Vacation Home Tax Rules – Know the Rules, Take Your Vacations, Make Some Money, and Deduct Your Costs (Up to a Point)
If you are considering buying a vacation home that you also rent to others, you may be able to take vacation home tax deductions. The rental income will be offset by your costs and the tax deductions can reduce your tax bill.
Rental Property vs. Vacation Home
There are very different tax rules associated with rental properties and vacation homes.
If you use your dwelling for personal use less than 14 days during the year or less than 10% of the days you rent it out, the IRS considers this dwelling a rental property, NOT a vacation home. You may deduct rental expenses from rental income to determine your net rental income. If expenses exceed income, you may be able to take a loss.
If you use your new dwelling for personal use more than 14 days during the year or more than 10% of the days you rent the unit (whichever is greater), you have a vacation home, subject to its own set of tax rules. Normally, you may deduct rental expenses from rental income, but you may not take losses or apply losses to reduce other types of income (wage, investment, etc.) You must also apply expenses in a certain order.
It is EXTREMELY IMPORTANT that you understand the implications of personal use of rental property (or rental of a dwelling unit). If you don’t consider these issues carefully, you could have some rather unpleasant surprises when it comes to the taxation of rental income while you own the dwelling unit and the taxation of any gain when you sell it.
We have outlined some of the issues, tests, and calculations below. Hopefully, this material will help you begin to consider the tax implications of your vacation home purchase.
Every situation is unique. Give us a call and we can help you do some scenario testing and a little tax planning that could help you realize some significant tax savings.
Rental Unit or Vacation Home?
Below you will find a more detailed discussion regarding the tests to determine the type of dwelling you have – rental unit or vacation home; how you would determine which expenses you can deduct from rental income, and how to calculate the proper amounts of your deductions. To being the process, you must first calculate…
Personal Use Days
- When you rent a dwelling unit that you also retain for personal use and you wish to deduct expenses associated with that unit, you must calculate the number of days during the year it was used for personal use and the number of days it was rented. The IRS (Publication 527) defines a day of personal use as any day the unit was occupied by the following persons:
- You or any other person who owns an interest in it, unless you rent it to another owner as his or her main home under a shared equity financing agreement.
- A member of your family or a member of the family of any other person who owns an interest in it, unless the family member uses the dwelling unit as his or her main home and pays a fair rental price. Family includes only your spouse, brothers and sisters, half-brothers and half-sisters, ancestors (parents, grandparents, etc.), and lineal descendants (children, grandchildren, etc.).
- Anyone under an arrangement that lets you use some other dwelling unit.
- Anyone at less than a fair rental price.
Any days donated to a charity or sold at a fundraising event are also counted as personal use days.
Days you stay in the unit that are used for doing maintenance or repairs are not counted as pesonal days.
Days Rented at a Fair Rental Price
Now you figure the number of days the unit was rented at a fair rental price. The IRS defines fair rental price as the amount a person unrelated to you would be willing to pay.
Tax Treatment of Income and Expenses
The tax treatment of rental income and expenses for a dwelling unit that you use for personal as well as rental purposes depends on whether you use it as your home. We touched on this above.
You use a dwelling unit as a home during the tax year if you use it for personal purposes more than the greater of:
- 14 days, or
- 10% of the total days it is rented to others at a fair rental price.
If you do not meet these criteria, according to the IRS, you do NOT use the dwelling unit as a home. Any rental income earned is passive income and losses are passive losses. There are very complex and special rules associated with passive income and losses. They are not presented as part of this discussion. If you have questions about passive income and losses, please contact us and we will be happy to go through these items with you.
If you meet the criteria of the test above, you have a residence, NOT a rental unit. Calculation of income and losses on this activity are based on a different set of rules than the passive income/loss rules and losses are severely limited.
One Exception to the Use as a Home – Minimal Rental Use
If you rent you home less that 15 days in a year, the income you receive is not treated as rental income. You owe no taxes on this income. You may not deduct any rental-related expenses.
This is the exception used by the folks in Augusta, GA who rent their homes to golfers during the week of The Masters golf tournament. They can pocket the income for renting their homes and pay no taxes on it. This is also true for those who rent out their homes during the furniture market in High Point.
There are other exceptions which are not discussed in these materials.
Calculation Rental Income and Expenses
If you lived in a dwelling unit more that the greater of 15 days or 10% the total days it was rented at a fair rental price, you must include payments as rental income. You may deduct expenses as shown below.
If your expenses exceed your rental income (you have a net loss), you may NOT use this loss to offset any other type of income – passive, investment, or active. You may carry over the net loss to the next tax year to offset the same type of rental income – income from the rental of a home.
You must divide expenses into expenses related to rental use and personal use days. According to IRS Publication 527:
- Any day that the unit is rented at a fair rental price is a day of rental use even if you used the unit for personal purposes that day. (This rule does not apply when determining whether you used the unit as a home.)
- Any day that the unit is available for rent but not actually rented is not a day of rental use.
Example:
Dick and Lizinka’s beach house at Wrightsville beach was available for rent last year. It was rented for a fair market rent from May 15 through June 30 and from July 14 through August 31 – a total of 96 days. Dick and Liz used the property from July 1 through 16 and several other days throughout the year. Their usage totaled 32 days.
Most of their expenses are therefore split – 75% to rental use, 25% to personal use.
Dick had rental income from the beach of $9,000.
Dick and Lizinka had the following expenses related to their beach home:
Mortagage interest 4000
Property taxes 1000
Utilities 400
Repairs 600
Depreciation 6000
Advertising 200
To determine what deductions may be taken against income, you must proceed through the following steps in order.
Step 1 – Calculate deductions for mortgage interest and property taxes:
Seventy five percent of mortgage interest and property taxes can be deducted from rental income = $3,750.
You may use the $1,250 remaining as itemized deductions on Schedule A of Form 1040.
Step 2 – Calculate the direct rental expenses.
Advertising fees are direct rental expensese. The entire $200 is deductible.
Step 3 – Calculate the expenses directly related to operating or maintaining a dwelling unit.
Utilities and repairs are directly related. Seventy five percent of these costs can be deducted = $750.
Step 4 – Deduct the depreciation associated with rental use.
Seventy five percent of the depreciation is associated to rental use = $4,500. Only $4,300 of depreciation expenses can be deducted this year since expenses exceeded revenue. All expenses total $9,200, rent revenue is $9,000. So there is a net loss of $200 which is carried over to the following year.
Remember – net deductions cannot exceed rental income for the year.
Give Us a Call
Well, that was easy…
Well, not so much…
This is a very simple example of the tax rules regarding vacation property and does not cover all situations that may arise. Contact us to go over your particular set of circumstances and avoid the vacation home tax traps.
Confused? The Tax Court has called these rules “exasperatingly convoluted”. Bolton v. Commisioner, 77 T.C. 104, 109 (1981).