers’ claimed deductions didn’t meet these fundamental requirements.
Reporting rental income and expenses
Remember that if you’re not dealing with the Master’s rule, rental income is taxable and must be reported on your federal tax return. However, expenses related to the rental property, such as maintenance, repairs, property taxes, and mortgage interest, can be deducted from the rental income, which can lower your tax liability.
Per the IRS, you generally deduct your rental expenses in the year you pay them. You normally report your rental income and expenses on Form 1040 or 1040-SR, Schedule E, Part I.
To take advantage of available tax deductions and credits, it's a good idea to seek guidance from a tax professional. A trusted and qualified professional can help you navigate applicable tax regulations and optimize your tax situation for your rental properties.
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