Do you own a second home that you sometimes use for vacations and sometimes rent out? The IRS wants to know how much time you spend doing both those things, because the answer can affects your federal income taxes.
This column summarizes the federal income tax treatment of vacation homes that are rented out enough during the year to be classified under IRS rules as rental properties rather than personal residences.
If your vacation home falls into the rental property category, here’s the scoop on the tax angles.
Is your vacation home classified as a personal residence or a rental property?
Good question. Here’s what the Internal Revenue Code and IRS regulations say about how to classify “mixed-use” vacation properties that have both rental and personal use during the year.
Your vacation home is classified as a rental property if:
- You rent it out for more than 14 days during the year and
- Personal use during the year does not exceed the greater of: (1) 14 days or (2) 10% of the days you rent the home out at fair market rates.
Personal use generally means use by the owner, certain family members, and any other party (family member or otherwise) who pays less than fair market rental rates. If your vacation home is used by another person under a reciprocal arrangement (“I use your place and you use mine”), such use is considered personal use. That’s the case whether or not you charge the other person fair market rent for your property and whether or not you pay fair market rent for the other person’s property.
Count only actual days of rental and personal use. Disregard days of vacancy, and disregard days spent mainly on repair and maintenance activities.
Example 1: During 2021, you rent your deluxe lakeside cabin (actually more like a nice house) to third parties at market rates for 210 days. Your family uses the place for only 21 days. Because your personal use does not exceed the greater of: (1) 14 days or (2) 10% of the rental days, the cabin is classified as a rental property for the year, and the tax rules explained here apply.
Your vacation home is classified as a personal residence if:
- You rent it out for more than 14 days during the year and
- Personal use during the year exceeds the greater of: (1) 14 days or (2) 10% of the days you rent the home out at fair market rates.
Once again, count only actual days of rental and personal occupancy. Disregard days of vacancy, and disregard days that you spend mainly on repair and maintenance activities.
Example 2: During 2021, your family, other family members, and friends use your lakeside cabin for 90 days. You rent the place out to third parties at market rates for 120 days. Because personal use exceeds the greater of: (1) 14 days or (2) 10% of the rental days, the cabin is classified as a personal residence for the year, and the tax rules explained in my earlier column apply. See here for more details.
Fundamental tax rule for rental properties
For vacation homes that are classified as rental properties, mortgage interest, property taxes, and other expenses must all be allocated between rental and personal use based on actual days of rental and personal occupancy.
Mortgage interest deductions
Mortgage interest allocable to personal use of a vacation home that is classified as a rental property does not meet the definition of qualified residence interest for itemized deduction purposes. The qualified residence interest deduction is only allowed for mortgage interest on a vacation home that is classified as a personal residence.
Example 3: Impact of classification as rental property on mortgage interest deduction.
As in Example 1, you rent your cabin for 210 days and use it for personal purposes for only 21 days. So, the place is classified as a rental property. That means you must allocate all the expenses between rental and personal usage using 210/231 as the rental-use fraction and 21/231 as the personal-use fraction. So, 21/231 of the mortgage interest for the condo is nondeductible. The same is true for 21/231 of the other expenses (insurance, utilities, maintenance, depreciation, etc.).
However, you can potentially deduct the personal-use portion of real property taxes on Schedule A of your Form 1040, subject to the limitation on itemized deductions for state and local taxes.
Schedule E losses and the dreaded passive activity loss (PAL) rules
When allocable rental expenses exceed rental income, a vacation home classified as a rental property can potentially generate a deductible tax loss that you can report on Schedule E of your Form 1040. Great.
Unfortunately, your vacation home rental loss may be wholly or partially deferred under the dreaded passive activity loss (PAL) rules. Here’s why. You can generally deduct passive losses only to the extent that you have passive income from other sources (such as rental properties that produce positive taxable income). Disallowed passive losses from a property are carried forward to future tax years and can be deducted when you have sufficient passive income or when you sell the loss-producing property.
Small landlord exception to PAL rules
A favorable exception to the PAL rules allows you to currently deduct up to $25,000 of annual passive rental real estate losses if you “actively participate” and have adjusted gross income (AGI) under $100,000. The $25,000 exception is phased out between AGI of $100,000 and $150,000.
The IRS says the $25,000 small landlord exception is not allowed when the average rental period for your property is seven days or less. In that case, your vacation home rental activity is considered a “business” rather than a rental real estate activity. Strange but true.
In the “business” scenario, your vacation home rental loss is deferred under the PAL rules unless:
- You have passive income from other sources or
- You materially participate in the “business” of renting the vacation home. We explain what constitutes material participation later.
Observation: In some resort areas, the average rental period may be seven days or less. The $25,000 exception to the PAL rules is unavailable if your vacation home falls into that category. Then you may have to pass one of the material participation tests explained later to claim a current deduction for your rental loss.
An exception for real estate professionals
Another exception to the PAL rules allows qualifying individuals to currently deduct rental real estate losses even though they have little or no passive income. To be eligible for this exception: (1) you must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate and (2) those hours must be more than half the time you spend delivering personal services (in other words, working) during the year. If you can clear those hurdles, you qualify as a real estate professional.
The second step is determining if you have one or more rental real estate properties in which you materially participate. If you do, those properties are treated as non-passive and are therefore exempt from the PAL rules. That means you can generally deduct losses from those properties in the current year.
Meeting the material participation standard
The three most likely ways to meet the material participation standard for a vacation home rental activity are when:
- You do substantially all the work related to the property.
- You spend more than 100 hours dealing with the property and no other person spends more time than you.
- You spend more than 500 hours dealing with the property.
In attempting to clear one of these hurdles, you can combine your time with your spouse’s time. Realistically, however, if you use a property management firm to handle your property, you are very unlikely to pass any of the material participation tests.
Example 4: Meeting the material participation standard.
Say you cannot take advantage of the $25,000 passive loss exception for rental real estate because your AGI is too high. You have zero passive income, and you don’t qualify as a real estate professional. So, you’ve been piling up suspended passive losses from your vacation home rental activity. Ugh.
However, you may be able to transform the activity into a “business” by reducing the average rental period to seven days or less. Then, as long as you can pass one of the material participation tests for the property, you can completely avoid the PAL rules and deduct the losses against your other income. Good.
Planning your vacation usage for the rest of the year
You may be able to micro-manage the number of rental and personal-use days between now and year-end. Your post-pandemic usage pattern may differ from the earlier norm. That usage pattern can potentially result in better or worse tax outcomes, especially when it flips your vacation home from personal residence stats to rental property status or vice versa.
For instance, you and your family may be anxious to spend more time at your vacation home and less time in the big city. That could put your vacation home firmly into the personal residence category. If so, adding more personal-use days may increase current itemized deductions for qualified residence interest expense and property taxes.
However, if you’re affected by the TCJA limitations on qualified residence interest expense and property taxes, adding more personal-use days may just result in bigger personal-use allocations of interest expense and property taxes that you can’t currently write off as itemized deductions because of the TCJA limitations. The tax results will depend on your exact situation. See here for more details.
Or the rental demand for your vacation home may be so high that it’s impossible to ignore the opportunity to collect more rental income. That could put your place firmly into the rental property category with the tax consequences explained here.
The bottom line
As you can see, this vacation home tax stuff can get complicated. Consider hiring a tax pro to advise you on how to get the best tax results for your specific situation.