A vacation home that generates income and provides a place for your vacation can be a great investment. You have the flexibility to escape the real world and stay at the home whenever you choose, and you can use the rental income earned to offset expenses that come with owning the property. However, complicated tax laws can sometimes cause taxpayers to avoid taking advantage of a rental transaction. If you are considering renting out your vacation home, this guide will set you up for smooth sailing.
The number of days makes a difference.
Before you can calculate and report rental activity on a Form 1040, you must first look at the number of days the property was rented versus the number of personal use days.
Rented 14 Days or Less
If the property is rented for 14 days or fewer during the year, any revenue earned is not reported on the tax return, which means rental expenses are not deductible. However, mortgage interest and property taxes can still be included on Schedule A as Itemized Deductions, subject to the usual limitations with respect to those deductions.
Personal Use is No More Than 14 Days OR 10% of the Number of Days Rented
If personal use is no more than 14 days or 10% of the number of days rented, the challenge is determining which expenses are from rental activity and which are from personal use. To start, the taxpayer will calculate the ratio of rental days to total days of use. Note that rental days are the actual days the property was rented, not the amount of days the property was available to be rented. Then, multiply this percentage of rental days by each expense to determine the amount reportable as “rental expenses.”
For example, if a taxpayer personally used their vacation home for 15 days and rented it for 160 days, the taxpayer will divide 160 days by 175 days (160 days rented + 15 days of personal use), which results in roughly 91% of total expenses being reportable as “rental expenses.” The taxpayer will then multiply the percentage by each expense and report the amounts on Schedule E.
What happens to the other expenses that are allocated as personal expenses (9% of expenses in the example)? Unfortunately, because those expenses are attributable to personal use, they are not deductible on the tax return. However, there is an exception. If you itemize deductions instead of using the standard deduction, you may still be able deduct the remaining mortgage interest and property taxes on Schedule A, subject to the limitations regarding those Schedule A deductions.
One benefit of a rental falling under this category is if there are more rental expenses than income, the taxpayer may be allowed to offset some of that additional expense with other income reported on Form 1040, subject to the passive loss limitation rules.
Personal Use is More Than 14 Days OR 10% of the Number of Days Rented
If personal use is more than 14 days or 10% of the number of days rented (whichever is greater), tax treatment of rental expenses depends on how much rental income was earned compared to the amount of rental expenses.
If you earned more rental income than expenses, the amount of rental expenses will be calculated and reported on Schedule E in the same manner as mentioned above when personal use is 14 days or less.
However, if expenses are greater than rental income, the process becomes more complicated. In this situation, rental expenses are reported in a specific order. Note: while allocating rental expenses, keep in mind that total rental expenses cannot be greater than rental income. You should first figure out the rental portion of each expense as described in the section above. Then, rental expenses will be deducted in the following order until rental income is offset:
- Rental portion of mortgage interest.
- Rental portion of property taxes.
- Rental portion of deductible casualty and theft losses.
- Rental expenses directly associated with the property itself including advertising, legal fees, commissions and office supplies.
- Rental portion of expenses related to operating or maintaining the property such as repairs, insurance and utilities.
- Rental portion of depreciation expense of the property along with any improvements and furniture.
Essentially, you will make your way down the list until rental income is netted with rental expenses to equal zero.
Once again, mortgage interest and property taxes allocated to personal use and not reported as rental expenses can be reported on Schedule A with Itemized Deductions, subject to limitation.
What is a Personal Use Day?
In its simplest form, a personal use day is a day in which a taxpayer uses his or her vacation home for pleasure (not performing maintenance) without paying fair market rent. There are a couple of rules you should consider before declaring a certain day as either personal or rental.
Rule #1: No Fair Rental Price Means Personal Use
Fair rental price is the price a person who has no association with the property owner would be willing to pay to stay at a vacation home. The price charged would not be considered fair if it is substantially less than what is charged for other homes in the area with similar characteristics (such as number of bedrooms/bathrooms, a pool, etc.). If, for example, the property owner or a family member stays at the home rent free, those days are considered personal use for calculating rental expenses.
Rule #2: Maintenance Days DO NOT Count as Personal Days
In the event that the property owner visits the home in order to perform routine maintenance and repairs, such days are neither personal nor rental. Even if family members and friends visit the property rent free on these days, they are still not considered personal use days, as long as the primary reason for the visit was for maintenance. It is highly recommended that you keep logs, receipts, etc. in order to document the maintenance days.
It is important to note that these rules do not apply to just condos, houses and cabins, but also include RVs and boats as long as there are sleeping, cooking and bathroom facilities. With regards to tax, the world of vacation home rentals can be a difficult one to navigate. These rules can get complicated quickly, so it is recommended that you consult your tax advisor early to make certain you are not skipping an eligible deduction or being forced to pass up a deduction due to a missed detail in the rules. By tracking details and keeping logs and receipts, you can ensure you maximize your tax benefit. Who knows – you might even be able to make some money while you are at it!