Deductions for rental of a room in your house; limitations on business and entertainment business deductions

This column, in slightly different format, originally appeared in The San Francisco Examiner Newspaper, Sunday June 22, 1997.


Note: This exercise is for educational purposes only and is not intended to be legal or tax advice. Your particular facts and circumstances must be considered when applying the U.S. tax law. You should always consult with a competent tax professional with respect to your particular situation.

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Question: I rent out a room in my house. For tax purposes, is this the same as renting a separate apartment?[Answer]

Question: I own my business. May I take friends to dinner or a ballgame without discussing business and deduct the entertainment as a business expense? [Answer]

Answer: No. If you rent out part of your home and use the remaining portion as a residence, your deductions (Form 1040, Schedule E) are limited, because the dwelling is also your residence. In most cases, your deductions cannot exceed the rent you collect (personal use limitation). As a result, you cannot normally offset a net loss from the rental of your residence against other income. Disallowed losses are carried forward to the next taxable year.

Renting out a room in your house, with or without a separate entrance, is subject to this limitation, if the tenant is entitled to use the dwelling's common areas (kitchen, bathrooms, living room or den).

The personal use limitation does not pertain to a completely separate and distinct dwelling unit. I your basement contains basic living accommodations, it will qualify as a separate dwelling unit.

Further, if you occupy your house either before or after a "qualified rental period" the limitation does not apply. In most cases, a qualified rental period is 12 consecutive months when your home is rented or held for rent, at a fair rental. During the qualified rental period, you cannot use your house as a residence

For example, if you vacate your home in 1996 for at least 12 consecutive months and move back in 1997, you will meet the qualified rental period standard for both 1996 and 1997, and will not be subject to the personal use limitation.

If the personal use limitation does not apply, you may deduct your expenses, even though they exceed your rental income, as long as you actively participate in the management of the dwelling (make decisions regarding rent or maintenance).

You are limited to $25,000 in annual losses, provided your adjusted gross income (AGI) is less than $100,000. The deduction is phased out at the rate of $1 for every $2 of AGI over $100,000, resulting in no current deduction for AGI over $150,000. Unused deductions are carried forward.

In short, renting a room or having a roommate where you both enjoy common areas will limit your Schedule E deductions (advertising, maintenance, repairs, depreciation) to the rental income - while a separate and district rental unit will permit losses to exceed income.

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Answer: No. Entertainment expense deductions (including business meals) must directly relate to the active conduct of the taxpayer's business, or directly precede or follow a substantial business discussion.

Usually, the IRS challenges entertainment and business deductions on substantiation requirements, rather than delving into the subjects discussed. Therefore, substantiation is key to proving your entertainment expenses.

To comply, maintain adequate records and record the information at or near the time of the expenditure which contain (1) the amount; (2) time and place of the event; (3) business purpose; and (4) business relationship between the taxpayer and those entertained.

Example: Writing on a credit card receipt for a restaurant meal "John and Jane Smith, clients, Discussed estate planning" adequately substantiates the deduction. Annotating your monthly credit card statements with such information also satisfies this requirement. Using one credit card exclusively for business deductions will ease this accounting.

Likewise, recording in a journal or expense sheet the date and name of the restaurant, cost of the meal, name of your client and the subject matter of the discussion would also meet the test. If the expense exceeds $75 (recently raised from $25), you'll need a receipt from the restaurant or another independent evidence of the expenditure.

Note: Entertainment deductions are limited to 50% of actual costs. Also, membership in any club organized for business, pleasure, recreation or social purpose (country clubs, golf and athletic clubs, airline and hotel clubs) is non-deductible, although expenses incurred at the event remain deductible if they meet the general requirements for an entertainment deduction.

Business leagues, trade associations, chambers of commerce, real estate boards, professional organizations, civic organizations and public service organizations are exempted from this rule.

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**NOTE: The information contained at this site is for educational purposes only and is not intended for any particular person or circumstance. A competent tax professional should always be consulted before utilizing any of the information contained at this site.**