There’s good news if you own a vacation home that you rent out: The Tax Cuts and Jobs Act (TCJA) didn’t have much effect on how your rental income and related expenses are treated under the tax rules. But those rules are still complicated. Here’s what you should know.
Classifying Your Property
Under the Internal Revenue Code and IRS regulations, there are two classifications for vacation homes.
1. Personal residence. Your property falls under this category 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.
Important note: Contact your tax advisor for details on the tax rules that apply to personal residence properties.
2. Rental property. Your vacation home falls under this category if:
- You rent it out for more than 14 days during the year, and
- Personal use during the year does not exceed the greater of: 14 days, or 10% of the days you rent the home out at fair market rates.
When making the determination between personal residence vs. rental property classification, you’re only supposed to count actual days of rental and personal occupancy. That means you disregard days of vacancy and days spent mainly on repair and maintenance activities.
Personal use generally means use by the owner, certain family members and any other party (family or otherwise) who pays less than fair market rental rates. If your vacation home is used by another person under a reciprocal arrangement, it’s considered personal use. That’s the case regardless of whether you charge one another fair market rent for use of the properties.
For example, suppose you rented your beachfront condo to third parties at fair market rates for 210 days in 2018. You and family members used the condo for 21 days. Because personal use doesn’t exceed the greater of 14 days, or 10% of the rental days, your condo is classified as a rental property for the 2018 tax year.
However, if you and your family members use the condo for 22 days or more during the year, the property will be classified as a vacation home and a different set of tax rules will apply for the 2018 tax year.
Fundamental Rule for Rental Properties
For vacation homes that are classified as rental properties, mortgage interest, property taxes and other expenses must all be allocated between rental and personal use based on actual days of rental and personal occupancy.
Mortgage interest allocable to personal use of a rental property doesn’t meet the definition of qualified residence interest for itemized deduction purposes. The qualified residence interest deduction is allowed only for mortgages on properties that are classified as personal residences.
For example, suppose you rent your beachfront condo for 210 days and use it for personal purposes for 21 days in 2018. The condo is classified as a rental property. So, you must allocate all the expenses between rental and personal usage using 210/231 as the rental-use fraction and 21/231 as the personal-use fraction.
Therefore, 21/231 (roughly 9%) of the mortgage interest for the condo is nondeductible. The same is true for other expenses, such as insurance, utilities, maintenance and depreciation. However, you can potentially deduct the personal-use portion of real property taxes on your federal income tax return, subject to the TCJA limitation on itemized deductions for state and local taxes.
PAL Rules
When allocable rental expenses exceed rental income, a vacation home classified as a rental property can potentially generate a deductible tax loss.
Unfortunately, your vacation home rental loss may be wholly or partially deferred under the passive activity loss (PAL) rules. Why? You can generally deduct passive losses only to the extent that you have passive income from other sources, such as rental properties that produce positive taxable income. Disallowed passive losses from a property are carried forward to future tax years and can be deducted when you have sufficient passive income or when you sell the loss-producing property.
Small Landlord Exception
A favorable exception to the PAL rules allows you to currently deduct up to $25,000 of annual passive rental real estate losses if you “actively participate” in the rental activity and have adjusted gross income (AGI) under $100,000. The $25,000 exception is phased out between AGI of $100,000 and $150,000.
According to the IRS, the $25,000 small landlord exception isn’t allowed when the average rental period for your property is seven days or less. In that case, your vacation home rental activity is considered a “business” rather than a rental real estate activity.
In the “business” scenario, your vacation home rental loss is deferred under the PAL rules unless:
- You have passive income from other sources or
- You materially participate in the “business” of renting the vacation home.
In some resort areas, the average rental period may be seven days or less. The $25,000 exception to the PAL rules is unavailable if your vacation home falls into that category. Then you may have to pass one of the material participation tests to claim a current deduction for your rental “business” loss. (See “Meeting the Material Participation Standard” below.)
Real Estate Professional Exception
Another exception to the PAL rules allows qualifying individuals to currently deduct rental real estate losses even if they have little or no passive income. To be eligible for this exception, you must pass two tests:
- You must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate, and
Those hours must be more than half the time you work during the year. - The next step is determining if you have one or more rental real estate properties in which you materially participate. If you do, those properties are treated as nonpassive and, therefore, are exempt from the PAL rules. That means you can generally deduct losses from those properties in the current year.
Year End Tax Planning
You may be able to adjust the number of rental and personal days between now and year end to achieve the best possible tax results for 2018. When your vacation home is firmly in the rental property category, adding more rental days often leads to more favorable tax results, because you can usually shelter the additional rental income with allocable rental expenses. Consult your tax advisor to determine what’s best for your situation.
Meeting the Material Participation Standard
The three most likely ways to meet the material participation standard for a vacation home rental activity are when:
- You do substantially all the work related to the property.
- You spend more than 100 hours dealing with the property and no other person spends more time than you.
- You spend more than 500 hours dealing with the property.
To clear these hurdles, you can combine your time with your spouse’s time. Realistically, however, if you use a property management firm to handle your property, you’re unlikely to pass any of the material participation tests.
How It Works
Suppose you’re unable to take advantage of the $25,000 passive loss exception for rental real estate because your adjusted gross income (AGI) is too high. You have zero passive income, and you don’t qualify as a real estate professional. As a result, you’ve been piling up suspended passive losses from your vacation home rental activity.
However, you may be able to transform the activity into a “business” by reducing the average rental period to seven days or less. Then, as long as you can pass one of the material participation tests for the property, you can avoid the PAL rules and deduct the losses against your other income.