Is your vacation home a vacation home?
If you bought your vacation home exclusively for personal enjoyment, you can generally deduct your mortgage interest and real estate taxes, as you would on a primary residence. Use Schedule A to take the deductions.
The IRS even allows you to rent out your vacation home for up to 14 days a year without paying taxes on the rental income. You might be able to deduct any uninsured casualty losses too, though you can’t write off rental-related expenses. (More on those below.) If the home is rented for more than 14 days, you must claim the income.
Now, if you own what you consider a vacation home but never visit it, or only rent it out, other tax rules apply. Without personal use, the home is considered an investment or rental property by the IRS. Time spent checking in on a house or making repairs doesn’t count as personal use.
Tax deductions for rental owners
As an exclusive rental property, you can deduct numerous expenses including taxes, insurance, mortgage interest, utilities, housekeeping, and repairs. Even towels and sheets are deductible. Use Schedule E. You can also write off depreciation, the value lost due to the wear and tear a home experiences over time.
Treat the rental property like a business, says Mark Steber, chief tax officer at Jackson Hewitt Tax Services. Keep detailed records and maintain a separate checking account. Figure you’ll spend a couple of hours a week, on average, over the course of the year managing the property.
To maximize deductions you need to be actively involved in the rental property. That means performing such duties as approving new tenants and coming up with rental terms. You also need to own at least 10% of the property. See IRS Publication 527 for details.
If your modified adjusted gross income (same as adjusted gross income for most people) is below $100,000, you can deduct as much as $25,000 for rental losses — that is, the difference between your rental receipts and your rental expenses. The deduction gradually phases out between a modified adjusted gross income of $100,000 and $150,000. You can carry forward excess losses to future years or offset losses to offset gains when you sell.
Mixed use of a vacation home
The tax picture gets more complicated when in the same year you make personal use of your vacation home and rent it out for more than 14 days. Remember, rental income is tax-free only if you rent for 14 days or fewer.
The key to maximizing deductions is keeping annual personal use of your vacation home to fewer than 15 days or 10% of the total rental days, whichever is greater. In that case the vacation home can be treated as a rental, meaning you get the same generous deductions. To avoid going over the 10% limit, essentially you shouldn’t use your vacation home more than one day for every 10 days you rent it.
Make personal use of your vacation home for more than 14 days (or more than 10% of the total rental days), however, and your deductions may be limited. An example: Your rental receipts are less than your rental expenses. You can’t offset the loss against other income sources, such as salaries and pensions. There’s a worksheet in Publication 527 that can help you determine which expenses you can carry over to the following year.
Another big blow: The IRS requires you to divide expenses between personal use and rental use. Let’s say you have a vacation home you personally use for 25 days and rent for 75 days. That’s 100 total days of use. You can only write off 75% of the expenses as rental expenses—75 rental days divided by 100 total days of use works out to 75%. Some of the personal expenses, such as mortgage interest and real estate taxes, may be deductible on Schedule A.
IRS closes tax loophole
A popular strategy used by owners of vacation homes to avoid paying capital gains on a sale was to convert a vacation home into a primary residence. This was accomplished by living in the home for two years out of the previous five before selling. Doing so qualified the sale for an exclusion from taxes for a profit of up to $250,000 for single filers and $500,000 for joint filers.
While the exclusion remains available, the IRS closed a loophole for vacation homes. For 2009 and later years, you pay regular cap gains taxes on the portion of the gain that’s equivalent to the time you used the home as a vacation home after 2008.
Let’s say you bought a vacation home on Jan. 1, 2003, and it becomes your primary residence on Jan. 1, 2011. Two years later, you qualify for the cap gains exclusion and decide to sell on Jan. 1, 2013. You’re liable for capital gains taxes on 20% of the gain. Why?
Because for 20% of the 10 years you owned the property, it wasn’t eligible for the exclusion: In 2009 and 2010, you used it as a vacation home. But you can take the exclusion for the other eight years — 2003 through 2008, when the old rules applied, and Jan. 1, 2011, to Jan. 1, 2013, when the place was used as a primary residence.
This article provides general information about tax laws and consequences, but shouldn’t be relied upon as tax or legal advice applicable to particular transactions or circumstances. Consult a tax professional for such advice.