Q: We are thinking about buying a vacation home this summer. We want to rent it out part of the time to help cover the expenses. What are the tax rules affecting renting out a summer home?
A: Your purchase decision should be based primarily on your anticipated recreational use of the property, not on the tax deductions or investment return you hope to get. As I explained in previous columns, recreational property values are highly volatile, rising rapidly when the economy is good and plummeting when the market goes “soft.” Making a profit on a vacation home largely depends on getting in and out of the market at the right time. If you get caught in the wrong part of the recreational real estate cycle, you may have to pay a steep price when you buy or take a big loss when you sell.
I am not an accountant, but I can give you some basic information on the tax rules regarding renting out vacation property. The income tax consequences of vacation home ownership are even more complicated. Your tax treatment depends on how many days you personally use the property. There are four basic categories of personal use:
1) If you own the vacation home primarily for your personal use and rent it out less than 15 days per year, the rental income from those few days does not have to be reported to the IRS as taxable income. The bad news is that you can’t deduct any expenses related to the rental use of the property. However, because a vacation property is considered a “second home” (assuming you have only one), you can deduct the mortgage interest and property tax expenses on your federal income tax return, just as you do for your primary residence.
2) On the other hand, if you don’t personally use the vacation home at all and hold it strictly for investment, all rental income and expenses are reported on Schedule E of your income tax return just as you would for any rental property. In addition to the mortgage interest and property taxes, you would be able to deduct insurance, utilities, repairs, maintenance and non-cash depreciation. In most cases, this results in a loss for income tax purposes.
3) It gets more complicated when you start mixing personal and rental use of a vacation home. If the home is rented more than 15 days per year and you personally use it less than 15 days per year (or 10 percent of the rental days, whichever is more), that is NOT considered “personal use.” For example, if the house were rented 10 months out of the year, that’s 300 rental days, which means you could spend up to 30 days per year (10 percent of the rental days) in the house without it being considered personal use. The vacation home would be treated as a rental property and you could claim all of the usual rental property deductions. However, IRS regulations require that you have a “profit motive,” which means you must make a profit at least three of every five years in order to claim all the rental property deductions.
4) If the vacation home is rented more than 15 days per year and your annual personal use is MORE than 15 days (or 10 percent of the rental days) that is considered “personal use” and you are not allowed to claim a tax loss on the property. All rental income must be reported on your income tax return, but expense deductions are limited to the total amount of rent collected. The IRS has a specific order for deducting expenses under this scenario. You can write off all of your mortgage interest and property taxes. Then, if the amount of rent collected exceeds the total amount of interest and taxes paid, the additional rental income can be used to offset operating expenses. If there is still more rental income left over, you can claim the depreciation deduction up to the amount of remaining rental income.
For example, let’s say you fit the vacation home rental/personal use ratio in category number 4 above. We’ll assume you pay $12,000 per year in mortgage interest and $1,500 per year in property taxes on the home. Rental operating expenses total $3,600 per year, and the full depreciation deduction (if allowed) would be $3,600 per year. That’s a total
cash outlay of $17,100 per year, plus $3,600 in non-cash depreciation for a grand total of $20,700. In this example, you would have to receive at least $20,700 per year in rental income on your vacation home in order to claim the maximum allowable tax deductions. If you took in only $17,100 per year, you could write off all of your cash expenditures, but you would not have enough rental income to claim the depreciation deduction. If you took in only $12,000 in rental income per year on your vacation home, you could write off only your mortgage interest as a rental expense. However, you would still be allowed to write-off the property taxes on the vacation home — you would just have to treat the taxes as an itemized deduction on Schedule A of your income tax return rather than as a rental property deduction on Schedule E. The mortgage interest and property taxes on a vacation home are always tax-deductible, whether it is rented or not.
Sound complicated? I told you it was. Believe it or not, I actually simplified the example above. Accountants will tell you that it really gets interesting when you start trying to allocate costs between “rental expenses” and “personal use” when there is not enough rental income to offset all expenditures. The basic rule is that you are not allowed to create a tax loss if you are using the vacation home for personal use a substantial portion of the time.
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