Summer is upon us! This is a welcome change from what was, for some of us, a wet and chilly spring. For many, the warmer weather means that vacation season is also here. Some may head to the woods for camping, some may hop on a plane to a resort, and some may head to a second home in a beloved location.
But if you rent that vacation home out to others throughout the year, you may have some special tax considerations on your hands. It all boils down to how many days you and your family use the home – and how many days it’s rented to others. For the purpose of today’s post, we’ll specifically discuss those taxpayers who rent out a second home, but also keep it for personal use.
Let’s start by discussing “personal use”. Personal use, according to the IRS, includes use of the property by the owner, use by family members of the owner, or use by an individual charged less than “fair market value”. On the other hand, days that are used expressly for the repair or maintenance of the dwelling are not considered personal use days. If you keep a second property for personal use, but also rent it out for a fair market rate, the IRS has a set of rules regarding the income and deductible expenses for that dwelling.
To Report, or Not to Report?
If you rent out a residence for 14 days or less during the year, you don’t need to report the rental income, and rental-related expenses aren’t deductible. However, if you itemize, you may still deduct your mortgage interest, property taxes, and casualty losses as normal.
If you rent the dwelling for 15 days or more, you will report your rental income on Schedule E. Related expenses may be deducted, but only in appropriate proportions (more below). Finally, the total number of days you used the dwelling for personal use determines whether the dwelling was also a “home” during the tax year, which can impact the limits on deductible rental income.
If you report rental income on Schedule E, you may also deduct your rental expenses. These expenses include mortgage interest, real estate taxes, and casualty and theft losses. They also include the cost of repairs, operating expenses, and depreciation.
But deductible rental expenses are limited to the proportion of days that the dwelling was used for rental purposes. In other words, the IRS doesn’t want you deducting rental expenses for personal use. The appropriate portion of deductible expenses is determined by dividing the total days rented by the total days used.
(Days rented)/(Total days used)=% of expenses allocated to rental use
For example, if you rented your home for 35 days and had 20 personal use days, the total days used are 55. Divide rental days (35) by total days used (55), and the result (64%) represents the total proportion of your total expenses that are deductible on Schedule E.
Home or Dwelling?
The fun doesn’t stop there. If the dwelling’s rate of personal use is (the greater of) 14 days or 10% of “rental days”, it is also considered a “home.” Once “home” status is achieved, deductible rental expenses are limited to gross rental income. In other words, you can’t deduct more than you earn. As a consolation, excess deductions can be carried forward into future years. Note, though, that the personal use portion of your expenses from mortgage interest, real estate taxes, and casualty loss are still an itemizable deduction on your tax returns.
If you rent your vacation home for 15 days or more, but your personal use is less than (the greater of) 14 days or 10% of the days you rent the home, the IRS does not consider the property to be used as a “home”. Division of expenses should still be performed (as discussed above), but you may deduct your rental expenses beyond your gross rental income. This can create some nice tax savings – but also opens you up to additional tests/limits. We won’t go into those here today – rather, this is a topic that should be explored with your tax advisor.
The Bottom Line
A second home can be a great getaway as well as a nice source of income. With that being said, the rules surrounding the taxation of rental income can be complex and confusing. Good record keeping and proactive planning can make a big difference when navigating this landscape. More detailed information is available in IRS publication 527. As always, if you have any questions about your rental property, please reach out to your advisor or your tax professional.