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This column summarizes the federal income tax treatment of vacation homes that might be rented out some to third parties during the year, but are still classified as personal residences under the tax rules. If you vacation property falls into that category, here’s what you need to know about the tax implications.
If you don’t rent the place out at all
If you own a vacation property that you don’t rent out at all during the year, it’s treated as a personal residence for federal income tax purposes. Changes made by the Tax Cuts and Jobs Act (TCJA) can negatively affect your allowable itemized deductions for mortgage interest and property taxes. For details, read more here.
Special tax break if you rent it out for just a few days
A special federal income tax break is available if you rent out your vacation home for less than 15 days during the year and use it for personal purposes for more than 14 days. In this scenario, which often happens with vacation homes located near major events such as professional golf tournaments, you need not declare a penny of the rental income.
The rental activity is completely disregarded under the tax rules. Strange but true! Report any allowable itemized deductions for mortgage interest and property taxes on Schedule A of your Form 1040. The only drawback is that you get no deductions for other expenses attributable to the rental period, such as advertising and cleaning costs.
Is your vacation home classified as a personal residence or a rental property?
Good question. Assuming your place doesn’t qualify for the aforementioned special break, here’s what the Internal Revenue Code and IRS regulations say about how to classify “mixed-use” vacation properties that have both personal and rental use during the year.
Personal residence
Your place is classified as a personal residence if:
* You rent it out for more than 14 days during the year, and…
* Personal use during the year exceeds the greater of: 1. 14 days or 2. 10% of the days you rent out the home at market rates.
Count only actual days of rental and personal occupancy. Disregard days of vacancy, and disregard days that you spend mainly on repair and maintenance activities.
Personal use generally means use by the owner, certain family members, and any other party (family member or otherwise) who pays less than market rental rates. If your vacation home is used by another person under a reciprocal arrangement (“I use your place and you use mine”), such use is considered personal use.
Example 1: During 2021, your family, other family members, and friends use your beachfront condo for 120 days. You rent the place out to third parties at market rates for 210 days. Since personal use exceeds the greater of: 1. 14 days or 2. 10% of the rental days, the condo is classified as a personal residence for the year, and the tax rules explained in this column apply.
Rental property
Your place is classified as a rental property if:
* You rent it out for more than 14 days during the year, and…
* Personal use during the year does not exceed the greater of: 1. 14 days or 2. 10% of the days you rent out the home at market rates.
Once again, count only actual days of rental and personal use — disregard days of vacancy, and disregard days spent mainly on repair and maintenance activities.
Example 2: During 2021, you rent your beachfront condo to third parties at market rates for 300 days. Your family uses the condo for 30 days. Since personal use does not exceed the greater of: 1. 14 days or 2. 10% of the rental days, the place is classified as a rental property for the year, and a different set of tax rules applies. (I’ll cover them in my next column. )
Tax angles for mixed-use vacation homes classified as personal residences
The fundamental tax principle for a mixed-use vacation home that’s classified as a personal residence is that deductible expenses allocable to the rental activity cannot exceed the gross rental income. In other words, the rental expenses cannot cause a tax loss. Gross rental income is defined as net of direct expenditures to obtain tenants such as commissions paid to realtors or rental agents and advertising expenses.
* Deduct allowable expenses allocable to rental use on Schedule E of your Form 1040.
* Claim itemized deductions for allowable mortgage interest expense and allowable property taxes allocable to personal on Schedule A of Form 1040.
Allocating expenses between personal and rental use
As you can see, you need a procedure to allocate vacation home expenses between personal and rental use. For a property that’s classified as a personal residence, the allocation procedure and tax return treatment are as follows.
Step 1: Allocate qualified residence interest expense from a mortgage taken out to buy or improve your vacation home and property taxes using actual days of rental and personal use. Subject to the TCJA limitations, write off the interest expense and property taxes as itemized deductions on Schedule A.
Key point: In many cases, none of the property taxes allocable to personal use will be deductible on Schedule A, because your annual limitation for itemized state and local property taxes and income taxes ($10,000 or $5,000 if you use married filing separate status) will be soaked up by deductions for state and local property taxes on your main residence and/or deductions for state and local income taxes. Rats!
Step 2: On Schedule E of Form 1040, report 100% of the gross rental income from your vacation home.
Step 3: On Schedule E report the rental-use percentage of mortgage interest that could otherwise be claimed as a Schedule A itemized deduction for qualified residence interest. Ditto for the rental-use percentage of property taxes that could otherwise be claimed as a Schedule A itemized deduction. However, these rental-use expenses cannot exceed the gross rental income from the property. If they exceed gross rental income, claim the excess interest and property taxes as itemized deductions on Schedule A — subject to the TCJA limitations.
Step 4: If there’s any net rental income left on Schedule E after Step 3, offset the income with allowable deductions for other expenses allocable to periods of rental use (property insurance, utilities, maintenance, depreciation, etc.). Note that other expenses allocable to rental use can include mortgage interest that does not meet the definition of qualified residence interest. For instance: interest on a loan that is not secured by your vacation home but the proceeds of which were expended on the vacation home or when the debt limits for itemized qualified residence interest expense deductions are exceeded. However, the other expenses allocable to rental use cannot exceed the remaining rental income after the subtractions in Step 3. To the extent allocable other expenses exceed rental income after Step 3, the excess expenses are disallowed for the current year. Go to Step 4. Other expenses allocable to personal use are nondeductible and have no impact on your tax return.
Step 5: Follow the ordering rule to determine which specific other expenses allocable to rental use are disallowed in Step 4. Under the ordering rule, disallowed expenses consist first of any disallowed depreciation and then a pro-rata portion of any other disallowed expenses. If depreciation is limited, the tax basis of your vacation home is reduced only by the allowed amount, if any.
Step 6: Carry over any disallowed other expenses allocable to rental use from Step 5 to your next tax year. In that year, the expenses are again subject to limitation based on that year’s rental income. Presumably, if you sell the property, you can use any tax gain attributable to the rental-use portion of the property to “free up” prior-year disallowed expenses allocable to rental use.
Example 3: As in Example 1, you use your beachfront condo 120 days for personal purposes during the year and rent it out 210 days. So, the condo is classified as a personal residence for tax purposes. That means you must allocate expenses between personal and rental usage using 120/330 as the personal-use fraction and 210/330 as the rental-use fraction. Then follow the step-by-step tax return procedure explained above.
Planning your vacation usage for the rest of the year
You may be able to micro-manage the number of rental and personal-use days between now and yearend, and your post-pandemic usage pattern may differ from the earlier norm. That usage pattern can potentially result in better or worse tax outcomes, especially when it flips your vacation home from personal residence status to rental property status or vice versa.
For instance, you and family members may be anxious to spend more time at the vacation home and less time in the big city. That could put the property firmly into the personal residence category. If so, adding more personal-use days may increase your itemized deductions for qualified residence interest expense and property taxes. However, if you’re affected by the TCJA limitations on interest and taxes, adding more personal-use days may just result in bigger personal-use allocations of interest and taxes that you can’t write off as itemized deductions because of the TCJA limitations. The tax results will depend on your exact situation. You gotta run the numbers.
Rental demand for your vacation home may be so high that you can’t afford to ignore the opportunity to collect more rental income. That could put your place firmly into the rental-property category. (I’ll explain the tax issues for vacation homes classified as rental properties in my next column.)
The bottom line
As you can see, this vacation home tax stuff can get complicated. Consider hiring a tax pro to advise you on how to get the best results. Meanwhile, please stay tuned for my next column on how handle a vacation home that’s classified as a rental property under the tax rules.
