Making the best tax use of a vacation home under today’s rules—Part I
An improved economy, a strengthened real estate market in many areas, and a favorable interest rate environment has led to a resurgence of interest in vacation or second homes. These properties offer a chance to provide the family with a place to rest and relax at a reduced cost when compared to expensive short-term resort rentals, and at the same time give owners a shot at capital appreciation over the long term. They also offer a chance to earn some rental income when the owner or family members aren’t using the property. This installment, the first of a 2-part Practice Alert, reviews today’s tax rules that apply to vacation homes that are rented to others during the year and suggests some planning moves.
Overview. The tax treatment of a vacation home depends on the mix of personal and rental use. If personal use of the home is extensive enough for it to be treated as used as a residence under Code Sec. 280A, deductions for the rental portion will be restricted by the vacation home rules in that Code Section, but deductions for the personal use portion won’t be affected. If there’s enough rental use for the property to be treated as rental property, not as a personal residence, then (1) the owner’s rent-related deductions will be restricted by the passive activity loss rules, not the vacation home rules, and (2) deductions for the personal use portion will be adversely affected.
Vacation Home Used as a Residence
A vacation home is treated as used as a residence during a tax year if personal use exceeds the greater of 14 days or 10% of the days the property is rented to others during the year at a fair rental. (Code Sec. 280A(d)(1)) Although the property is considered to be a residence, the owner still must treat the rental portion of the vacation home separately from the personal portion.
Rental portion. With an exception for limited rental use noted below, rentals are included in income on Schedule E, but may be offset with deductions for the rent-related portions of expenses such as utilities, maintenance, upkeep, mortgage interest, real estate taxes and insurance. The owner also may claim a depreciation deduction relating to the rental use. However, under Code Sec. 280A(c)(5), those type of deductions can’t exceed rental income less:
- Other deductions related to the rental activity itself, such as advertising, broker’s commissions, and cleaning fees paid by the owner after rental periods. RIA observation: One example of a deduction that fits into this category is the owner’s costs to travel to his vacation home in connection with its rental. For example, he may have to drive out to the home to meet a prospective tenant, or to arrange for the home to be cleaned up or repaired before the rental season begins. These types of expenses should be deductible (e.g., at the rate of 57.5¢ per mile in 2015 for driving), along with other rental-related costs.
- Deductions (such as interest and real estate taxes) allocable to the rental use which would be deductible whether or not the vacation home was rented out.
Excess expenses are carried forward and may be used in a future year when there’s additional rental income.
For any year in which the rules of Code Sec. 280A(c)(5) apply to a property, the passive loss rules don’t apply. (Code Sec. 469(j)(10))
Personal portion. The owner deducts on Schedule A the real estate taxes and mortgage interest allocable to personal use of the home. Because personal use exceeds the greater of 14 days or 10% of the days it is rented out during the year, the vacation home is treated as a qualified residence for purposes of the mortgage interest deduction. (Code Sec. 163(h)(4)(A)(i)(II)) Assuming the taxpayer doesn’t own another vacation home and meets the other rules for deducting qualified residence interest, he can fully deduct the personal-use portion of the year’s mortgage interest.
Allocating expenses. IRS says that all expenses are apportioned between rental and personal use based on the number of days used for each purpose. (Prop Reg § 1.280A-3(d)(3)(iii); IRS Publication 527, 2014, pg. 17) However, the Tax Court (Buchholz, William, TC Memo 1983-378TC Memo 1983-378), Ninth Circuit (Bolton v. Comm., (1982, CA9) 51 AFTR 2d 83-30551 AFTR 2d 83-305), and Tenth Circuit (McKinney, Edith v. Comm., (1983, CA10) 52 AFTR 2d 83-628152 AFTR 2d 83-6281) maintain that interest and taxes are allocated to rental use based on the ratio of actual rental days to total calendar days. All other expenses (e.g., utilities and maintenance) are allocated based on the ratio of rental days to total days of use.
