If you’re lucky enough to own a vacation home, or are thinking about investing in one, you should be aware of the tax implications associated with this type of property, particularly if you are planning to rent it at least some of the time. It is also important to note that the IRS definition of a vacation property encompasses not only houses, cottages, and condominiums, but also mobile homes, recreational vehicles, and boats. In addition, remember that you may be obligated to pay state and local taxes on the rental of your vacation property as well as federal taxes.
The tax liabilities associated with a vacation home and the deductions you can claim against the property primarily depend on the time you spend there, or, as the IRS calls it, your “personal use” of a second home. The IRS definition of personal use covers time that you or any member of your family, including your spouse, children, siblings, parents, grandparents, and grandchildren spend at your vacation property. Personal use also includes renting your vacation home to anyone for less than fair market value, trading your place to stay somewhere else and donating your property for charitable use.
Let’s look at two scenarios that illustrate how the tax rules apply to vacation properties that are rented at least occasionally:
Scenario 1: You rent your vacation property most of the time. The IRS rules state that if you spend fewer than 14 days or 10% of your time each year at your vacation home, you can write off expenses associated with owning a rental property. These deductions are allowed in proportion to the amount of time your property is rented. For example, if you have a cottage that you rent for half of the year, then half of your mortgage interest, property taxes, utilities, insurance costs, and repair expenses would be deductible against rental income. In addition, you can deduct the other half of your second home’s mortgage interest and property taxes against your other income. You can also write off 100% of the cost of advertising for tenants or other expenses directly related to renting. Keep in mind that you have to show evidence of actively managing your vacation property to qualify for these tax deductions such as screening potential tenants, writing rental terms, and arranging for any necessary property repairs.
Scenario 2: You spend more than 15 days a year at your vacation home and also rent it periodically. The tax implications in this scenario are based on how much time you or your family spends at your vacation retreat and the length of stay of your renters.
If the personal time you spend at your vacation property is greater than the 14 days or 10% of the year mentioned above, the IRS states that you must divide your total expenses between rental use and your personal use based on the number of days used for each purpose. For short-term rental situations of 14 or fewer days, rental income is tax-free. For longer rental periods, you need to claim the rental income and deduct eligible expenses in proportion to the percentage of time that each rental period represents of the total days of property use. This is where careful record keeping is crucial.
In this scenario, you will not be able to deduct your rental expense in excess of the gross rental income limitation (your gross rental income less the rental portion of mortgage interest, real estate taxes, and casualty losses, and rental expenses like realtors' fees and advertising costs). However, you may be able to carry forward some of these rental expenses to the next tax year, subject to the gross rental income limitation for that year.
Having a vacation property in a relaxing location is a wonderful way to get away from the stresses of everyday life. Renting your retreat can also help to provide extra income and help to reduce your tax obligations. It is critical that if you do own a second home, a boat, or other vacation property, you keep track of rental income and when it is occupied for personal use and rental use so that when you are preparing to file your taxes your sanctuary does not become another source of stress.
If you have any questions about this information, please contact our firm—we are always here to help.