Summer is the time for family vacations in the sun, sand and fresh air. It’s also a good time to plan for how your vacation home will be used for the second half of the year.
Should you rent it out more to generate additional cash flow to help cover the expenses? What are the tax consequences of renting? Will you need to plan additional family getaways to maximize your tax benefits? Here are the answers to these frequently asked questions and some other guidance for vacation rental properties with significant personal use.
Personal Days vs. Rental Days
The IRS has different rules for vacation properties depending on how often they’re used personally by the owner compared to how often they’re rented out during the tax year. Personal use includes use by:
- Other family members, whether or not they pay fair market rent, and
- Anyone else who pays less than market rent.
For the purpose of these rules, family members include your spouse, siblings, half-siblings, ancestors (such as parents and grandparents) and lineal descendants (such as children and grandchildren).
Personal use also includes time spent at your property by another party under a reciprocal sharing arrangement, whether or not the other party pays market rent. Under such an arrangement, the parties agree to “swap” properties.
More Than 14 Days of Personal Use, Less Than 15 Days of Rental Use
If you spend more than 14 days this year at your vacation home and rent it for less than 15 days, the tax rules are simple: The property is considered a personal residence, and you don’t need to report any rental income on your tax return. However, this favorable tax treatment also means that you can’t deduct expenses attributable to the rental, such as rental agency fees and cleaning. But you can usually write off all the mortgage interest and property taxes as itemized deductions (subject to the phaseout rule for high-income folks that normally applies to these deductions).
This can be good news if your vacation home happens to be located near a major event, such as a PGA golf tournament or a popular music festival. You may be able to rent it for a short period at above-market rates and pay no federal income tax.
Significant Personal Use Plus More Than 14 Days of Rental Use
The rules are different if your personal use of the vacation home is significant but you also rent it out to unrelated third parties more than a couple of weeks per year. To be considered “significant,” your personal use must exceed the greater of:
- 14 days, or
- 10% of the rental days.
For example, a vacation home that’s rented for 30 days during the year and used by your family for 30 days falls into this category.
These types of properties are treated as personal residences for federal income tax purposes but you must report the rental income. You can deduct interest on up to $1 million worth of mortgage debt on up to two personal residences (or up to $1.1 million if home equity loans are involved). Property taxes are always deductible, no matter how many homes you own (unless you’re subject to the alternative minimum tax).
How do you handle rental income and expenses on these types of properties? Reporting rental items for federal income tax purposes requires a six-step procedure:
- Report 100% of the rental income on your tax return.
- Claim any direct rental expenses, such as rental agency fees and advertising.
- For mortgage interest and property taxes, distinguish between rental and personal use. Count all days the property wasn’t actually rented as personal-use days. For example, say your property is rented for three months during the year, used by your family for two months and vacant for seven months. Allocate 25% (3 divided by 12) of the mortgage interest and taxes to rental use and 75% (9 divided by 12, which includes periods of vacancy) to personal use.
- Deduct as rental expenses the allocable mortgage interest and property taxes from Step 3. (This would be 25% in the previous example.)
- If there’s any net rental income left after Step 4, deduct as rental costs allocable indirect expenses — such as maintenance, utilities, association fees, insurance and depreciation — but only to the point where you zero out the rental income. In allocating indirect expenses, consider only the actual rental and personal-use days and ignore days of vacancy. So, in the previous example, 60% (three months divided by five months) of the maintenance, utilities and so forth is allocable to rental use and 40% (two months divided by five months) is allocable to personal use. The 40% is a nondeductible personal expense. Even so, the bottom line on your rental income and expense tax form will probably be zero, because the rental income will likely be fully offset by deductible expenses.
- Write off the personal-use percentage of mortgage interest and property taxes as an itemized deduction on your return. In the previous example, 75% of mortgage interest and property tax would be allocated to personal use. For property owners in higher tax brackets, mortgage interest and property tax write-offs may be reduced under the phaseout rule.
This six-step procedure usually will allow you to fully deduct all the mortgage interest and property taxes (part as rental expenses and part as itemized deductions) and enough other expenses to cancel out your rental income. Additionally, you’re allowed to carry forward any unused indirect expenses to future years when you can deduct them against rental profits (if you ever have any) or when you sell the property.
Midyear Tax Strategies
For personal residences that are rented out for a significant part of the year, you’re unlikely to have to pay taxes on rental income if you have substantial expenses to deduct — and most vacation home owners do. So, try to rent out your property as much as possible for the rest of the year. That way, you’ll receive more rental income, which is good for cash flow, and you can probably still offset all the rental income with allocable mortgage interest and property taxes, direct rental expenses and indirect expenses.
At the same time, don’t forget to keep using it personally, so the property exceeds the 10%-of-rental-days threshold. Few property owners (or their families and friends) complain about mixing in a few more personal-use days between now and year end.
The rules explained here apply only to vacation homes that are used significantly by you (or your family and friends). For vacation homes that are classified as rental properties, different tax rules apply. Contact your tax professional for more information on tax issues related to renting out your vacation home.