Taxation of rental vacation homes

Being in the real estate finance business for over 8 years now I have come across many a conversation about the tax and investment benefits of owning rental real estate.  I’ve found that many people (including many real estate and mortgage professionals) overstate the tax benefits of owning investment real estate.  There is a lot of detail in the tax code designed to prevent owners of investment real estate from using losses on their property to offset earned income (from their “regular” full-time work).  One area that I find particularly detailed (i.e. annoying) is the tax treatment of property held for investment AND recreational use.  These rules are designed to apply to vacation homes where the owners occupy the property for a portion of the year and rent it out to vacationers for a portion of the year.

Before I go into detail it’s important that I mention that I am not a tax professional.  If you are reading this blog post and are wondering how these rules apply to your situation you are encouraged to visit the IRS’s website and consult with a tax professional.

So how are vacation homes taxed?  As is the answer to many tax questions- IT DEPENDS.

The first question to ask is whether or not the home is rented out for 14 or fewer days during the year?  If it is then the income DOES NOT have to be recognized and the only expenses that would be deductible are property taxes and qualifying mortgage interest on schedule A of the taxpayer’s return.  The best example of the potential benefit of this rule is for property owned on Augusta National Golf Course.  Every year property owners are able to rent their homes out during Master’s Week for thousand’s of dollars.  Assuming they only rent the property out during that week they do not need to claim that income on their tax returns.  However, they are not able to deduct the cleaning and maintenance expenses either.

If a vacation home is rented out for 15 or more days during the year then the next question is whether the property is used by the owner for the greater of 14 days or 10% of the rental days.  If the personal use is less than the greater of 14 days or 10% of rental days then the property will be considered a rental home and ALL of the income and associated expenses will flow through schedule E on the owner’s tax return.  If the personal use of the rental property exceeds that threshold then the property is considered to be “mixed-use” and the associated expenses must be pro-rated based on the number of personal use and rental days.

For example, let’s say a person owns a home down at the coast.  During the year the home is rented out to vacation-goers for 180 days.  The property owner may use the home for up to 18 days (10% of the rental days) and still classify the home as a rental property.  They would report all income and expenses on a schedule E.  However, if they used the property for 20 days during the year then the home is considered to be mixed-use and 10% of the expenses would be considered personal (20/200 days in use) and 90% of the expenses (180/200) could flow through schedule E of the tax return.  All of the income would also be claimed.

This is a fairly complex rule but the tax code wasn’t designed for ease of use.  Feel free to leave any questions below in the comment section.