Planning to Rent Your Vacation Home? Understand the Tax Implications in Advance

Renting your vacation home and collecting some extra cash may seem like a day at the beach.  However, the tax rules surrounding rental properties may make the forecast look a little less promising. Tracking your income and expenses, calculating depreciation, determining your eligibility to deduct losses, and considering personal liability are a few items to keep in mind when navigating the rental landscape.

Understanding the tax implications ahead of time is crucial if landlords plan to take advantage of tax benefits and avoid any unwelcome surprises come April 15th. Property owners may be eligible for certain tax deductions that may make owning that beach home a bit more affordable. The first step is determining how the IRS views and treats the property for tax purposes. Depending on how much you use the property personally versus renting to a third party will determine if the property will be classified as a vacation home or a rental property.

Vacation Home

Property Rented for 14 Days or Less, and Property is Used Personally for 15 Days or More:

– A special IRS rule allows taxpayers to rent out their personal residence or vacation home for up to 14 days without having to report the rental income (or any associated expenses) on their tax return. This rule is sometimes referred to as “The Masters Exemption”.  In the 1970’s, residents who lived near the famed Augusta National golf course lobbied Congress to enact this loophole, enabling them to collect tax-free income by renting their home to wealthy individuals during the Masters Tournament.

– Real estate taxes and mortgage interest may still be deducted as an itemized deduction, but any other associated expenses are not permissible.

Property Rented for 15 Days or More, and Personal Use is More Than 14 Days or 10% of Rental Days (whichever is greater):

– All rental income must be reported to the IRS.

– Expenses incurred may be deducted against rental income, but losses cannot be deducted. Expenses include insurance premiums, cleaning and maintenance, utilities, mortgage interest, real estate taxes, and depreciation.

Rental Property

Property Rented for 15 Days or More, No Personal Use:

– All rental income must be reported to the IRS.

– Expenses incurred may be deducted against rental income, losses may be allowed.

Property Rented for 15 Days or More, Personal Use Less than 14 Days:

– Same as above, but the exception is that expenses must be allocated between rental and personal use.

Rental properties are also subject to passive activity loss limitations rules.  Losses may only be deducted if certain criteria are met. First, the taxpayer must actively participate in management decisions (coordinating repairs, approving new tenants, deciding on rental terms). Next, an income limitation provides for a maximum $25,000 loss to be taken. When the taxpayer’s modified adjusted gross income (MAGI) reaches $100,000, the phase out kicks in and losses are no longer deductible when MAGI reaches $150,000.

As with every rule, there are exceptions if one is classified as a real estate professional under IRS rules.  If you fall under this classification, your rental activity is not subject to the passive activity limitations, rental losses are deductible each year and certain other provisions apply. However, the rules to qualify for this status are very strict and detailed records must be kept by the taxpayer to substantiate that they qualify as a real estate professional. You should consult your tax advisor to determine if you might qualify for this status.

While not directly tax-related, another factor real property owners must consider is the risk of personal liability. Owners are responsible for ensuring the safety of the property for their tenants and guests. Although homeowner’s insurance covers most incidents that property owners will face, there are several situations in which additional coverage from an umbrella policy would be an option. Beyond, this one may even need to consider creating a separate legal entity to own the property to provide additional protection

Property owners must be thoughtful in deciding whether to engage in rental real estate activities. The current tax law, recordkeeping requirements, and personal liability are just a few of the complicated matters one must consider. Discussing these issues with your tax advisor is imperative when it comes to understanding what it all means for your unique situation.