You recently inquired about the income tax consequences of renting out your vacation home for part of the year. The tax consequences depend upon the amount of time the home is rented and the amount of time you use the home for personal purposes.
Minimum Rental Use. If you rent the property for fewer than 15 days during the year, you are not allowed deductions directly attributable to such rental, but that’s because of a bigger benefit: no rental income is includible in gross income. Deductions allowed without regard to whether or not the home is used for business or the production of income (e.g., mortgage interest, property taxes, or a casualty loss) may still be taken.
Deduction Limitations. If you rent the property for 15 or more days during the tax year and it is used by the taxpayer for personal purposes for the greater of (a) more than 14 days or (b) more than 10% of the number of days during the year for which the home is rented, the rental deductions are limited. Under this limitation the amount of the rental activity deductions may not exceed the amount by which the gross income derived from such activity exceeds the deductions otherwise allowable for the property, such as interest and taxes.
According to the IRS, expenses attributable to the use of the rental unit are limited in the same manner as that prescribed under the “hobby loss” rules (i.e., the total deductions may not exceed the gross rental income and the expenses are further limited to a percentage that represents the total days rented divided by the total days used). However, the Tax Court has rejected this formula (the decision has been affirmed on appeal by both the Ninth and Tenth Circuit Courts of Appeals). It is the Tax Court’s position that mortgage interest and real estate taxes are not subject to the same percentage limitations as are other expenses because they are assessed on an annual basis without regard to the number of days that the property is used. As a result, the formula employed by the Tax Court computes the percentage limitation for interest and taxes by dividing the total days rented by the total days in the year. The following example illustrates the operation of the two methods for allocating rental unit expenses.
Example. During the year an individual rents out his vacation home for 91 days and uses the home for personal purposes for 30 days. The gross rental income from the unit is $2,700 for the year. He pays $621 of real property taxes and $2,854 of mortgage interest on the property for the year. The additional expenses for maintenance, repair and utilities total $2,693.
The IRS allocation of all expenses would be based on 75% (91 days rented / 121 days used). In contrast, the Tax Court would allocate taxes and interest based on 25% (91 days rented / 365 days) and use the 75% limitation for the additional expenses for maintenance, repair, etc.
Personal use. A vacation home is deemed to have been used by the taxpayer for personal purposes if for any part of the day the home is used:
- for personal purposes by the taxpayer, any other person who owns an interest in the home, or the relatives (spouses, brothers, sisters, ancestors, lineal descendants, and spouses of lineal descendants) of either;
- by any individual who uses the home under a reciprocal arrangement, whether or not a rental is charged; and
- by any other individual who uses the home unless a fair rental is charged.
If you have any questions as to how these rules may apply to your particular situation, please do not hesitate to call.
Jerry E. Bartram, CPA