Preface: “The vacation we often need is freedom from our own mind.” – Jack Adam Weber
Rentals of Vacation Property
Credit: Benuel B. Glick, EA
Maybe you own, or want to own, a rental dwelling at a strategic, beach-front location. Or perhaps it’s a cabin located in the mountains where vacationers go during the summer and hunters gather during hunting season. Whatever the scenario, likely the motive for owning it is partially for hunting, vacationing, or other personal benefits. You may be wondering if there are tax strategies that prove advantageous to these expensive hobbies.
If you rent out part or all of a dwelling unit and use any part of the dwelling for personal purposes, the IRS has some “tests” for you to apply in determining the allocation of qualifying expenses for appropriate tax treatment. These tests are applied on a per tax year basis.
First, to qualify as a dwelling unit it must provide basic living accommodations (i.e., sleeping space, and cooking facilities etc.). It can be mobile such as a recreational vehicle, boat etc., (no, a tent does not qualify). One structure can contain multiple dwelling units; think apartment, basement, garage, or any room that satisfies the basic living accommodations requirement. A dwelling unit does not include property used solely as a hotel, motel, inn, or similar establishment.
Consider the following 3 classifications of residential real estate, listed in the order of generally least favorable to most favorable tax treatment preferences;
- Personal residence
- Vacation home (a.k.a. Section 280A property)
- Rental property
But, how do you know if your hunting cabin is a rental property, a vacation home, or a personal residence? This is where we refer to those tests from the IRS mentioned above. The following are two “minimum use” tests which we’ll refer to as rental use test, and personal use test.
“Rental Use” Test
This test examines the number of rental use days, defined as days the property was rented to unrelated third parties* at a fair rental price. Over 14 days during the tax year = pass. 14 days or less = fail. If your dwelling fails this test, it will be considered a personal residence. If it passes, we apply the next test.
“Personal Use” Test
This test considers the number of personal use days for the tax year. Assuming your dwelling passed the rental use test, if you or a related party* personally used this dwelling for more than the greater of 14 days or 10% of the days rented to others at a fair rental price, it fails the personal use test and is considered a vacation home. Conversely, if the personal use days are less than the greater of 14, or 10% of the days rented to others at fair market value, your dwelling passes the personal use test and is considered a rental property.
Now that you’ve determined whether you have a personal, vacation, or rental dwelling unit, let’s explore the tax treatment for each.
You don’t need to report rental income if your home fails the rental use test.
Example; say you own a dwelling in a strategic location. Due to a famous horse race in the area, you rent it out for a premium of $700 per day for 10 days during the tax year. This creates $7,000 revenue that you don’t need to report to the IRS. Except for qualifying mortgage interest and real estate taxes on Schedule A, no expenses are reported either.
If your dwelling is considered a vacation home for the tax year, you report all the income. The expenses are allocated to rental using the following ratio; fair rental days ÷ (fair rental days + personal use days). Note that the days you spend working substantially full time repairing and maintaining the property are ignored and treated the same as a vacant day.
Important to know for vacation homes is that a net rental activity on Schedule E may not show a loss. However, itemized deductions such as qualified mortgage interest and real estate taxes, may allow an overall deduction for the property in certain instances. Any deductions on Schedule E in excess of revenues are suspended. Suspended deductions may be taken in a future year if there is enough revenue but may not be taken when the property is disposed. Deductions need to be taken in the following order;
- deductions that normally appear on Schedule A,
- normal deductions, (utilities, etc.),
Example; you own a dwelling that was used by you or your family for 30 days during said tax year. You rented it out for 158 days to non-related parties* at a fair rental price. For simplicity, we’ll say your total utility bill was $2,500. Following is the formula to determine how much of the $2,500 you allocate to your rental, 158 ÷ (158 + 30) = 84%. Therefore 84% of $2,500 may be deducted against gross income for that unit to the extent that it does not create a loss. The remaining 16% is a personal expense.
Let’s say qualified mortgage interest and real estate taxes are a combined total of $5,500 for the year. You may take 84% of $5,500 against gross income as well (applied before the utilities). The remaining 16% of the $5,500 may be included on Schedule A, itemized deductions. There are additional limitations here beyond the scope of this article.
If your dwelling unit passed both the rental and personal use tests, it is classified as a rental property. In which case you get to deduct the full applicable expenses against gross income.
Example; let’s use the example from the prior section but instead of personally using your dwelling for 30 days, you used it for 15 days. Since you are allowed up to the greater of 14 days or 10% of the days rented at fair rental value (158 x 10% = 15.8), you get to allocate 100% of the $2,500 utilities and $5,500 combined mortgage interest and taxes to the rental property.
Although there are temporary limitations for short-term rental losses, in this category you are not limited to the blanket net loss rule that applies to vacation homes. Just know that the tax code has limitations on offsetting passive losses against passive income.
The passive losses rules are beyond the scope of this article, but that can create a temporary limitation. A rental is considered short term if the average days rented out during the year are 7 days or less per party.
In this article, we glimpsed into the complexity of vacation homes. Keep in mind that this is not all encompassing. It is safe to say that there are numerous stipulations to consider in applying appropriate tax treatments to your rental property.
*Related party rentals do NOT qualify as rental use unless it is both rented at a fair rental value and the related party uses the unit as a principal residence. If both requirements are met, use by the related party is considered rental use. A related party is your, or any person with financial interest in the unit’s, brother, sister, spouse, ancestor, or lineal descendant.
This article is general in nature, and it does not contain legal or tax advice. Contact your advisors to discuss your specific tax situation.