With the kickoff of summer and traveling back on the radar, vacation house rentals are a hot topic. This article will provide you with some insight regarding the taxation of vacation house rentals by discussing three scenarios and the different tax rules that apply.
Rental income earned is reported on Schedule E of an individual’s federal tax return (form 1040). Whether you need to report rental income, can deduct rental expenses, or claim losses depends on the extent the property is used for personal purposes. If the property is used for personal purposes the next determining factor is if the property is considered to be used as a “home”. A property is considered to be used as home if the taxpayer uses it for personal purposes during the tax year for more than the greater of: 14 days or 10% of the total days you rent it to others at fair rental price. Here are three situations to describe the various tax treatments.
Scenario one: Not used as a home. In this case, since the taxpayer does use the property for personal purposes less than 14 days during the year or less the 10% of the total days rented, whichever is greater, the primary purpose of the property is rental. The taxpayer will be required to report all rental income received. Rental expenses will be apportioned between rental (deductible) and personal use. The expenses attributable to personal use are not deductible as rental expenses although mortgage interest and real estate taxes paid may be deductible as itemized deductions. Since the IRS does not consider this a “home”, if rental income less rental deductible expenses result in a net loss, the taxpayer is allowed to claim the loss subject to the passive loss limitation rules discussed in IRS Publication 925.
Scenario two: Used as a home and rented 15 days or more. Like scenario one, all rental income earned in scenario two is required to be reported. Rental expenses are divided between personal and rental use and are deductible to the extent of rental use. A key difference between scenario one and scenario two is the losses allowed. In this case, the IRS considers this a “home” and the property is therefore subject to vacation home loss rules. As a result, net losses created by expenses other than deductible real estate taxes and mortgage interest are not permitted. Any disallowed losses are to be carried forward and used in years of excess rental income.
Scenario three: Used as a home but rented less than 15 days: In this case the primary purpose is personal use. Since the owner rents the property minimally (less than 15 days during the year) no rental income earned is required to be reported and the taxpayer cannot claim any offsetting rent-related expenses. This rule poses both pros and cons depending on whether the taxpayer earns net profits or losses from the rental property. From a positive perspective, this can cause a tax break and special benefit for those who own properties in prime vacation spots or popular areas where even a few rental days can bring in a sizable profit essentially tax free.
In conclusion, it is important to know the tax rules when deciding to rent out your vacation home. To figure out if it is beneficial for you requires weighing the benefits, costs, and your personal goals for the property. Consider speaking to your WG advisor to come up with the best strategy for you.