During the pandemic, many people purchased second homes near the mountains or coast as a way to safely escape on the weekends. With platforms like Airbnb, HomeAway, and Vrbo, a vacation home can become another source of income when not being used by the property owner or their family.
However, it’s important to understand the potential benefits and tax consequences of renting a vacation home. Residences used both personally and as a rental property generally fall into one of three categories for tax purposes, and that categorization determines how and where the taxpayer reports the property’s income and expenses at tax time.
Personal residence with limited rental use
If you rent out your home for fewer than 15 days, the property still qualifies as your personal residence. Any income earned from renting the property isn’t taxable.
You can deduct mortgage interest and property taxes as itemized deductions on Schedule A (subject to the normal limitations). However, you cannot deduct any other expenses associated with the rental, such as cleaning fees, utilities, insurance, advertising, or service fees charged by the rental platform. These are all considered non-deductible personal expenses.
Despite the loss of those deductions, this category provides significant benefits when you rent out your vacation home for short-term events. That’s why people sometimes refer to this category as “The Masters Rule” – Augusta residents have been enjoying tax-free rental income for decades.
Vacation home with rental use
The IRS applies a personal use test to vacation homes with both personal and rental use. A vacation home is used for personal purposes during the year for:
- More than 14 days, or
- 10% of the total days you rent it to others at a fair rental price.
To determine the number of days you’ve used the property for personal purposes, consider any personal use by you or members of your family unless the family member pays a fair rental price and uses the property as their primary residence. Also consider any days you rent the property to others at less than the fair rental price. This might include renting to friends at a discount or donating use to a charity.
Days spent repairing and maintaining the property, including travel days when the trip’s primary purpose was to repair or maintain the property, don’t count as personal use days. However, you need to keep records documenting time spent on repairs to ensure these days aren’t counted as personal use days.
In this category, rental income is taxable, and the IRS limits deductions to the amount of income from the property. However, there’s an order for claiming allowable deductions:
- Qualified home mortgage interest, property taxes, and casualty losses
- Non-operating expenses associated with the rental, such as advertising, legal fees, and commissions
- Operating expenses associated with maintaining and operating the property, such as utilities and repairs
These expenses have to be prorated based on the number of rental days compared to the total number of days the home is occupied personally.
Rental property with limited personal use
If you don’t pass the personal use test, the property is considered a rental property with limited personal use. Rental income is taxable, there are no ordering rules for claiming deductions, and rental expenses aren’t limited to rental income.
However, you still have to allocate deductions for the rental (on Schedule E) based on the days the property was rented out (or available to rent). You lose out on the portion of your mortgage interest deduction allocable to personal use.
The property is also potentially subject to passive loss rules. Real estate, by definition, is a passive investment. Passive losses can generally only offset passive income from other rental properties or from a business in which you don’t materially participate. If passive losses exceed your passive income, they’re suspended and carried forward to future tax years, when you either have passive income to offset or sell the property. Taxpayers with a modified adjusted gross income of $100,000 or less can deduct up to $25,000 in passive losses against their ordinary income.
As you can see, claiming income and expenses on a vacation home can be tricky. How and where you report income and claim deductions can change from year to year depending on how many days you use the property for personal purposes or rent it out. It’s important to keep good records documenting how you use the property and have regular discussions with your MST tax adviser.
As always, if you have any questions about how the vacation home rental rules impact your tax planning and preparation, contact your MST adviser. We’re happy to schedule a time to discuss these or any other questions you might have.