Here’s one way to get more tax enjoyment from vacation home
Strategy: Rent out the home part of the year. Although it can be a hassle, especially for first-time landlords, the cash flow and tax benefits may outweigh the inconvenience.
For starters, the rental income you receive can pay for most or all of the carrying costs. You can use rental expenses—repairs, utilities, insurance and depreciation—to offset the income for tax purposes. Depending on your situation, you might turn it into a tax loss.
However, if you’re not careful, you may fall into a tax trap for excessive “personal use.” That’s why it’s important to firm up plans before the summer rental season begins in earnest.
Here’s the whole story: If your personal use of the vacation home exceeds the greater of 14 days or 10% of the time you rent out the home, the IRS limits the annual deduction for rental expenses to the amount of the rental income. You can’t claim a loss from the activity, although rental income in excess of rental expenses remains taxable.
On the other hand, the annual rental expenses may be 100% deductible, even if you show a loss for the year, as long as you stay below the 14-day/10% limit. A few days here and there can make a big tax difference.
Let’s say you rent out your lakeside cottage for 12 weeks (84 days) at an average rate of $2,000 per week (a total of $24,000 in rental income). Initially, you and your family plan to spend one week vacationing there plus five weekends during the year for an annual total of 17 days. The expenses attributable to the rental will come to $32,000, so you expect to show an $8,000 loss this year.
As things stand now, you can deduct only $24,000 in rental expenses. Reason: Your personal use exceeds the 14-day/10% limit. However, if you reduce the family’s annual personal use to 14 days or fewer, you can deduct the extra $8,000 (assuming you have no problem under the passive loss rules).
Note that the entire day is treated as a “personal use day” for tax purposes no matter how many hours the taxpayer spends at the vacation home. Furthermore, any day the home is used by a family member counts as a personal use day, even if the owner is paid a fair rental value.
Strategy: Convert personal use days into nonpersonal days. A day spent cleaning up the place for rental use or making repairs doesn’t count as a personal day if the work is your main reason for being there. It doesn’t matter if the rest of the family comes along for the ride.
Let’s go back to our previous example. Suppose you spend a couple of weekends in April getting the cottage in shape and a weekend in October winterizing the place. As a result, you are effectively spending the same amount of time at the vacation home without jeopardizing the loss deduction. But you’re not “out of the woods” quite yet (see box).
Tip: If you rent out a vacation home for 14 days or fewer during the year, all the rental income is tax-free.
Take an ‘active’ role in rentals
Under the passive activity loss rules, losses from passive activities such as real estate rentals may only be used to offset income from passive activities.
Strategy: Become an “active participant” in the rental activity. This allows you to use up to $25,000 of passive rental real estate loss to offset nonpassive income. The $25,000 allowance offset phases out for AGI between $100,000 and $150,000.
The active participation requirement can be satisfied by regular, continuous and substantial involvement in the activity such as participating in management decisions, approving new tenants, arranging repairs, deciding on rental terms, etc. To qualify for this exception, you must own at least a 10% interest in the property.
Tip: The passive activity loss rules aren’t a concern if personal use exceeds the 14-day/10% mark. In that case, you can’t deduct a loss anyway.
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