Do you own a vacation home that’s rented out but also used for a significant amount of time by you personally? Such properties are subject to tax rules that are different from those that apply to properties rented out with minimal personal use. Here’s how to optimize your tax results in light of several key changes made by the Tax Cuts and Jobs Act (TCJA).
What’s Considered Personal Use?
Personal use includes use by you, other family members (whether they pay fair market rent or not), and anyone else who pays less than market rent. For this purpose, family members are your spouse, siblings, half-siblings, ancestors (such as parents and grandparents) and lineal descendants (such as children and grandchildren).
Personal use also includes time spent at your place by another party under a reciprocal sharing arrangement, whether the other party pays market rent or not.
Days devoted principally to repairs and maintenance are considered days of vacancy and disregarded. This is true even if family members are present while you make repairs and do maintenance.
Let’s take a look at two categories of ownership.
Category 1: Rented Less than 15 Days with More than 14 Days of Personal Use
The rules are simple if you rent your vacation home for less than 15 days and use it personally for more than 14 days during the year. You aren’t required to report any rental income in this case. But you also can’t deduct any direct rental expenses (such as rental agency fees and cleaning costs).
If your vacation home is located near a major event — for example, a pro golf tournament or a major multiday concert — you may be able to rent it for a short period, possibly at high rates, and pay zero federal income tax.
When it comes to saving taxes with a Category 1 property, the more rental days the better — as long as they don’t exceed 14 days for the year.
Category 2: Rented More Than 14 Days with Substantial Personal Use
The rules are more complicated for another category of properties that are rented more than 14 days, but also are used a significant amount of time for personal purposes. We’ll refer to these vacation homes as “Category 2” properties. Your vacation home falls into Category 2 if 1) you rent it for more than 14 days during the year, and 2) personal use exceeds the greater of:
- 14 days, or
- 10% of the rental days.
For example, a vacation home that’s rented for 60 days during the year and used by your family for 30 days falls into Category 2.
Category 2 properties are treated as personal residences for federal income tax purposes. You must follow these five steps to account for the property’s rental income and expenses on your personal tax return:
- Report all rental income.
- Deduct all direct rental expenses, such as rental agency fees and advertising.
- Allocate mortgage interest and property taxes between rental and personal use (see below).
- Deduct the allocable mortgage interest and property taxes as rental expenses.
- If there’s any net rental income left after Step 4, deduct as rental costs allocable indirect expenses, such as maintenance, utilities, association fees, insurance and depreciation — but only to the point where you zero out rental income.
In allocating indirect expenses, consider only actual rental and personal-use days during the year and ignore days of vacancy. For example, if you rent your vacation home for 90 days during the year and use the property 60 days for personal purposes, allocate 60% of the indirect expenses to rental use and 40% to personal use. The 40% is nondeductible. Even so, most Category 2 properties won’t generate a profit, because the rental income will usually be fully offset by deductible expenses.
You can carry over any disallowed allocable indirect expenses to future years when you can deduct them against rental profits (if you have any). The mortgage interest and property taxes allocable to personal use can be written off as itemized deductions on your personal tax return, subject to the new TCJA limits for 2018 through 2025. (See “How the TCJA Affects Vacation Home Owners” above.)
Mortgage Interest and Property Taxes: Rental vs. Personal Use
The IRS says you should use only actual days of personal and rental use to allocate all nondirect vacation home expenses, including mortgage interest and property taxes. However, two U.S. appeals court decisions say you can allocate mortgage interest and property taxes differently, by treating actual rental occupancy days as rental days and all other days — including days of vacancy — as personal days (Dorance Bolton v. Commissioner, 9th Cir., 1982 and Edith McKinney v. Commissioner, 10th Cir., 1983).
Before the TCJA, the method allowed by the appeals court cases was often more beneficial for two reasons.
- It allocates more mortgage interest and property taxes to personal use. Under prior law, you could usually fully write off these expenses as allowable itemized deductions.
- It allocates less mortgage interest and property taxes to rental use. So, you could currently deduct more of the other expenses allocable to rental usage (such as property insurance and utilities) against rental income.
But after the TCJA limits on itemized deductions for mortgage interest and property taxes, some vacation home owners may benefit from using the IRS method instead of the appeals court method. That’s because you’ll never get any tax benefit from allocating more interest and taxes to personal use than you can currently claim as itemized deductions after the TCJA changes. Your tax advisor can run the numbers at tax return time and figure out the best allocation method for interest and taxes.
Tax-Savings Strategy for Category 2 Properties
If your property fits solidly into Category 2 for the year and your expenses comfortably exceed rental income (the usual situation), you’ll probably come out ahead tax-wise by renting it out for additional days between now and year end. That way, you’ll receive more rental income, and you can probably still offset it with direct expenses, allocable mortgage interest, property taxes and allocable indirect expenses.
But it’s important to keep your property in Category 2 status by having enough personal-use days to exceed 10% of the rental days. If necessary, you may need to add a few more personal-use days before year end.
The tax rules for vacation homes are complicated, and different rules apply if your place is used primarily as a rental (with limited personal use). Contact your Mitchell Wiggins tax advisor to help ensure you comply with the current rules for reporting rental income and expenses on your 2018 tax return, as well as to discuss possible additional tax-saving opportunities.
How the TCJA Affects Vacation Home Owners
There are several provisions of the Tax Cuts and Jobs Act (TCJA) that will affect vacation home owners.
New limit on property tax deductions. For 2018 through 2025, the TCJA limits itemized deductions for personal state and local property and income taxes to a combined total of only $10,000 ($5,000 for those using married filing separately status). Under prior law, you could claim itemized deductions for an unlimited amount.The new limit can affect your ability to claim itemized deductions for property taxes on a vacation home that’s classified as a personal residence.
New limits on home mortgage interest deductions. For 2018 through 2025, the TCJA limits the amount of home mortgage debt from which you can claim itemized deductions for qualified residence interest expense. These limits can affect your ability to claim itemized deductions for mortgage interest on a vacation home that’s classified as a personal residence.
Specifically, you can treat interest on up to $750,000 of home acquisition debt (incurred to buy or improve a first or second personal residence) as deductible qualified residence interest ($375,000 for married filing separately status).
In addition, the TCJA generally eliminates the prior-law provision that allowed you to treat interest on up to $100,000 of home equity debt as deductible qualified residence interest ($50,000 for married filing separately status).
These limitations mainly affect newer buyers, because existing mortgages are grandfathered in under pre-TCJA limits. Ask us for more information about your situation.
Increased standard deductions. For 2018 through 2025, the TCJA almost doubled the standard deduction amounts.
This change can adversely affect vacation home owners because their itemized deductions (including those for mortgage interest and property taxes) may not exceed their standard deduction amount for 2018 through 2025.