Acquiring a vacation home can be an exciting prospect, whether it’s for personal getaways, generating rental income, or as part of long-term planning. However, this significant step also brings specific tax considerations that you should understand from the outset.
At Lightening the Load, we’re here to guide individuals and couples through the tax landscape of property ownership. This blog post will clarify the tax impacts of owning a vacation property.
Tax Considerations for Your Vacation Property
The way your vacation property affects your taxes largely depends on how you use it. The Internal Revenue Service (IRS) has specific rules that distinguish between properties used solely for personal enjoyment, those primarily rented out, and those with mixed personal and rental use.
- Primarily for Personal Use
If your vacation home is used mainly for personal enjoyment and rented out for less than 15 days during the tax year, here’s what you need to know:
- Rental Income: You are not required to report the rental income received.
- Deductions: You generally cannot deduct expenses related to the rental activity. However, you may still be able to deduct qualified mortgage interest and property taxes, similar to your primary home, subject to certain limitations on the total amount of mortgage debt.
Rob’s weekly tax tip – The “Augusta Rule”
“This tax-exempt rental income also applies where your business rents your primary residence from you.
Let’s say your LLC business is elected to be taxed as an S-Corporation, so you must file a separate Form 1120-S for the business tax return each year. On this tax return, you would record a rent expense of say, $21,000, reducing the taxable income from the business. The $21,000 is transferred to you, the owner, as rent for the use of your home for up to 14 days during the year. Since the period of use does not exceed 14 days, the $21,000 of rent income is exempt from taxes on your personal tax return.
Does this transaction hold any merit in the eyes of the IRS? How can you legitimately do this? If you own a business with primarily remote workers – maybe a consulting firm, financial planning firm, or another form of professional services – you can host a conference or business meeting at your primary residence. You could host multiple meetings during a year as long as the total days do not exceed 14. I would recommend keeping an agenda for the meeting(s) or recording meeting minutes for documentation purposes.”
— Rob Burgess, CPA
- Primarily for Rental Use (Limited Personal Use)
If you rent out your property for 15 days or more, and your personal use is limited (generally not more than the greater of 14 days or 10% of the total days rented at fair rental value), the property is primarily considered a rental activity.
- Rental Income: All rental income must be reported on your tax return.
- Deductible Expenses: You can deduct a wide range of expenses related to the rental activity, including:
- Mortgage interest (allocated to rental use)
- Property taxes (allocated to rental use)
- Insurance premiums
- Utilities
- Maintenance and repairs
- Cleaning fees
- Depreciation (a deduction that accounts for the wear and tear of the property over time)
- Rental Loss Limitations: If your deductible rental expenses exceed your rental income, you may be able to report a tax loss, which can offset other taxable income, subject to passive activity loss rules.
- Mixed Personal and Rental Use
This is a common scenario for many vacation homeowners. If you rent out your property for 15 days or more and also use it for personal purposes beyond the limited threshold (more than 14 days or 10% of total rental days, whichever is greater), specific rules apply:
- Rental Income: All rental income must be reported.
- Allocating Expenses: You must allocate expenses between personal and rental use based on the number of days the property was used for each purpose. Only the portion related to rental use is deductible.
- Loss Limitation: A significant rule for mixed-use properties is that your deductible rental expenses cannot exceed your rental income. This means you generally cannot report a tax loss from the rental activity for tax purposes. Any disallowed expenses can often be carried forward to future tax years.
Tax Implications Upon Sale
When you eventually sell a vacation property, the tax impact will depend on how you used it:
- Capital Gains Tax: Any gain from the sale of the property will generally be subject to capital gains tax. The tax rate depends on how long you owned the property (short-term or long-term capital gains).
- Depreciation Recapture: If you claimed depreciation deductions while renting the property, a portion of your gain upon sale may be taxed at a higher “depreciation recapture” rate.
- Primary Residence Exclusion: To qualify for the tax exclusion on gains from the sale of a primary residence (up to $250,000 for single filers or $500,000 for married couples filing jointly), you generally must have owned and used the home as your main residence for at least two out of the five years before the sale. A vacation property typically doesn’t meet this condition unless you convert it to your primary home for the required period.
Navigating Your Vacation Property’s Tax Impact
Understanding the tax implications of a vacation property can be complex, especially with varying rules for personal use, rental use, and mixed use. Proactive tax planning is crucial to ensure you’re maximizing eligible deductions and correctly reporting income.
At Lightening the Load, we’re your steadfast partners on this tax journey, offering personalized advice tailored to your unique circumstances. Let us help you understand and manage the tax impact of your vacation property.
Let us lighten your load.
