Your vacation home property may cost you in tax $$

If you use your rental property as your personal residence for part of the year, so that it becomes your vacation home property, you may be in for an unpleasant surprise when it’s time to file your tax returns – unless you’re prepared.

By Gary Krupa, CPA, April 1, 2021
Updated April 18, 2021

Possible dramatic limitation on what you can deduct from rental income

I prepared my first tax return involving vacation home property in late February, 2021. I thought reporting the rental income and deductions from it would be similar to reporting them for a rental property.

Thus if you’re filing an individual return, you’d report rental income and deductions on a Schedule E of form 1040. You’d report mortgage interest and taxes on form 1040 Schedule A. The only difference would be that you’d allocate deductions based upon how many days you rent the property versus how many days you live in it.

For example, if you live in your vacation home for three months and rent it out for nine months, you’d prorate your deductions. You’d report 9/12 of the rental expenses on Schedule E, and 3/12 of the mortgage interest and taxes on Schedule A. You’d carry forward deductions not claimed for the year to future years.

However, I was dead wrong. And that’s not a good place for an accountant to be. Especially when I discovered this while preparing a well-paying client’s tax returns this year. Fortunately, I learned the rules of the game quickly enough, and prepared the client’s returns accurately.

It turns out that for a vacation home, how much you can deduct is limited to your gross rental income. You’d report your rental income in full – no proration there. You’d carry forward unused deductions to future years.

This limitation applies only when the greater of the following occurs for the year. You use your home as a personal residence for more than 14 days. Or you use it as a personal residence for more than 10% of the number of days rented at a fair market rental.

 

Rental property alternatives

If you rent the property out for > 14 days of the year, your rental expenses are fully deductible. However, your rental deductions may then be reduced according to the passive loss rules.

If, instead, you rent the property out for < 14 days of the year, your rental expenses aren’t deductible. You’d exclude your rental income from the property from your gross income.

vacation home property

A real life example of vacation home sticker shock

In the case of the client whose tax returns I was preparing, the postponed rental deductions for one vacation home property caused her to have to pay an additional $2,686 in tax for 2020! Here’s the breakdown of what her tax was before reporting the vacation home, and after:

Before After Difference
Federal $ 7,558 $ 9,890 $ 2,332
Arizona 0 36 36
Montana 3,066 3,384 318
Total $10,624 $13,310 $ 2,686

The client and her two co-owners of the property, a married couple, had purchased a house in February of 2020 that they rented to others until the end of November. They began living in the home during the entire month of December. They plan to use the property as their residence during the winter months, and rent it out during the summer. Thus it qualifies as a vacation home or qualified residence. Their rental deductions are limited to their rental income.

 

Planning around the vacation home restrictions

The question I’d have, and I imagine you’d have, is how does one avoid or plan to avoid such a large increase in tax?

One obvious solution would be to limit your personal use of the rental property to < fourteen days or less than 10% of the number of days the home is rented. Then you’d be able to deduct your rental expenses in full. Except you can only deduct 50% of the cost of meals.  

An alternative approach that may save you money

Another solution is one that isn’t foolproof, but one that’ll be of benefit to you if you have substantial itemized deductions. What I mean by substantial is an amount of itemized deductions greater than your standard deduction.

When you’re in that situation you can take advantage of an alternative formula used for determining your mortgage interest and real estate taxes. The alternative approach would permit you to deduct less of the interest and RE taxes from your rental income. You can then deduct more of your other rental deductions, e.g. utilities, maintenance, from your rental income in the current year.

You’d then deduct your remaining mortgage interest and RE deductions as itemized deductions. That would leave you with more in itemized deductions. Again, this would only be beneficial if your total itemized deductions exceed your standard deduction.

The alternative formula is this: you wouldn’t allocate interest and taxes based on the number of days rented divided by the total days your home is used, as the IRS allows. Instead you’d allocate those expenses based on the number of days rented by 365 days, or 366 days if a leap year is involved. That’s according to at least two Tax Court rulings. Its rationale is that mortgage interest and real estate taxes are assessed on an annual basis regardless of the number of days you use the property. Consequently, you’d calculate a smaller allocation percentage for them as rental expenses and a larger one for them as itemized deductions.

 

The Bed and breakfast exception

Also note that if you use your home or a portion of it as a bed and breakfast, the restriction on rental deductions referred to above won’t apply. In that case the expenses that relate to that portion of your residence may be limited under the hobby loss rules. That is to say, you wouldn’t be able to deduct the expenses unless you report a profit for the bed and breakfast on your tax returns for at least three out of five consecutive years – unless the IRS proves otherwise (which isn’t likely).

The lesson here is that you must plan for how you’ll be using your rental property so as not to have it classified as a vacation home. That is, if you want to deduct your rental expenses in full.

For more information on vacation home taxation, here’s an IRS resource you can consult: IRS publication 527 for 2020. Coverage of vacation homes starts on page 17 and ends on page 22.

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