Before jumping into the vacation rental market, it's important for homeowners to understand the tax implications of renting out their vacation home. From rental income to deductions and depreciation, the tax effects of renting out a vacation home can be complex and impact the bottom line.
Less than 15 days
If you rent the property out for less than 15 days during the year, it’s not treated as “rental property” at all. In the right circumstances, this can produce revenue and significant tax benefits. The IRS has a special rule that allows property owners to rent out their property for up to 14 days per year without having to report the rental income on their tax return, and it applies regardless of whether the rental property is a primary residence, a second home, or a vacation property.
Essentially, if you rent out your property for less than 15 days in a year, you do not have to report the rental income on your tax return and you do not have to pay taxes on that income. On the other hand, you can only deduct property taxes and mortgage interest—no other operating costs or depreciation. (Mortgage interest is deductible on your principal residence and one other home, subject to certain limits.)
If you rent the property out for more than 14 days, you must include the rent received in income. However, you can deduct part of your operating expenses and depreciation, subject to certain rules. First, you must allocate your expenses between the personal use days and the rental days.
For example, if the house is rented for 90 days and used personally for 30 days, that means 75% of its use is rental (90 out of 120 total use days). You’d allocate 75% of your costs such as maintenance, utilities and insurance to rental. You’d also allocate 75% of your depreciation allowance, interest and taxes for the property to rental. The personal use portion of taxes is separately deductible. The personal use part of interest on a second home is also deductible (if eligible) where the personal use exceeds the greater of 14 days or 10% of the rental days. However, depreciation on the personal use portion isn’t allowed.
Claiming a loss
If the rental income exceeds these allocable deductions, you report the rent and deductions to determine the amount of rental income to add to your other income. If the expenses exceed the income, you may be able to claim a rental loss. This depends on how many days you use the house for personal purposes.
Here’s the test: if you use it personally for more than the greater of a) 14 days, or b) 10% of the rental days, you’re using it “too much” and can’t claim your loss. In this case, you can still use your deductions to wipe out rental income, but you can’t create a loss. Deductions you can’t use are carried forward and may be usable in future years. If you’re limited to using deductions only up to the rental income amount, you must use the deductions allocated to the rental portion in this order:
- Interest and taxes
- Operating costs
- Depreciation
If you “pass” the personal use test, you must still allocate your expenses between the personal and rental portions. In this case, however, if your rental deductions exceed rental income, you can claim the loss. The loss is passive, however, and may be limited under passive loss rules.
Passive loss rules
Losses from rental property are considered passive losses and can generally offset passive income only. This includes income from other rental properties or another business in which you do not materially participate and does not include investment income or income from activities in which you do materially participate.
Under the passive activity rules you can deduct up to $25,000 in passive losses against your ordinary income (W-2 wages) if your modified adjusted gross income (MAGI) is $100,000 or less.
This deduction phases out $1 for every $2 of MAGI above $100,000 until $150,000 when it is completely phased out. These limits apply to both those filing single or married filing joint. To take losses against your ordinary income, you must demonstrate active participation in the activity.
We're here to help
These are only the basic rules. There may be other rules if you’re considered a small landlord or real estate professional. Contact us if you have questions, and we can help plan your vacation home use to achieve optimal tax results.