The tax consequences of renting out a vacation home can be very different, depending on how often you use the property personally.
If your property is rented for less than 15 days each year, the rental income does not need to be reported and rental expenses cannot be deducted on your tax return.
If the property is a primary or secondary residence, though, you may be able to deduct any mortgage interest and real estate taxes as itemized deductions.
Example: Jack owns a home within walking distance to Churchill Downs, where the Kentucky Derby is run. He only rents his home out (very lucratively) on Derby weekend each year. This rental income is all tax-free, since he rents the home out less than 15 days per year.
- If your property is rented for 15 days or more, your rental income must be reported. The amount of expenses you can deduct depends on whether the property is considered to be a dwelling unit as defined by the IRS.
A property is considered to be a dwelling unit if:
- You use it for personal purposes for more than the greater of 14 days or 10% of the total number of days you rent the home at fair rental value.
- It provides basic living accommodations (sleeping space, bathroom facilities, cooking facilities).
- In either situation, you would prorate your property expenses between rental use and personal use with the following formula: (# of days of rental use/total # of days used for rental and personal purposes).
- If you rented the property 15 days or more, and it is considered a dwelling unit, your deductible rental expenses are limited to rental income.
Example: Liz owns a ski condo in Breckenridge, Colorado. She stays there six weekends in the winter and a week in the summer, for total personal use of 19 days. Liz rents the condo for 100 days. She collected $20,000 in rent income. The property is considered a dwelling unit. She can deduct up to $20,000 in rental expenses.
- If the property is considered a primary or second home for you, you may be able to deduct the personal portion of mortgage interest and real estate taxes as itemized deductions.
- If you rented out the property 15 days or more, and it is not considered a dwelling unit, your deductions are not limited by rental income.
Example: Jenna owns a beachside apartment in Tampa, Florida. She stayed there just 4 days during the year and rented it out for 40 days. Using the formula from above, her rental use is 91% (40 days rental use/44 days of personal and rental use). She will be able to deduct 91% of her property expenses, regardless of the amount of rent income she collected. *
*If Jenna’s prorated rental expenses exceed her rental income, she will have a tax loss on the property. Rental property losses are subject to a set of rules called the passive activity loss rules; because of these rules, some or all of Jenna’s loss may have to be carried forward and used in future years.
Another consideration when renting out a vacation home is whether you provide what the IRS calls substantial services. Substantial services include housekeeping and concierge services, meals and entertainment, and other hotel-type services. If you provide these services, then your rental is considered to be a self-employment activity. Your net income from the rental will be subject to self-employment tax, which is typically a 15. 3% tax on top of income tax.
What happens when you sell
Finally, one other area that often causes confusion with rental properties is how a taxable gain or loss is calculated when the rental property is sold. Each year a property is used as a rental, you should claim a deduction on your tax return for depreciation expense. The deduction reduces your cost basis in the property, so when it is sold, the cost basis is often less than the original purchase price. If you do not understand this concept, you may be surprised with a much larger than expected tax bill when you sell your property!
If you have other questions about the tax consequences of renting out a vacation home, please contact us.