Knowing the Three Tax Scenarios for Vacation Homes

Some of your clients may own a second home that they treat as a vacation getaway. If they can afford to use it personally all year-round, more power to them, but the tax benefits are few and far between. However, others choose to rent out the home to tenants, at least part of the time. In this case, the tax breaks can be bountiful, but the rules are somewhat tricky.

Let's look at three common situations involving vacation homes: (1) The home is rented out almost the entire year. (2) The home is used personally almost the entire year. (3) The home use is split between rental and personal use.

1. The home is rented out the entire year. This is usually the strongest position tax-wise. Of course, any rental income received is taxable, but expenses are typically deductible against the income. Furthermore, the owner may be entitled to a tax loss as long as the family's personal use doesn't exceed the greater of 14 days or 10 percent of the time the home is rented out. In other words, the home is essentially treated as an investment for tax purposes.

However, under the "passive activity loss" (PAL) rules, the annual loss is generally limited to the amount of annual income from other passive activities. A $25,000 offset for rental real estate activity, such as renting out a vacation home, is available to active participants, but this limited tax break is phased out for someone with an adjusted gross income between $100,000 and $150,000.

What Can You Deduct?

The IRS has listed in alphabetical order the following common deductible rental expenses in Pub. 527, Residential Rental Property:

  • Advertising
  • Auto and travel expenses
  • Cleaning and maintenance
  • Commissions
  • Depreciation
  • Insurance
  • Interest (other)
  • Legal and other professional fees
  • Local transportation expenses
  • Management fees
  • Mortgage interest paid to banks, etc.
  • Points
  • Rental payments
  • Repairs
  • Taxes
  • Utilities

2. The home is used personally almost the entire year. This is the "no fuss, no muss" option. If the home is rented out for two weeks or less, you can't claim any deductions, but you don't have to pay tax on rental income, either. Thus, it's a wash for tax purposes. Some vacation home owners will cash in under the rules for short-term rentals if there is a special event (e.g., a golf tournament or outdoor festival) taking place nearby.

3. The home use is split between rental and personal use. This scenario, as you might imagine, is the most complicated. Generally, the rental income is taxable, but expenses are deductible only up to the limits discussed above.

It's especially important to keep track of personal use. If a vacation home owner can manage to keep personal use below the 14 day/10 percent threshold, he or she may be able to claim a loss, subject to the PAL restrictions. In addition, if personal use exceeds the threshold, you must deduct the personal portion of your expenses, including mortgage interest and property taxes, on Schedule A as itemized deductions.

Note that a day spent fixing up the place for the rental season or doing repairs doesn't count as a "personal use" day even if you spend the rest of the day relaxing. This allows for more time at the getaway without jeopardizing a loss deduction.

Clients are often confused by these complex rules, so you should provide the assistance they need to maximize the tax benefits. Put them in a position to succeed tax-wise without costing them their personal enjoyment.

Related article:

Capital Gains Law, Investment Values Drive Second Home Market


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