Do you own a vacation home? If so and you rent it to third parties, you may be confused about the federal income tax rules that apply. Confusion is especially common if you changed your usage pattern during the pandemic. It may have caused your property to be classified as a personal residence — rather than a rental property — for federal income tax purposes.
Here’s an overview of the tax implications for vacation homes that fall into the personal residence category.
No Rental Income, No Problem
If you own a vacation property that you don’t rent out during the year, it’s obviously treated as a personal residence for federal income tax purposes. Unfavorable changes made by the Tax Cuts and Jobs Act (TCJA) can affect your itemized deductions for mortgage interest and property taxes. For instance, if you have a jumbo mortgage on your main residence and pay heavy property taxes on it, there may be no room left to deduct mortgage interest or property taxes on your vacation home.
The TCJA limits itemized deductions for mortgage interest to interest paid on the first $750,000 of home acquisition debt generally starting with loans taken out after December 15, 2017. Preexisting home acquisition debts are grandfathered under the prior law limit of $1 million.
In addition, through 2025, itemized deductions for personal state and local taxes are limited to a combined total of only $10,000 ($5,000 for married filing separately). The limitation applies to state and local 1) income (or sales) taxes and 2) property taxes. Moreover, personal foreign real property taxes can no longer be deducted. So, if you’re lucky enough to own a vacation villa in the Bahamas or a beach condo in Cancun, you can’t deduct the property taxes.
Properties Rented for Fewer than 15 Days
A special federal income tax break is available if you rent out your vacation home for less than 15 days during the year and use it for personal purposes for more than 14 days. This scenario often happens with vacation homes located near major events, such as professional golf tournaments. Here, you don’t need to report any rental income. The rental activity is completely disregarded for federal income tax purposes.
You can report any allowable itemized deductions for mortgage interest and property taxes on your personal tax return. The only drawback is that you can’t deduct other expenses attributable to the rental period, such as advertising and cleaning costs.
Personal Residence vs. Rental Property
Assuming your place doesn’t qualify for the special break for properties rented for fewer than 15 days, here’s what the Internal Revenue Code and IRS regulations say about how to classify “mixed-use” vacation properties that have both personal and rental use during the year.
Your vacation home is classified as a personal residence if:
- You rent it out for more than 14 days during the year, and
- Personal use during the year exceeds the greater of 14 days or 10% of the days you rent the home out at fair market rates.
Count only actual days of rental and personal occupancy. Disregard days of vacancy and days that you spend mainly on repair and maintenance activities.
Personal use means use by the owner, certain family members and any other party (family member or otherwise) who pays less than fair market rental rates. If your vacation home is used by another person under a reciprocal arrangement (“I use your place and you use mine”), such use is also considered personal use. That’s the case regardless of whether you charge the other person fair market rent for your property and whether you pay fair market rent for the other person’s property.
Consider this example: During 2021, your family and friends use your beachfront condo for 120 days. You rent the place out to third parties at market rates for 210 days. This condo is classified as a personal residence for the year because your personal use exceeds the greater of 1) 14 days, or 2) 10% of the rental days. See “Reporting Income and Allocating Expenses,” below, for how to report the income and expenses related to your personal residence vacation home on your federal income tax return.
Conversely, your vacation home is classified as a rental property if:
- You rent it out for more than 14 days during the year, and
- Personal use during the year doesn’t exceed the greater of 14 days or 10% of the days you rent the home out at fair market rates.
Again, count only actual days of rental and personal use. Also disregard days of vacancy and days spent mainly on repair and maintenance activities.
Here’s another example: During 2021, you rent your beachfront condo to third parties at market rates for 300 days. Your family uses the condo for 30 days. This condo is classified as rental property for the year, because personal use doesn’t exceed the greater of 1) 14 days, or 2) 10% of the rental days. A different set of tax rules applies to rental properties.
Year-End Planning Considerations
You may be able to manage the number of rental and personal-use days between now and year end. How you decide to use the property for the remainder of the year may have important tax implications. In some cases, your usage may flip the property’s tax classification from personal residence status to rental property status (or vice versa).
For instance, you and family members may be anxious to spend more time at your vacation home and less time in the big city. That could place your vacation home firmly into the personal residence category. If so, adding more personal-use days may increase current itemized deductions for qualified residence interest expense and property taxes.
However, if you’re affected by the TCJA limitations on interest expense and property taxes, adding more personal-use days may just result in bigger personal-use allocations of interest expense and property taxes that you can’t currently write off as itemized deductions because of the TCJA limitations. The tax results will depend on your exact situation.
Alternatively, the current rental demand for your vacation home may be so high that you can’t resist the opportunity to collect more rental income. That could put your place into the rental property category.
What’s Right for Your Property?
As you can see, the federal income tax rules for vacation homes can be complicated. Consult your tax professional for advice on how to get the best tax results in your particular situation.
|Reporting Income and Allocating Expenses
The fundamental federal income tax principle for a mixed-use vacation home that’s classified as a personal residence is that deductible expenses allocable to rental usage can’t exceed the gross rental income. In other words, rental expenses can’t cause a tax loss.
Gross rental income is defined as rental income after subtracting direct expenditures to obtain tenants, such as commissions paid to rental agents and advertising expenses. Deduct allowable expenses allocable to rental use on Schedule E of your personal return. You can also claim itemized deductions for allowable mortgage interest expense and allowable property taxes allocable to personal use.
How do you allocate vacation home expenses between personal and rental use? For a vacation home that’s classified as a personal residence, apply the following seven steps to report the rental income and allocate expenses: