If you own a vacation home, it pays to consider the income tax implications, especially if you plan to use the home for both personal enjoyment and rental income. In some cases, minor adjustments in the way you use the home can reduce your tax bill.
Residence or rental classification
The income tax treatment of a vacation home depends in part on whether it’s classified as a residence or as a rental property. A vacation home is considered a residence if your personal use of the home during a given year exceeds 14 days or 10% of the number of rental days, whichever is greater. So, for example, if you rented out your vacation home for 90 days during the year, your personal use would have to exceed 14 days, because that’s greater than 10% of the rental days. But if you rented it out for 180 days, your personal use would have to exceed 18 days.
This sounds like a simple test, but distinguishing between personal and rental use can be tricky. Personal use includes use by you, your family (including your spouse, siblings, parents, children, grandchildren or other lineal descendants), a co-owner, someone with whom you’ve done a home exchange, or anyone else who doesn’t pay fair market rent.
Use by family members is considered personal even if they pay fair market rent (unless the home is their primary residence). But days that you spend substantially full-time on repairs and maintenance aren’t considered personal use.
When a vacation home is classified as a residence, the number of rental days affects the tax treatment:
- If you rent out the home for less than 15 days a year, the rental income is tax-free. But you won’t be able to deduct any rental expenses. Nevertheless, the tax-free treatment can be a valuable tax break, especially if an important event is held nearby and market rental rates are at a premium.
- If you rent out the home for 15 days or more, you’ll have to report the revenue as income. But you also may be entitled to deduct some or all of your rental expenses.
Regardless of the home’s classification, you have to allocate interest, taxes and other expenses (such as utilities, repairs, maintenance, insurance and depreciation) between personal and rental use. But the home’s classification will affect the deductibility of these expenses:
You can deduct the personal portion of mortgage interest and property taxes as itemized deductions. Generally, you can deduct interest on up to $1 million in acquisition debt on your main residence and a second residence. But note that property taxes aren’t deductible for alternative minimum tax (AMT) purposes, so you could lose that deduction if you’re subject to the AMT.
The rental portion of expenses (assuming you rent the home for 15 days or more) is deductible up to the amount of rental income. In other words, if rental expenses exceed rental income, you can’t deduct the loss from your salary or other income. But you can carry it forward to offset rental income in future tax years.
The personal portion of mortgage interest isn’t deductible, but the personal portion of property taxes can be reported as an itemized deduction. Rental expenses are deductible, and you can deduct losses, subject to the passive loss rules.
Passive losses generally are deductible only against income from other passive activities. But, the rules may allow you to deduct up to $25,000 in rental losses, provided you “actively participate” in the property’s management. This deductibility is phased out beginning when the owner’s modified adjusted gross income (MAGI) is $100,000 and eliminated when it reaches $150,000.
You can deduct unlimited losses if you’re a “real estate professional,” which generally means you have more than 750 hours of work activity related to real estate or spend more than 50% of work time in real estate. But vacation homeowners typically aren’t able to meet this test.
Determining the lowest tax bite
Cindy, whose MAGI is $100,000, owns a lakeside vacation home. During the year she uses it 20 days and rents to vacationers 80 days, collecting a total of $16,000. Her mortgage interest is $14,000, her property taxes are $6,000, and her other expenses total $8,000 for the year.
Because the home is considered a residence, Cindy’s rental expense deductions are limited to her $16,000 in rental income. Based on her use of the home, her expenses are 20% personal and 80% rental, so she can deduct 20% of her interest and taxes, or $4,000, as itemized deductions. The remaining $16,000 of interest and property tax expenses can offset her rental income, but she can’t deduct any of her other expenses. She could carry the rental loss of $6,400 (80% of $8,000) forward to offset rental income in future years, but she might never have enough rental income to absorb it. So, her total deductions related to the home are $20,000 for the year.
If Cindy reduces her personal use to 14 days, the home becomes classified as a rental property, and her expenses are now approximately 15% personal and 85% rental. The rental portion of interest, taxes and other expenses is $23,800 (85% of $28,000), resulting in a $7,800 loss, which is fully deductible because it doesn’t exceed $25,000. Although Cindy can’t deduct the personal portion of interest, she can deduct the 15% personal portion of her property taxes, or $900, as an itemized deduction. By converting the property from personal to rental, she increases her total deductions related to the home to $24,700.
But if Cindy’s MAGI were $150,000, the $7,800 loss couldn’t be deducted currently and instead would be carried forward until the property was sold or had a profit. In that case, Cindy’s deductions would be higher if the home were treated as a residence.
Note that, if Cindy were subject to the AMT, the results also would be different because of the loss of the deduction for the personal portion of property taxes. They also could be different if she had other passive income she could offset with the rental loss.
Do the math before you relax
Owning a vacation home can bring much personal enjoyment as you, your family and perhaps future generations create new memories of time spent together. But it can also complicate your tax situation, particularly if you rent out the home. By understanding the tax implications of your buying a vacation home, you’ll be able to reduce your tax bite and better enjoy the time you spend there.
© 2011 Douglas Rutherford, CPA. All Rights Reserved. Douglas Rutherford is a nationally recognized CPA practicing in the real estate industry. He is the founder of Rutherford, CPA & Associates, and the President and CEO of RentalSoftware.com. He is also the developer of the national leading real estate investment analysis software, the Cash Flow Analyzer ® & Flipper’s ® software products. Doug earned his Masters of Taxation degree from Georgia State University, Atlanta, GA. Visit RealEstateAnalysisSoftwareBlog.com for more information and resources for successful real estate investing.