USA taxes: Vacation home deduction rules vs 4562 Form depreciation

Regulations/Tax Issues
1

This is a question specific to how/whether you must enter depreciation for your vacation home on form 4562 if you cannot use depreciation in Schedule E because your rental income won’t allow you to. This is a problem that is specific to vacation homes since it is due to the way you must treat expenses on Schedule E in the case of a vacation home.

It is clear to us (and our tax lawyer) that we need to use Schedule E for our vacation home.

Schedule E has specific instructions that list EXACTLY in which order you may list your expenses. When your rental income is not enough to cancel out all of your expenses, you must stop listing them, in the order required, when you get to $0 net profit.

For us, it means that we do not get to enter any depreciation. However, Turbo Tax still produces a 4562 with the full depreciation amount for the year.

Since the basis for the house changes with the amount of depreciation reported, this could be a problem when we sell the house, if the IRS uses the depreciation reported by 4562s when we sell the house (since that will increase the profit from the sale and increases our long term capital gain taxes).

So, my primary question is: what do we report on Form 4562?

  • The paper depreciation that we did not take in Schedule E,
  • or the $0 amount that we took on Schedule E? And do we need to include a note of explanations?

My secondary question is: How de we get Turbotax to deal with the matter in the right manner?

My guess at this stage is (I am not certain though):

  • if we do not use the depreciation in Schedule E because of rental income limitation, we should not enter a depreciation amount in Form 4562 (or enter $0).
  • this means that we would not be able to e-file since Turbotax insists on filling a 4562 with a full depreciation amount, and we’d have to modify this by hand.

Note: the IRS has a pretty clear worksheet (Worksheet 5.1) In Publication 527 to figure out how you enter your rental deductions in Schedule E for vacation homes. What is not clear is how it relates to Form 4562 and what to enter in Form 4562.