Tax Rules for Vacation Rental Properties

A vacation rental property is not only a source of income, but often a wise investment. Real estate, especially in desirable areas, tends to appreciate in value. There are other advantages, too: vacation rentals can diversify your investment portfolio and qualify you for certain tax deductions. And, of course, there is the opportunity to use the property for personal vacations when it’s not rented out. But if you’re not careful, vacationing in your investment property could result in unfavorable tax consequences. Take the time to understand the tax rules for vacation rental properties.

Vacation Property Tax Rules: What is a Personal Residence?

There are tax benefits (and some tax disadvantages)to owning a vacation rental property—but if that property is classified as a personal residence under federal tax law, a different set of rules apply. The federal government considers your vacation home a personal residence if it meets the following criteria:

• You rent the property out for more than 14 days in a calendar year, AND
• Personal use of the property during the year is more than the greater of:
  • 14 days, OR
  • 10% of the days you rent the house out at fair market rates.

For example, let’s say that you and your family own a lakefront cottage in a warm climate that allows you to rent it out 180 days per year. 10% of 180 is 18. Under the rule above, you could make personal use of the cottage for up to 18 days without it being considered a “personal residence,” since 18 is greater than 14. If you stay there with your family for 21 days (21>18) the cottage would be a personal residence under federal tax law.

If you were only able to rent the cottage at fair market rates for 90 days, 10% of that would equal nine days. The cottage would be considered a personal residence for tax purposes only if you used it for more than 14 days (because 14 days is greater than 10% of the time you rent the property out).

What Counts as “Personal Use?”

Personal use doesn’t just mean you and your immediate family. If you let your cousin borrow the cottage for a weekend, or you rent it to your coworker for a week at below-market rates, those are still charged to you as days of personal use.

Some people have even tried to get around the personal use rule by swapping: they stay in a friend’s vacation rental for a period of time, while the friend stays in theirs, and may even pay each other rent at fair market rates. The IRS says no dice: that’s still “personal use” for purposes of determining whether a property is a personal residence or a vacation property under the tax code.

What happens when the house is standing empty, or when you are on the property primarily to do necessary repairs and maintenance? Those don’t count as either rental days or personal use days.

Vacation Property Tax Rules for Brief Rentals of a Personal Residence

Let’s look at things from the opposite perspective: what happens if, rather than staying in your vacation rental property for part of the year, you rent out your personal residence for a week or two? This is common in areas that have high demand for rental space for a regular, but limited period—say, an annual golf tournament or business convention.

Good news: so long as you rent your personal residence out for less than 15 days per year, and make personal use of it for at least 14 days, you do not need to declare the rental income on your taxes. On the other hand, you don’t get to deduct expenses associated with the rental, such as cleaning before and after, but that trade-off is usually worth it, especially for areas and events for which houses rent for many thousands of dollars per week. You can still deduct your mortgage income for the rental period.

Allocation of Expenses for Taxes on Vacation Rental Property

If your vacation home is classified as a rental property for tax purposes, you must allocate expenses such as mortgage interest and property taxes between the number of days you rent the property out and the number of days you make personal use of it.

For instance, let’s say that you rent your cottage out for 180 days and stay there for 18 days. You would allocate allowable expenses according to the fraction of the total of the days that the cottage was used for either rental or personal use. In that example, The total number of days is 198 (180+18). The fraction of expenses allocated to personal use would be 18/198; the fraction allocated to rental use would be 180/198.

Certain expenses, such as the qualified residence interest deduction, are available for vacation homes—IF they are classified as personal residences. In the example above, the cottage would be classified as a rental property. The result? The personal-use fraction of the mortgage interest would be non-deductible, along with expenses for maintenance, insurance, depreciation, and utility payments. The personal-use fraction of certain other expenses, like real property taxes, may be deductible on your personal income tax return.

Tax-Deductible Losses on Vacation Rental Property

If your vacation home is classified as a rental property, you may find that in some years, your allocable rental expenses are greater than your rental income. This may happen due to a natural disaster or the need for major repairs. That may constitute a deductible tax loss, and you might be able to report it on Schedule E of your personal income tax return.

However, passive losses such as this can only be deducted to the extent that you have other passive income against which to take them. For instance, if major repairs to your beach house after a hurricane generated a $10,000 passive loss, but rental income from your ski condo generated $15,000 in passive income, you could claim the loss on your tax return. Without passive income, you may “carry forward” the loss until you have sufficient passive income to claim it against, or until you sell the property that produced the loss.

There are exceptions to these passive activity loss (PAL) rules for small landlords and certain real estate professionals. Contact your tax professional to learn more.

The Bottom Line

Whether your real estate is classified as a personal residence or a rental property impacts your taxes; if you are not careful, you could change the classification without realizing it. To learn more about tax rules for vacation rental properties and to make sure your real estate is classified in the way that is best for you, schedule an appointment today with the accounting and tax preparation professionals at Gudorf Tax Group.