According to IRS Publication 527, Residential Rental Property, if you rent a property that you also use personally, the rules for personal use of a dwelling unit may apply and the rental expenses you can deduct may be limited. Your deductible expenses would be limited to the amount of rental income you have. In other words, you could not offset a loss on the rental against other income you report on your tax return. You can carry forward your excess rent expenses to the following year, but they would be subject to the same limitation – your rental income for that year.
You are considered to use the property personally if a member of your family uses the property. Family members for this purpose include your spouse, brothers and sisters, half-brothers and half-sisters, ancestors (parents, grandparents, etc.), and descendants (children, grandchildren, etc.). But this does not apply if the family member uses the property as his or her main home and pays a fair rental price.
According to the IRS, a fair rental price could be determined by comparing your property with similar properties in your area. Some considerations include whether the property is used for the same purpose, is approximately the same size and in the same condition, has similar furnishings and is in a similar location.
If the family member also has an interest in the property, the use of the property would be considered personal use unless the family member uses the property as his or her main home and you rent the property to that family member under a shared equity financing agreement. This is an agreement by which you and one or more other persons acquire undivided interests for more than 50 years in the property and one or more of the owners is entitled to occupy the property as his or her main home by paying rent to the other owner or owners.
So, if you rent the property to a family member who uses the home as his or her main home and pays you a fair rental price, the rental would generally not be considered personal use by you. You could deduct rent expenses that exceed your rental income, subject to the passive activity limits. Generally you can only offset losses from passive activities against other passive income. But there is an exception if you actively participate in the rental activity.
According to the IRS, you actively participate if you own at least 10% of the property and you make management decisions such as approving new tenants, deciding on rental terms, collecting rent, approving expenditures, and arranging for others to provide services such as repairs. If you actively participate, you can offset rental losses up to a maximum special allowance. The special allowance is $25,000 if you are single or married filing jointly, and $12,500 if married filing separately. This special allowance is phased out if your modified adjusted gross income is more than $100,000 ($50,000 if married filing separately) and generally if your modified adjusted gross income is more than $150,000 ($75,000 if married filing separately), there is no special allowance.
If you are not renting your property for profit, you can deduct your rental expenses only up to the amount of your rental income. You cannot deduct a loss or carry forward rent expenses to the following year. In this case you would report your rental income as other income on Form 1040 or 1040NR. You could deduct mortgage interest, qualified mortgage insurance premiums, real estate taxes and any casualty losses on Schedule A if you itemize deductions. Your other rent expenses would be deductible as miscellaneous itemized deductions to the extent they exceed 2% of your adjusted gross income.
There is a presumption that you are renting the property for profit if your rental income has been more than your rent expenses for 3 years out of a period of 5 consecutive years. If you are just starting to rent the property you can elect to have this presumption made after you complete the 5-year period. To make this election you need to file Form 5213 within 3 years from the due date for filing your tax return for the year you first rented the property. If you receive a notice from the IRS proposing to disallow your rent expense deductions, you must file Form 5213 within 60 days.
Form 5213 – Election to Postpone Determination as To Whether the Presumption Applies That an Activity is Engaged in for Profit
Publication 527 – Residential Rental Property – IRS