Vacation Home Rentals: How the Income Is Taxed

Article Highlights:

• Home never rented 
• Home rented less than 15 days 
• Personal use less than the greater of 15 days or 10% of the rental days 
• Personal use exceeds the greater of 14 days or 10% of the rental days • Selling a vacation home 

If you have a second home in a resort area, or if you have been considering acquiring a second or vacation home, you may have questions about how rental income is taxed should you decide to rent it part of the time. Vacation home rental rules include some interesting twists that you should know about before you begin renting. Although some individuals prefer to never rent out their homes, others find this to be a helpful way to cover the cost of the home. If you choose never to rent it out at all and it is your designated second home, the property taxes and the home mortgage interest may be written off as part of your itemized deductions. However, the interest is deductible only as long as the combined acquisition debt on your first and second homes does not exceed $1,000,000. In addition, the interest on up to $100,000 of equity debt for the two homes can be deducted. If you are unfortunate enough to be subject to the alternative minimum tax (AMT), to the extent that you are taxed by the AMT, the property taxes and equity debt interest are not deductible.

If the home is partly rented out, then there are three rules to consider, based on the length of the rental:

1. Rent Less Than 15 Days - If the property is rented out for less than 15 days, the money can be pocketed tax-free, and the interest and taxes can continue to be deducted as if the property were not rented out at all. In this situation, any other directly related rental expenses, such as the agent fee, utilities, post-rental cleaning, etc., are not deductible. This rule has led to some significant tax-free income for individuals who own a home or second home that is suitable as a filming location. 
    
2. Personal Use Is Less Than the Greater of 15 Days or 10% of the Rental Days - In this scenario, the home’s use would be allocated into two separate activities: a rental home and a second home. Let’s say that the home is used 5% for personal use; 5% of the interest and taxes would be treated as home interest and taxes that can be deducted as an itemized deduction. The other 95% of the interest and taxes would be rental expenses, combined with 95% of the insurance, utilities, allowable depreciation and 100% of the direct rental expenses. The result can be a deductible tax loss, which would be combined with all other rental activities and limited to a $25,000 loss per year for taxpayers with adjusted gross incomes (AGI) of $100,000 or less. This loss allowance is ratably phased out between $100,000 and $150,000 of AGI. Thus, if your income exceeds $150,000, the loss cannot be deducted; it is carried forward until the home is sold or there are gains from other passive activities that can be used to offset the loss. 
    
3. Personal Use Exceeds the Greater of 14 Days or 10% of the Rental Days - In this scenario, no rental tax loss is allowed. Let’s assume that the personal use of the home is 20%. As for the remaining 80%, it is used as a rental. The rental income is first reduced by 80% of the taxes and interest. If, after deducting the interest and taxes, there is still a profit, the direct rental expenses (such as the rental portion of the utilities, insurance and any other direct rental expenses) are deducted, but not more than will offset the remaining income. If there is still a profit, you can take depreciation, but it is again limited to the remaining profit. End result: No loss is allowed, but any remaining profit is taxable. The other personal 20% of the interest and taxes is deducted as an itemized deduction, subject to the interest and AMT limitations discussed earlier. Take note that if the rental income becomes less than the business portion of the interest and taxes, the balance of the interest and taxes is still deductible as home mortgage interest and taxes. 

Sale of the Vacation Home - A vacation home rental is considered personal use property. Gains from the sale of personal use property are taxable, but losses are not deductible. Thus, when the sale of a vacation home results in a loss, the loss may or may not be deductible. If the property was treated partly as personal-use property and partly as a rental (as discussed in #2 above); then, depending upon the overall use of the property, the loss may be allowed, but divided between a nondeductible personal-use portion and the deductible rental portion. In all of our other scenarios, the loss would not be deductible at all.

Unlike a primary home, the second home does not qualify for the home gain exclusion. Any gain would be taxable, unless the rental is the primary residence for two of the five years preceding the sale–meaning the vacation home was occupied as the taxpayer’s primary residence for two of the prior five years immediately preceding the sale and it was not rented during that two-year period.

In that scenario, the taxpayer would qualify for the home sale exclusion provided he had not used that exclusion for another property in the prior two years. As a result, the gain in excess of the depreciation previously claimed on the home could be offset by the home gain exclusion ($250,000/$500,000 for a married couple filing jointly where the spouse also qualifies).

Tax law also includes some complicated rules related to the gain exclusion where a home was acquired by tax-deferred exchange or converted from a rental to primary residence that may require careful planning to utilize the home gain exclusion.

An additional note: in situations where the property is rented for short-term stays or when significant personal services (such as maid services) are provided to guests, the taxpayer may likely be considered to be operating a business and not just renting a home. If so, reporting requirements may be different. 

As with all tax rules, there are certain exceptions to be aware of. Please call this office so we can discuss your particular situation in detail.

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