Finance: Vacation Home or Rental Property?
The Tax Rules of the Road Are Different for Each Category
By TERRI JUDYCKI
Terri Judycki, CPA, MST
Many decide to rent the home in order to offset some of the ownership and maintenance costs. It is important to understand the tax consequences that result from mixed personal/rental use of the property.
Depending on usage, a property with mixed use can be categorized as one of the following:
• Personal residence, if rented out for fewer than 15 days during the year;
• Vacation home, if rented out for more than 14 days and if personal use exceeds the greater of 14 days or 10% of the days rented; or
• Rental property, if personal use does not exceed the greater of 14 days or 10% of the days rented.
It is important to note that a property can be categorized differently from one year to the next.
A personal residence that is used for personal purposes for more than 14 days but rented for fewer than 15 days is treated as solely a personal residence. The income is not taxable, and expenses are not deductible, other than the taxes and qualified residence interest that may be deductible on Schedule A.
If the property is rented for more than 14 days and personal use exceeds the greater of 14 days or 10% of the rental days, rental income and allocable expenses are reported on Schedule E. Deductions (other than taxes and qualified residence interest) are limited to rental income, and ordering rules apply to determine which expenses are allowable.
Gross rental receipts are reduced by costs to obtain tenants, such as commissions and advertising. Expenses are then allocated between personal and rental days. For example, if the property is rented for 75 days and used personally for 25 days, then one-quarter of the expenses are personal and three-quarters are deductible as rental expenses. The expenses allocated to rental use are considered in the following order: (1) expenses that are deductible whether or not the property is rented, such as taxes and qualified residence interest; (2) operating expenses, other than depreciation; and (3) depreciation.
Expenses in the second and third categories may not create a loss. Any such expenses disallowed due to the income limitation may be carried forward to future years until there is sufficient rental income. The taxes and qualified residence interest allocated to personal use are deductible on Schedule A, subject to limits. Note that there is a conflict between the IRS and the Tax Court concerning the proper allocation of taxes and interest. Because taxes and interest are incurred regardless of use, the Tax Court has allowed taxpayers to pro-rate those expenses over the entire year.
Property that is rented and has personal use that does not exceed the greater of 14 days or 10% of the days rented is not considered a residence under tax rules; it is considered rental property. While expenses must still be allocated between personal and rental days, there are no ordering rules for expenses, and expenses are not limited to income. Passive-activity-loss rules may limit the use of any loss for a particular tax year.
The taxes attributed to personal use may still be deducted on Schedule A, but the portion of mortgage interest allocated to personal use may not be deducted on Schedule A, because the property is not considered a residence. This may be a tax trap, depending on the size of the mortgage. If the interest allocated to personal use is significant, it may be beneficial to use the property personally for more than the greater of 14 days or 10% of the rental days.
Because tax treatment depends on the mix of personal and rental use, it is important to understand how tax law defines ‘personal use.’ In determining personal use, in addition to the days of use by the owner, days used or rented by anyone at less than fair rental must be included. Rental to a family member, even at fair rental, is considered personal use unless the property was used as the family member’s principal residence. Days the taxpayer spends repairing and maintaining the property on a full-time basis are not counted as days of personal use.
Timeshare units have additional complications. Personal use by other owners, such as other timeshare owners, is included in determining the extent of personal use. This rule makes it almost certain that timeshares will never be considered rental property.
Personal usage by all the unit owners will almost always be sufficient to cause all the owners to be subject to vacation home rules and limitations. Also, in order to qualify for as a residence with fewer than 15 days rent, the rental days for all the unit owners must be fewer than 15 days, again making it almost impossible to qualify for that exception.
However, in determining whether the mortgage interest can be deducted as qualified residence interest, the taxpayer need only determine whether his or her personal use exceeds the greater of 14 days or 10% of the individual owner’s rental days. Due to a special rule governing mortgage-interest deductions, if the unit is not rented at all, the mortgage interest may be deductible on Schedule A, provided all the other requirements are met.
While an owner’s use of property is normally driven by non-tax considerations, it is important to understand how choices will affect tax consequences. Because each taxpayer’s situation is different, determining how changes in use will affect taxes requires individual analysis.
If you have questions regarding the status of your second home or are planning to purchase a second home that may see mixed use, be sure to speak with your tax professional.
Terri Judycki, CPA is a tax senior manager with the Holyoke-based public accounting firm Meyers Brothers Kalicka, P.C.; (413) 322-3510; [email protected]
