What You Need to Know About Vacation Rental Property Taxes

April 13, 2022
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Many people have second homes that they use both for personal use and as short-term rental properties. So, what are the tax implications when a property like this has multiple uses?

Residence vs. Rental

Under tax code rules, a vacation home is either defined as a:

  • Personal Residence; or
  • Rental Property

The IRS will consider your vacation home a rental income property if it meets the following criteria:

  • You rent it out for more than 14 days during the year; and
  • Your personal use during the year does not exceed the greater of (a) 14 days or (b) 10% of the days your rent the home out at fair market rates.

You essentially need to count the actual days when the property is used for rental or personal use. You should disregard any days of vacancy, or days spent primarily on repair or maintenance activities.

If your vacation home is classified as a rental property for tax purposes, you must allocate your mortgage interest, property taxes and other expenses between rental and personal use—based on actual days of rental and personal occupancy.

Mortgage Interest Deductions

Mortgage interest can only be deducted on properties that are classified as personal residences. Mortgage interested that is allocated to personal use of a classified rental property does not meet the definition of qualified residence interest for itemized deduction. In other words, you cannot deduct mortgage interest if the property is considered a rental property under tax code rules.

Schedule E Losses and PAL Rules

A vacation home classified as a rental property can generate a deductible tax loss if the allocable rental expenses exceed the rental income. In this case, you can claim the loss on Schedule E of your tax return.

However, your rental loss may also be wholly or partially deferred under passive activity loss (PAL) rules. You can generally deduct passive losses only to the extent that you have passive income from other sources. For example, you have another rental property that produces positive taxable income. If a passive loss is disallowed for the current tax year, it can be carried forward to future tax years. It can later be deducted when you have sufficient passive income or when the property is sold.

The “Small Landlord” Exception

One favorable exception to the PAL rules will allow you do deduct up to $25,000 of annual passive rental real estate losses if you “actively participate” in the property management AND you have an adjusted gross income under $100,000. Between $100,000 and $150,000 in AGI, this exception is gradually phased out.

The IRS will not allow the small landlord $25,000 exception when:

  • The average rental period for your property is seven (7) days or less; or
  • The average period of customer use for the property is 30 days or less, and significant personal services are provided by or on behalf of the owners of the property (such as guest services, daily cleaning, laundry, etc.).

The “Real Estate Professional” Exception

Another exception to PAL rules will allow qualifying individuals to deduct rental real estate losses without additional passive income. To be eligible for this exception, you must qualify as a “real estate professional” by meeting the following criteria:

  • You must spend more than 750 hours during the year on real estate activities in which you materially participate; and
  • Those hours must be more than half the time you spend working (as in your regular job, if you have one) during the year.

If you have one or more rental real estate properties in which you materially participate, those properties are treated as active income (i.e., non-passive) and are exempt from PAL Rules. You will be able to deduct losses from those properties in the tax year.

Material Participation Standards

How do you quantify your material participation in the maintenance and management of a vacation home used as a rental property? Here are three standards the IRS will consider:

  1. You do a substantial amount of work related to the property
  2. You spend more than 100 hours dealing with the property, and no other person spends as much time on it as you
  3. You spend more than 500 hours dealing with the property

You may also combine your spouse’s time with your own to clear some of these hurdles. If you use a property management company, however, you are not likely to pass any of these material participation tests.

For more information about managing your rental properties and developing the best possible tax plan—personally or as a business owner—contact Illumination Wealth today.