Vacation Home Usage Has Tax Implications

Do you own a vacation home that's classified as a rental property for tax purposes? Rental property owners may be tempted to use their rental properties for their personal "staycations" or as remote office locations during the COVID-19 pandemic. But this could cause adverse tax consequences, depending on your situation. Here's what you need to know.

Personal Residences

Under the federal income tax rules, a vacation home is classified as a personal residence if:

  • You rent it out for more than 14 days during the year, and
  • Personal use during the year exceeds the greater of 1) 14 days or 2) 10% of the days you rent the home out at fair market rates.

When evaluating the time spent at the home for tax purposes, count only actual days of rental and personal occupancy. Disregard days of vacancy and days spent mainly on repair and maintenance activities.

Personal use generally means use by the owner, certain family members and any other party (family or otherwise) who pays less than fair market rental rates. If your vacation home is used by another person under a reciprocal arrangement ("I use your place and you use mine"), such use is considered personal use. That's the case regardless of whether you charge the other person fair market rent for the use of your property and whether you pay fair market rent for your use of the other person's property.

Important: A special federal income tax break is available if you rent your vacation home for less than 15 days during the year and use it for personal purposes for more than 14 days during the year. In this scenario, which often happens with vacation homes located near major events, such as a professional golf tournament, you don't need to declare a penny of the rental income. That's because the rental activity is completely disregarded for federal income tax purposes. You would report any allowable itemized deductions for mortgage interest and property taxes on Schedule A of your Form 1040. The only drawback is that you get no deductions for other expenses attributable to the rental period, such as advertising and cleaning costs.

Rental Properties

Under the federal income tax rules, a vacation home is classified as a rental property if:

  • You rent it out for more than 14 days during the year, and
  • Personal use during the year doesn't exceed the greater of 1) 14 days, or 2) 10% of the days you rent the home out at fair market rates.

Again, when evaluating the time spent at the home for tax purposes, count only actual days of rental and personal use. Disregard days of vacancy and days spent mainly on repair and maintenance activities.

For example, in 2021, you rent your beachfront condo to third parties at fair market rates for 210 days. You and family members use the condo for 21 days, which equals 10% of the rental days (21 days divided by 210 days). The condo is classified as a rental property for the 2021 tax year, because your personal use doesn't exceed the greater of 1) 14 days, or 2) 10% of the rental days.

However, if you and/or family members use the condo for 22 days or more during the year, the property is classified as a personal residence, and a different set of tax rules applies. Those rules can be more favorable or less favorable, depending on your circumstances.

Vacation Homes Classified as Rental Properties

For vacation homes that are classified as rental properties, mortgage interest, property taxes and other expenses must all be allocated between rental and personal use based on days of rental and personal occupancy.

Mortgage interest allocable to personal use of a vacation home that's classified as a rental property doesn't meet the definition of qualified residence interest for itemized deduction purposes. The qualified residence interest deduction is only allowed for mortgages on vacation homes that are classified as personal residences.

Let's continue with the previous example, assuming you rent your beach condo for 210 days and use it for personal purposes for 21 days. So, it's classified as a rental property. That means you must allocate expenses between rental and personal usage using 210/231 as the rental-use fraction and 21/231 as the personal-use fraction.

Accordingly, 21/231 of the mortgage interest for the condo is nondeductible. The same is true for 21/231 of the other expenses, such as insurance, utilities, maintenance and depreciation. However, you can potentially deduct the personal-use portion of real property taxes on your tax return, subject to the limitation on itemized deductions for state and local taxes.

Schedule E Losses and the PAL Rules

When allocable rental expenses exceed rental income, a vacation home that's classified as a rental property can potentially generate a deductible tax loss that you can report on Schedule E of your personal tax return. Unfortunately, your vacation home rental loss may be wholly or partially deferred under the passive activity loss (PAL) rules.

That's because you can generally deduct passive losses only to the extent that you have passive income from other sources, such as rental properties that produce positive taxable income. Disallowed passive losses from a property are carried forward to future tax years and can be deducted when you have sufficient passive income or when you sell the loss-producing property.

Small Landlord Exception

A favorable exception to the PAL rules allows you to currently deduct up to $25,000 of annual passive rental real estate losses if you "actively participate" and have adjusted gross income (AGI) under $100,000. The $25,000 exception is phased out between AGI of $100,000 and $150,000.

However, under tax law, the $25,000 small landlord exception isn't allowed when the average rental period for your property is seven days or less. In that case, your vacation home rental activity is considered a "business" rather than a rental real estate activity. In this scenario, your vacation home rental loss is deferred under the PAL rules unless you:

  • Have passive income from other sources, or
  • Materially participate in the "business" of renting the vacation home. (See "Meeting the Material Participation Standard" at right.)

Important: In some resort areas, the average rental period may be seven days or less. The $25,000 exception to the PAL rules is unavailable if your vacation home falls into that category. Then you may have to pass at least one of the material participation tests to claim a current deduction for your rental loss.

Real Estate Professional Exception

Another exception to the PAL rules allows qualifying individuals to currently deduct rental real estate losses even though they have little or no passive income. The requirements for this exception are as follows:

  • You must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate, and
  • Those hours must be more than half the time you spend delivering personal services (in other words, working) during the year.

If you can clear both hurdles, you qualify as a real estate professional.

The second step is determining if you have one or more rental real estate properties in which you materially participate. If you do, those properties are treated as nonpassive and are, therefore, exempt from the PAL rules. That means you can generally deduct losses from those properties in the current year.

Planning for Summer Rentals

People who own vacation homes and understand the applicable tax rules can try to manage the number of rental-use vs. personal-use days between now and year end. That usage can potentially result in better or worse tax outcomes, especially when it flips your vacation home from rental property status to personal residence status (or vice versa).

Meeting the Material Participation Standard

Meeting the so-called "material participation" standard can help you sidestep the passive activity loss (PAL) rules, which can potentially limit deductions from rental properties. The three most likely ways to meet the material participation standard for a vacation home rental activity are when:

1. You do substantially all the work related to the property.

2. You spend more than 100 hours dealing with the property, and no other person spends more time than you.

3. You spend more than 500 hours dealing with the property.

In attempting to clear one of these hurdles, you can combine your time with your spouse's time. Realistically, however, if you use a property management firm to handle your property, you're unlikely to pass any of the material participation tests.

Suspended passive losses from your vacation home rental activity may be piling up if you don't qualify for the small landlord or real estate professional exceptions to the PAL rules (see main article). However, you may be able to transform the activity into a "business" by reducing the average rental period to seven days or less. Then, as long as you can pass one of the material participation tests for the property, you can avoid the PAL rules and deduct losses against your other income.

When your vacation home is firmly in the rental property category, adding more rental days can often lead to better financial results, because you can usually shelter the additional rental income with allocable rental expenses. Your HK tax advisor can help plan your vacation home usage to achieve optimal tax results. Call us at 330-453-7633 or email at info@hallkistler.com.

Categories: May 2021, Monthly Bulletins
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