Vacation Home Taxes 101

Investment Taxes, Property Taxes, Taxes

It sounds like a great idea – purchase a vacation home in your favorite destination and recoup some of your costs by renting the home out when you are not using it. This can be an excellent choice, but investigate the tax issues that are associated with vacation/rental homes before you purchase.

The tax concerns are different depending on the amount of time you occupy the home vs. renting it out (business vs. personal use). Personal use also includes renting to relatives or renting well below market value. The rules are divided into three categories according to the business/personal use ratio.

  • Limited Rental – If you only rent out the home for fourteen days or less over the course of a tax year, the home is considered a personal residence. In that case, your rental income is not even reportable. This option appeals to people who rent out their home for special occasions like weekend festivals.

    Since the rental income is not reportable, the rental expenses cannot be deducted. However, you can deduct mortgage interest and property taxes (100% of interest on up to $1 million of mortgage debt or $100,000 of a second mortgage). Points are also deductible, but generally only over the entire term of the loan for a second home. See IRS Publication 936, “Home Mortgage Interest Deduction,” for details.

  • Limited Personal Use – Conversely, if you use the home for personal use for fourteen days or less, or less than 10% of the rental days at fair market value, the home is considered rental property for tax purposes.

    Rental income must be reported, and all rental expenses can be deducted. These expenses include utilities, repairs, taxes, management fees, homeowner’s insurance, mortgage interest/points, depreciation, advertising, legal fees, transportation, and cleaning and maintenance. See IRS Publication 527, “Residential Rental Property,” for details.

    If you report a loss, the “passive activity” rule limits the deduction – however, if you actively manage the property you may still deduct losses up to $25,000 within phase-out limits. Passive losses can be collected and used to offset taxable profit upon sale of the home, but in that case, you are effectively operating a business. You must have profit from rental activity for at least three out of five years and cannot jump back and forth between business/non-business categories to avoid the rule. See IRS Publication 925, “Passive Activity and At-Risk Rules,” for details.

  • Mixed Use – In this case, you have to report all rental income and can only deduct rental expenses by the ratio of days rented at fair market value to the total number of days occupied. Excess expenses cannot be used to offset other income, but they can be taken as personal itemized deductions on Schedule A or carried over to the next year’s taxes.

    One exception: the amount paid to a property manager is 100% deductible.

Note that for all of the above categories, any days that you spend at the home engaged in fixing up or maintaining the property do not count as personal days for tax evaluation purposes.

The definition of vacation home is relatively broad. Boats or RV’s can be considered as vacation homes assuming they have permanent sleeping, cooking, and toilet facilities.

One vacation home tax break was reduced several years ago. Prior to 2009, you could make your vacation home your primary home for at least two years and take up to $500,000 in profit upon sale free of capital gains tax. Now this only applies to the percentage of time owned prior to 2008.

Taxes should not determine where and when you buy a vacation home – but the impact should not be completely dismissed either. With a little research, you can acquire your dream vacation home and take as many potential tax advantages as possible along the way. That’s a classic win-win situation.

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