Tax Insight: For Tax Year 2014 and Beyond, 3rd ed. Edition (2015)

Part V. Real Estate Income and Deductions

Chapter 25. Second Homes and Vacation Rentals

Be Sure You Get This Right

Chapters 23 and 24 focused on all of the rules related to rental real estate that is solely dedicated to that purpose. In many cases, however, individuals own real estate that they rent during part of the year and use for personal benefit during another part of the year. In these cases, there are a few additional rules that come into play that determine the expenses that you are allowed to claim as deductions on your tax return. At times these rules can make a significant difference in the tax you will owe, so it is important to understand how they work. It is possible that something as simple as staying one extra day in your rental in a given year could really cost you a lot of money. The following items will be discussed in this chapter:

· Tax-free income and home swapping

· Personal use vs. fair market rents

· Pro-rated deductions

Tax-Free Income and Home Swapping

Though it may seem like a strange idea to some, I have known people who trade their homes with another person for a week or two each year to vacation in a faraway place and stay in a nice home at little cost. In fact, there are exchanges on the Internet where you can enter the dates and destination that you desire and the business will try to match you up with another person who would like to visit your home town at the same time. Then you swap homes with that person and save each other a lot of money. Each year you can pick a different location and try to match up with a different person to make a swap again.

I have known others who live in ideal locations for certain events who rent their house out for the event and just go away for a little while. The first time I heard of this was when I lived in Utah and people around us were planning to rent their homes out during the 2002 Winter Olympics. By leaving and renting their homes out for a couple of weeks, they were able to earn enough money to pay for a vacation and a couple of months of their mortgage payments. I have heard of others who live near college football stadiums and rent their homes out on the weekends of home games each year, or during graduation.

If you are okay with strangers’ living in your home while you are temporarily gone, this could be a great way to earn some extra money. It’s even easier and more common now with the existence of services such as airbnb.com. In fact, as long as you do not rent your home out for more than 15 days during a year, the income that you earn is tax-free! You can’t take any deductions for the home (beyond those available as personal deductions), but you don’t have to recognize any income either. I didn’t include this idea in the tax-free income chapter, but it is pretty intriguing.

Note Home swaps are considered rents. If you swap homes for more than 15 days during the year you are actually supposed to recognize the fair market value of that swap as rental income, subject to the rules for personal use outlined in the next sections.

Personal Use vs. Fair Market Rents

If you do own a home that you rent out more than 15 days in the year, as well as use for personal reasons, you must account for the income and expenses on that home by using a special formula. This formula determines whether you can claim a loss from the rental of the home. This is the case regardless of whether the home is your primary residence, a second home, or a vacation rental—in any case you must fall in line with the following rules.

First, you must calculate the number of days that you use the home for personal use. Personal use days include:

· Each day, or portion of a day, that you use the home for personal reasons. Even if you use the home for personal purposes on a day that it is rented out at fair-market value, you must count that day as a day of personal use for this part of the equation. However, do not count days where you used the home and the day was primarily spent making repairs or getting it ready for tenants (this is an important loophole).

· Each day in which the home is used by your spouse, children, grandchildren, parents, brothers, sisters, or grandparents. This is the case, regardless of whether or not they pay you fair-market value for rent, if the home is a vacation rental. However, if the home is being used as their primary residence and they pay you fair-market rent, you do not have to count those days as personal-use days.

Next, you must count the number of days that the home was rented at fair-market value to individuals not included in the preceding list. Then you must determine whether your personal-use days exceeded the greater of 14 days or 10% of all days that the property was used. The formula for the second factor would look like:

[Were the total personal days > (10% × total days used by anyone)?]

If your personal-use days were more than the greater of 14 days or 10% of all the days used, then you are only allowed to deduct expenses to the extent of income—you cannot claim a loss from the rental of the home. (However, you can still claim the personal portions of the expenses as itemized deductions on your return.)

Regardless of whether you are allowed a loss on the home, all expenses for the home must be pro-rated according to the steps outlined in the section below.

Note The terms “home” or “residence” are broadly defined in this rule. Any place may qualify under these rules as long as it has minimum living accommodations, such as a bathroom, a place to sleep, and a place to prepare food. Under these guidelines many nontraditional homes come into consideration, such as motor homes, trailers, and boats.

If you use a residence for more than 14 days or more than 10% of the total days it is used, you can count the property as a second home and deduct the personal portion of interest expense and property taxes as itemized deductions on Schedule A of your return.

Pro-rated Deductions

If you have used a home for both personal and rental purposes during the year (regardless of how many personal days), you must allocate all of the expenses in pro-rated amounts between personal and rental use. Expenses are allocated as deductions taken against rental income based on this formula:

[Days rented at fair market value ÷ Total days of rental and personal use]

The days that the property is held out for rent, but not actually rented, are not counted as rental days. However, contrary to the rules in the previous section (determining the ability to claim a loss), any day that you rent the property to a family member at fair-market rates counts toward the days-rented-at-fair-market-value portion of the formula. In addition, in this formula you do not need to count as a personal day any days in which you use the property for personal use and also rent it a fair-market value.

Once you have determined the ratio from the formula above, you must apply that ratio to each deductible expense to determine how much you may deduct from rental income on your return. As an example, if you rented a property at full market value 90 days during the year, and also used it for personal purposes an additional 10 days, the ratio of expenses that you could deduct would be 90% [90 days fair-market value ÷ (90 market value days + 10 personal days = 100 total days) = 90% business use]. In this example you would deduct expenses as outlined below:

Note You are not considered to have made any personal use of a residence that you rent or try to rent at fair market value before selling it if you actually sell the home within 12 months. For example, if you lived in a home from January 1 to April 15, then rent the home from May 1 to September 30, and then sell the home on November 15, your use of the house from January through April is not considered personal use. This means that the deductions for the rental are not subject to the rental income limitation.