One of the real estate investments you may consider is a vacation home. Who wouldn’t love a place to jet off to, when the going gets rough, or you just need a vacation? Plus, you may be able to rent it out when you’re not using it and make some extra cash. However, there are some important tax implications to consider when you’re renting out that vacation home. Arthur Hiller, CPA, helps break down some of these tax implications. Read on to find out answers to your questions about rental of a vacation home or residence.

When purchasing a vacation home or residence that will be rented out for part of the year, there will be income tax consequences. The tax consequences depend upon the amount of time the home is rented and the amount of time the home is used for personal purposes.

Minimal Rental Use. If you rent the property for fewer than 15 days during the year, you are not allowed deductions directly attributable to such rental, but no rental income is includible in gross income. So if a production company wants to use your home in a movie and they pay you $15,000 for 14 days of production, that money will be tax free. Your normal deductions will be allowed without regard to whether or not the home is used for business or the production of income (e.g. mortgage interest, property taxes, or a casualty loss) may still be taken.

Deduction Limitations. If you rent the property for 15 or more days during the tax year and it is used by the taxpayer for personal purposes for the greater of (a) more than 14 days or (b) more than 10% of the number of days during the year for which the home is rented, the rental expenses are limited. Under this limitation the amount of the rental expenses may not exceed the amount of the gross income received from the rental. You can still take the balance of the deductions that would normally be allowed, such as interest and taxes, but as you will see in the next paragraph, the interpretation of how interest and property taxes are handled in the calculation can make a difference.

According to the IRS, expenses for the use of the rental unit are limited in the same manner as those under the “hobby loss” rules (i.e., the total deductions may not exceed the gross rental income and the expenses are further limited to a percentage that represents the total days rented divided by the total days used). However, the Tax Court has rejected this formula (the decision has been affirmed on appeal by both the Ninth and Tenth Circuit Court of Appeals). It is the Tax Court’s position that mortgage interest and real estate taxes are not subject to the same percentage limitations as are other expenses because they are paid on an annual basis without regard to the number of days that the property is used. As a result, the formula used by the Tax Court computes the percentage limitation for interest and taxes by dividing the total days rented by the total days in the year. The following example will show the difference of how the expenses are calculated between the two methods.

Example. During the year an individual rents out his vacation home for 91 days and uses the home for personal purposes for 30 days. The gross rental income from the unit is $2,700 for the year. He pays $621 of real property taxes and $2,84 of mortgage interest on the property for the year. The additional expenses for maintenance, repair and utilities total $2,693.

The IRS allocation of all expenses would be based on 75% (91 days rented / 121 days used). The Tax Court would allocate taxes and interest based on 25% (91 days rented / 365 days) and use the 75% limitation for the additional expenses for maintenance, repair, etc. This allows more of the regular expenses to be used against the income and leave property taxes and interest to be deducted on an itemized deduction against other income.

Personal use. A vacation home is deemed to have been used by the taxpayer for personal purposes if for any part of the day the home is used:

1. for personal purposes by the taxpayer, any other person who owns an interest in the home, or the relatives (spouses, brothers, sisters, ancestors, lineal descendants, and spouses of lineal descendants) of either;
2. by any individual who uses the home under a reciprocal arrangement, whether or not a rental is charged; and
3. by any individual who uses the home unless a fair rental is charged.

Hopefully this helped answer some of your questions about vacation home rental.  Should you have any further questions, feel free to contact Arthur Hiller, CPA, directly at (818) 999-4443 or hillercpaoffice@hillercpa.com

Note: This is not considered tax advice by Richard Schulman. You should contact your tax professional for any up-to-date tax advice related to your specific tax situation.