The summer weather may have you considering the purchase of a vacation home. Many people who own a vacation home choose to rent out the home when they are not there in order to recoup some of the costs, or even to make a profit. You might also benefit from being able to deduct certain expenses associated with a rental property on your tax return. However, be aware that if you also personally use a property you rent out, there are certain limitations on the amount of expenses you can deduct. Tax treatment of rental income and expenses depends on how many days the property is rented and your level of personal use. Here are five different scenarios that a property owner may experience:
- No Rental Property, No Income Reporting – Residence is rented out for less than 15 days
Under this special rule, if you rent your property to others for two weeks or less during the year, you do not need to report the income at all. However, you cannot deduct any rental expenses other than property tax and qualified mortgage interest on Schedule A for itemized deductions. To qualify for this benefit, you must personally use the property for at least 14 days during the year. Some taxpayers take advantage of this rule by renting out their vacation homes (or primary homes) for special events.
- Hotel/Motel/Inn – Regularly available short-term rental property
If your vacation home is regularly available for short-term rental use (think Airbnb) and you provide substantial services for tenants (daily meals and laundry service), you may have a trade or business. Income and expenses for a trade or business are reported on Schedule C for a sole proprietor. Income from this type of property is subject to self-employment tax.
- Standard Rental Property – Long-term rental with no personal use
If you do not use your vacation home personally at all during the year, you have a standard rental property. In this case, you would report 100% of all income and expenses on Schedule E of Form 1040. It is important to note that the definition of personal use includes days rented to others if a fair market rate is not charged and includes use of the vacation home by your relatives (even if a market rate is charged). If your rental expenses for the year exceed your rental income, you have a loss.
Rental losses are subject to the passive activity rules, which are complicated. Generally, passive losses can only be used to offset passive income. (Examples of passive income include certain investment income and business income from a business in which you are a limited member or partner.) One exception to this rule is if you actively participate in your rental property and your modified adjusted gross income is $100,000 or less (for married taxpayers filing jointly). In this case, you could deduct up to $25,000 of your rental loss.
- Vacation Home – Personal use days do not exceed the greater of 14 days or 10% of total days rented
If you or your relatives spend time at your vacation home during the year, you must allocate your expenses between personal use and rental use. (See Deducting Rental Expenses below for how to allocate.) If your personal use days do not exceed the greater of 14 days or 10% of total days rented at fair market value during the year, you may be able to deduct a loss on Schedule E. However, note that the loss could be subject to the passive loss limitation rules described above.
- Residence – Personal use days exceed the greater of 14 days or 10% of total days rented
Under this scenario, you would also allocate your rental expenses per the Deducting Rental Expenses information below. You would then deduct the expenses in a specific order. If you use the property personally for more than the greater of 14 days or 10% of the days rented at fair market value, you have used the property “too much” and would not be able to claim a loss for the year. You would still report the rental income and the allocation of expenses, but you could not reduce your income below zero on Schedule E. The excess loss may be carried over and used in future years.
Deducting Rental Expenses
Renting out your vacation home may allow you to deduct a portion of certain expenses for maintaining the property. Generally, you must allocate your expenses between rental use and personal use on your tax return. Rental expenses are calculated by using a ratio of days rented at a fair market rental price to the total number of days the property is used during the year. Allocated rental expenses may be deducted on Schedule E (or Schedule C) of Form 1040. The difference between this amount and your total expenses is the amount that is allocated to personal use.
Certain remaining personal use expenses may be deducted on Schedule A of Form 1040. Expenses that may be deductible on Schedule E (or C) include (but are not limited to) advertising, auto and travel, cleaning and maintenance, commissions, insurance, legal and professional fees, repairs, supplies, utilities, and depreciation. Expenses that may be deducted on Schedule E (or C) for the rental portion and the remainder on Schedule A for the personal portion include mortgage interest and taxes.
Owning a vacation home can have both personal advantages and tax advantages, but the rules and regulations can be complicated. It is important to maintain good records of your income, expenses, rental days, and personal use days. If you would like more information or have any questions about renting out a vacation home, please contact us.