Tax Consequences of a Vacation Home Rental

Last week we discussed rental properties. Today, we’re talking poo.

No, wait, that was the conversation the doctor had with my five year old this morning. Not pleasant, and made me never want to eat mashed potatoes again.

On the site, we’re discussing something that’s (hopefully) ess smelly: the tax consequences of Vacation Home Rentals.

Handling Those Mountain Views Or Beach Front Properties

My boss recently quit. He bought a beach front condo in Maui, and decided he was sick of renting it to other people. So he picked up his family and moved there full time.

For me, I’d prefer something in the mountains, at least during the summer. I’ve been cooped up in winter condos enough to know that a small condo might turn into The Shining in miniature.

If you ever buy your own vacation home, whether in the mountains or on the beach or Muncie, Indiana, how you use the property affects how you deal with taxes.

In some places you can get two of those three

In some places you can get two of those three

If You Never Rent It Out

Let’s start with the easy items to address. If you never rent out your vacation property, you would get similar deductions as your regular home. Property tax would always be deductible, and your mortgage interest would be deductible as long as (a) this and your primary home are you only properties, and (b) the total mortgage between the two properties is less than $1.1 million. More information on that can be found on the Mortgage Interest Deduction page.

Full Time Rental

If you never use the vacation home rental property, what’s wrong with you? Also, you’re on the wrong page. Head back over to the Rental Property Tax Deductions page.

Some Rental, Some Personal Use

Now let’s get into the good stuff. For most normal, sane people, you’ll buy a vacation home in a place you love, but rent it out while you’re not using it to offset some of the costs. From here on out, we’re going to discuss this scenario, which will need a few more breakouts to make things easier.

Defining Personal Use

While it seems like “personal use” should just be, you know, when you personally use the property. This is tax, though, so it has to get complicated. For vacation home rental purposes, personal use consists of the home being used in any of the following scenarios:

  1. The person who owns the property uses the vacation home
  2. Relatives of the owner use the property, including spouses, brothers, sisters, ancestors, lineal descendants, and spouses of lineal descendants. Note that this is still considered personal use EVEN if you charged for it.
  3. Anybody uses the property under some sort of reciprocal arrangement (i.e. you use my property and I’ll use yours, a.k.a. home swaps). Note that this is still considered personal use EVEN if rent is charged. I know, weird. The IRS just doesn’t want any funny business going on
  4. Used by anybody else when less than the fair rental amount is charged.

For the most part, this really shouldn’t be too tricky, and the scenarios seem pretty straight forward. Where people have gotten in trouble is when they rent the property for less than the fair rental amount (even, in one court case, only $10 less than what the court considered to be the fair rental amount), and when they charge rent to a relative and try to consider it non-personal use. It’s not, even if you were to charge your relative MORE than you’d charge other people.

Okay, now that we know what “personal use” is, the tax effect is different depending on the breakout between rental days and personal use days.

Vacation Home Is Rented For Fewer Than 15 Days

If your vacation home rental is rented out for fewer than 15 days, the IRS considers it completely personal property. You will not have to include any rental income on your tax return (yay), but you also won’t be able to take any rental deductions (boo). Go back up to the “If You Never Rent It Out” section above to see what deductions you can take.

Note that the IRS doesn’t care if you actually use the property during the year for this treatment to apply.

Vacation Home Is Rented More Than 14 Days, Personal Use Is More Than 14 Days (or 10% of Rental Days)

Okay, so you cleared that first hurdle and use the property as a vacation home rental for at least 15 days. The next step is to figure out how often you use the property.

If your personal use of the property is the greater of 14 days or 10% of the rental days (e.g. if you rent it out 300 days, replace “14 days” with “30 days. But you get up to 14 days of personal use, even if you only rent the property out 15 days), the IRS basically treats your vacation home rental as a hobby.

So what does that mean? It means that your rental income does have to be included on your tax return (boo), but you can also take rental deductions (yay). However, your rental deductions are limited to your rental income (boo).

For example, let’s say you rent your home out for 30 days and use the property for 20 days. You gross $3,000 of rental income, and you have rental deductions of $4,000 (more on calculating those deductions later). Under this scenario, you’ll only be able to deduct up to $3,000 of those rental deductions, which is just enough to offset the $3,000 rental income.

Note that this is really the worst case scenario. Unless your rental expenses are always at least as much as your rental income, you’ll have to be reporting rental income on your tax return. On the flip side, you have no possibility of deducting losses that are higher than your rental income.

Vacation Home Is Rented More Than 14 Days, Personal Use Is Less Than 15 Days (or 10% of Rental Days)

This is often the best case scenario. As long as you use the property fewer than 15 days (or 10% of the rental days as explained above), you can take losses on your rental property to offset ordinary income.

Again, I’ve mentioned this in previous posts, but you really shouldn’t get into a transaction JUST to have tax losses. However, if you do have a loss on the property, you have the potential of using the loss to offset some of your ordinary income.

IMPORTANT NOTE: Rental property is considered Passive Income, which falls under other crazy rules. Head back over to my Rental Property page to figure out how all that works.

Calculating The Rental Deduction

Since your using your Vacation Home Rental part time, you won’t be able to use all of your expenses as business expenses. Some of those expenses are personal expenses and can’t be deducted.

Figuring out how what portion of these expenses are treated as rental expenses should be easy, but the Tax Court has gone through and made it harder (though better).

The IRS went with a simple formula: take your total rental days and divide it by your total use days.

Example: Let’s say you have personal use of 13 days and rental use of 30 days, for a total of 43 days of use. If you have $1,200 of utility expenses that year, the IRS says you’d take your rental days divided by your total days and multiply it by the expense, or 30/43 * 1,200 = $837 of rental expense related to utility expenses.

That’s pretty easy, and it’s what you’d use for the vast majority of your expenses. However, the Tax Court rejected this formula for mortgage interest and real estate taxes. They said those two deductions should be use the rental days divided by total days of the year, since the expenses are incurred whether or not the property is in use.

Example: You have 13 days of personal use and 30 days of rental. Your real estate taxes for the year are $2,000. According to the Tax Court, you deduction for real estate taxes would be 30/365 * $2,000 = $164.

Why does this matter? Let’s get to the ordering of the deduction, then I’ll explain.

Ordering Your Deduction

For your Vacation Home Rental deduction, there’s actually an order you can take the deduction. First, you take mortgage interest, real property taxes, and casualty losses attributed to rental use. Next, you can take operating expenses other than depreciation. Lastly, deduct depreciation.

Okay, so let’s put these all together to help it make sense. Really, the only time these items will matter is if you use your property more than 14 days (or 10%) and the hobby rules apply.

If you use the IRS rules, more of the Mortgage Interest and Real Property Taxes will be applied to the rental property, which is limited to the rental income generated. Under the Tax Court rules, you rental expense related to Mortgage Interest and Real Property Taxes will be significantly less, allowing you to use more of your other expenses to offset your rental income.

And what about the remainder of the Mortgage Interest and Real Property Taxes? Those are applied to you personally, can can potentially take them as itemized deductions (subject to the itemized deduction rules for those items).

Wrap Up

Whew, these technical pages are getting long. Hopefully I covered all your questions. If you have more, feel free to ask them in the comments below. Or, as always, ask a CPA or Enrolled Agent.