Tackling Tax Questions About Vacation Homes

Tackling Tax Questions About Vacation Homes - By Lauren Baier Kim

RealEstateJournal.com spoke with Tom Ochsenschlager, vice president of taxation at the American Institute of Certified Public Accountants, about income taxes and tax deductions for second-home owners. The AICPA is a New York-based professional organization for certified public accountants.

How a second home is used -- for personal use, as a rental property, or both -- affects how you will be taxed for income on that property and the way in which you can take deductions for that home, Mr. Ochsenschlager says.

I rent out my vacation house only a few days a year. Do I have to pay tax on my rental income?

There is a provision where you can rent your house, which a lot of people did for the 1996 Olympics in Atlanta, for two weeks or less a year and not have to pay any tax on the rental income. That's what is sometimes referred to as the Masters provision. People along the Augusta National Golf Club, where the Masters Tournament takes place, rent their homes for fabulous amounts, but the tournament takes less than two weeks.

People in this category can't take any deductions against the income from their property for things like utilities and maintenance, but they don't have to report any rental income. Some people make a lot of tax-free money each year renting their house for recurring events like the Masters.

How does one figure out if Uncle Sam considers a property a personal home or a rental property for tax purposes?

There are three different kinds of rental vacation homes.

One, discussed above, falls under the so-called Masters provision -- if you rent it for 14 days or less, then you don't pay tax on the rental income.

The second category applies if you rent the home for more than 14 days but also have significant personal use. For this purpose, significant personal use is defined as the greater of 14 days or 10% of the number of days that it is rented.

If the house falls into this category, then it is considered a secondary home and not a rental property. For example, if the house is rented at fair market value for 200 days and is used either by the vacation-home owner, or rented for less than fair market value -- for instance, to friends or family -- for 21 days, it is a secondary home. If it falls in this category, you have to pay taxes on the rental income but can take deductions against the rental income. Generally, your deductions can't exceed your rental income.

The exception to this general rule is that you can claim what are called statutory deductions: interest and property taxes. In some cases, these two deductions might add up to more than the rental income. This would be a situation where you would be able to claim an operating loss for a secondary home. Generally, a secondary-home owner does not get a tax benefit from a loss, nor can he or she carry it forward or back to apply to another tax year.

The third type of house is one that you don't use yourself -- or let someone else, such as a family member, use it for less than fair-market rental value -- for more than the greater of 14 days or 10% of the days that it is rented. A house in this category is considered a rental property. You have to pay taxes on the rental income but generally can take deductions in excess of the income.

Still, there are the catches. First, the deductions have to be apportioned between personal use and rental use. So, say you used the property for 10 days and rented it for 200 days. Then, every deduction would be apportioned between personal use and rental use. Generally, you would be able to take 200/210 (days rented over total days used) times each deduction to determine what you can claim as a deduction related to the rental activity. In this case, the mortgage interest and real-estate taxes that are allocated to personal use would be claimed as itemized deductions on your Schedule A with the remainder claimed as a deduction against the rental income on Schedule E for Form 1040.

A second limitation on your ability to take advantage of a current loss on this category of house is the so-called "passive loss rule." The details of this rule are beyond the scope of this article, but suffice it to say that most individuals cannot claim a loss from a rental property on their personal return. Rather, the loss is carried forward to future returns to use in a year in which the property does generate positive income. Sometimes, this is not until the property is sold or otherwise disposed of.

What sort of deductions can owners of rental properties take?

There is an ordering to the deductions. The order you have to take them is the mortgage interest and real-estate taxes first, and then you get to take out-of-pocket deductions that are related to the rental property: things like repairs, maintenance, utilities, homeowner's association dues -- that is, fees paid toward the management of the community's common areas -- and dues to a swim or racquet club that is available to you and the people who rent the property, and finally, the appropriate depreciation for the structure. Generally, that is whatever you paid for the house, plus any capital improvements, such as an addition on the house, divided by the life of the structure, which is assumed to be 27 ½ years. Note the depreciation is only on the cost of the house, not the land. Remember, however, the ability to claim deductions in excess of the income is likely to be subject to the passive loss rules.

If your vacation home is considered a secondary home, and not a rental residence, what deductions can you take?

Generally, the deductions are the same as those for owners of rental properties. The difference is that, if the deductions create a loss, an owner of a rental property gets to carry a loss forward -- or, in some situations, carry it back -- whereas the owner of a secondary home that generates a loss -- other than a loss created by mortgage interest and real-estate taxes -- does not get a tax benefit from that loss.

In both cases, to determine what is deductible, you first have to take the rental portion of expenditures -- such as real-estate taxes and mortgage interest -- that is statutorily deductible. After that, you would take expenses directly related to the rental, such as advertising and commissions. Then, you would take the rental portion of out-of-pocket expenditures discussed above, such as repairs, maintenance costs, utilities, property management fees, association dues and the like.

For instance, if you personally used the residence half the time and rented it half the time, half of your real-estate taxes and mortgage interest would be reported as an itemized deduction on your individual tax return. The other half of the mortgage interest and real-estate taxes would be reported as a deduction from your rental income.

The last deduction you take is depreciation, which is also apportioned between personal and rental use. Remember, you only take these deductions to the extent that you have net rental income after taking all the deductions described in the order above.

Click here for the full Wall Street Journal story.

Additional Resources

Publication 527, Residential Rental Property
Topic 415 -- Renting Residential and Vacation Property
Publication 925, Passive Activity and At-Risk Rules