RIA observation: The Courts’ approach can yield bigger overall deductions for the vacation home owner. For example, if a home is rented three months a year and used by the owner for vacations for one month a year, IRS’s allocation of interest and taxes is based on the period of actual occupancy (four months), and the amount of rental income against which other expenses can be deducted is reduced by 3/4 of the interest and taxes. But if interest and taxes are allocated on the basis of an entire year (as permitted by the Tax Court, Ninth and Tenth Circuits), rental income is reduced by only 1/4 of the interest and taxes (3 months divided by 12 months), with the other 3/4 deductible as itemized deductions. The reduction in the rental expense to only 1/4 of the total can then bring about a larger deduction of other rental expenses that would otherwise be disallowed under the Code Sec. 280A(c)(5) limitation.
Special rule for limited rental use. A taxpayer who rents out his vacation home for less than 15 days during the year doesn’t report rental income and can’t claim offsetting rent-related vacation home deductions. (Code Sec. 280A(g)) This one-of-a-kind tax break can be a windfall for those who own properties in prime vacation spots or in other sought-after areas (e.g., one near a prime sporting event) where even a few rental days can bring in substantial dollars.
Tax credit for residential energy efficient property installed in vacation home used as residence. For property placed in service before 2017, an individual is allowed an annual nonrefundable personal tax credit under Code Sec. 25D for the purchase of certain residential energy efficient property. As applied to such property installed in a vacation or second home used as a residence, the credit is equal to the sum of 30% of the amount paid for:
- Qualified solar energy property (i.e., property that uses solar power to generate electricity in a home);
- Qualified solar water heating property;
- Qualified small wind energy property; and
- Qualified geothermal heat pump property. (Code Sec. 25D(a), Code Sec. 25D(e)(4))
The equipment must be installed in a dwelling unit that’s located in the U.S. and used as the taxpayer’s residence (Code Sec. 25D(d)), and can’t be used to heat a swimming pool or hot tub. (Code Sec. 25D(e)(3))
The credit covers installation and labor costs (Code Sec. 25D(e)(1)) and includes sales tax. If the equipment is used less than 80% for nonbusiness purposes, only the expenses properly allocable to nonbusiness use are taken into account. (Code Sec. 25D(e)(7))
Vacation Home Used as Rental Property
A vacation home is treated primarily as rental property for a tax year in which personal use of the unit doesn’t exceed the greater of 14 days or 10% of the days the property is rented out during the year at a fair rental. In this situation, the owner’s deductions are restricted by the Code Sec. 469 passive loss rules, not by the vacation home rules.
Rental portion. When a vacation home is treated as rental property, its income and deductions generally are automatically treated as passive in nature (unless the owner qualifies under the Code Sec. 469(c)(7) material participation exception for qualifying real estate professionals). If deductions allocable to the rental portion exceed rental income, the loss generally can only offset other passive income until the property is disposed of. However, if the owner actively participates in the vacation home rental activity, and adjusted gross income (AGI) doesn’t exceed $100,000, then he can shelter non-passive income with up to $25,000 of losses from active-participation real estate rental activities, including the vacation home rental enterprise. The $25,000 allowance starts to phase out when AGI exceeds $100,000, and disappears completely when AGI reaches $150,000. (Code Sec. 469(i)(3)(A))
The active participation standard, which is less stringent than the material participation requirement, can be satisfied without regular, continuous, and substantial involvement in operations as long as the taxpayer participates in a significant way by, for example, making management decisions or arranging for others to provide services. Management decisions that are relevant in determining whether a taxpayer actively participates include approving new tenants, deciding on rental terms, approving capital or repair expenditures, and other similar decisions. (S Rept No. 99-313 (PL 99-514), 1986-3 CB 737) The $25,000 allowance won’t be available if a management or rental agent handles all aspects of renting the unit and maintaining it. See, e.g., Madler, TC Memo 1998-112TC Memo 1998-112.
The rules are different if the property is not treated as a rental activity under the special rules of Reg. § 1.469-1T(e)(3)(ii). For example, if the average period of customer use is seven days or less, the property will be treated as a trade or business, which means the taxpayer must be a material participant in the activity in order to claim deductions in excess of income.
Personal portion. The owner gets a Schedule A itemized deduction for the real estate taxes allocable to his personal use of the vacation home. However, since personal use does not exceed the greater of 14 days or 10% of the time the unit is rented out, the home is not treated as a qualified residence under Code Sec. 163(h)(4)(A)(i)(II). As a result, the interest paid on a mortgage secured by the vacation home, and allocable to personal use, will be treated as nondeductible personal interest.