With summer upon us, a lot of families are heading to the beach or the mountains for vacation, you may get the idea that it would be great to own a vacation home or condo to rent out when you are not using it. After all, with online rental platforms like Airbnb and VRBO, finding renters can be easy. And generating some revenue to cover ownership costs is nice as well as the associated tax breaks from rental properties. This can indeed be a great option for some property owners. However, there are some potential pitfalls that come with owning and renting out a vacation property aside from the additional wear and tear on the property.
The tax limitations that come into play with vacation properties are largely based on personal use versus rental (business) use. Internal Revenue Code Section 280A only allows deductions on vacation homes for the allocable rental or business use of the property, subject to a number of special rules and limitations.
Personal use is defined as use of the property by the owners, family members (regardless if they paid fair market value rent), and anyone who is being charged less than fair market value for the property. This rule includes days that are donated for charitable purposes, so think thoroughly before freely donating use of your vacation home at a charity event. In addition to the guidelines above, shared use of a property with other property owners under reciprocal arrangements are counted as personal use.
Personal Use vs. Fair Rental
Properties can be considered a rental property for tax purposes if personal use of the property is limited to no more than 14 days or 10% of the total days the property is rented at fair market value, whichever is greater. Once considered a rental property, allowable expenses for the ownership and maintenance of the property are deductible. However, it could be potentially limited under the passive activity loss rules unless the owner is a real estate professional.
If personal use exceeds 14 days or 10% of the total rental days, the vacation property is then considered a personal residence. Once considered a personal residence, deductible expenses are limited to the amount of rental income each year under the vacation home rules. The excess carries over to future tax years to offset rental income. However, mortgage interest and real estate taxes allocable to personal use can still be deducted as Schedule A itemized deductions.
If the property is rented out for 14 days or less per year, the rental income doesn’t have to be reported on your tax return. You could also deduct the mortgage interest and property taxes as you normally would for a second home on your primary residence. It would, however, be subject to the mortgage interest limitation rules.
Short-term Rental Issues
When a property’s average rental period is seven days or less, which is often the case with short-term vacation home rentals, it is not considered a rental property by the IRS. Instead it’s generally treated like any other non-real estate. In this scenario, owners would not be eligible for the AGI $25,000 per year net rental real estate loss allowance. Passive business activity under the passive activity loss rules and hours spent by owners allocable to the operation of that property are not counted toward the 750-hour test to obtain real estate professional status.
Another issue with short-term rentals, that many are unaware of, is the local and sales taxes that may apply to their short-term rental properties. Most jurisdictions consider properties rented for seven days or less to be hotels for sales tax purposes.
So, what about days when an owner needs to be at the property to perform repair and maintenance functions? Fortunately, owners and guests can be onsite during repair and maintenance activities without having to count the time as personal days if it is performed substantially full-time by the owner of the property. Tax law, however, remains somewhat unsettled about what exactly what constitutes “substantially full-time basis”.
Additional rules and limitations can come into play with vacation homes, some of which can get very technical. Please contact one of our experienced CPAs if you’d like to explore vacation home options.