If you own a vacation home that you use for both rental and personal purposes, now is a good time to plan how to use it for the rest of this year and for next year -- with tax savings in mind.
This is especially true if the property is in a winter destination. Even if you only rent the property during the summer, planning now for how it's used next year could save you money on next year's tax return. I'll tell you what you need to know in two installments. This is part 1.
First, you need to figure out which of three categories your vacation property is in, because each category has its own set of tax rules.
The category depends on your personal and rental usage during the year. For tax purposes, personal usage includes use by you, other family members (whether they pay fair market rent or not), or anyone else who pays less than market rent. For this purpose, family members include your spouse, siblings, half-siblings, ancestors (such as parents and grandparents), and lineal descendants (such as children and grandchildren).
Any day you spend working substantially full-time taking care of the property is not counted as a personal-use day, even if the other occupants goof off while you're working.
Finally, personal use also includes time spent at your place by another party under a reciprocal sharing arrangement ("I use your place in exchange for you using my place," for example), whether the other party pays market rent or not.
Category 1: Rented more than 2 weeks with substantial personal use as well
Your vacation home falls into Category 1 if you rent it for more than 14 days during the year and your personal use exceeds the greater of: (1) 14 days or (2) 10% of the rental days. For example, a vacation home that's rented for 30 days and used by your family for a month falls into Category 1.
Tax drill for Category 1 properties
Category 1 properties are treated as personal residences for federal income tax purposes. Our beloved Internal Revenue Code allows you to deduct interest on up to $1 million worth of mortgage debt on up to two personal residences ($1.1 million if home equity loans are involved). Property taxes are always deductible, no matter how many homes you own.
Those fortunate enough to own more than two homes can pick the two with the most mortgage interest each year -- usually the principal residence and the vacation home with the biggest loan.
How exactly do you handle the rental income and expenses for your Category 1 vacation home? Good question. Follow this six-step procedure.
Step 1: Report 100% of the rental income on Schedule E (Supplemental Income or Loss) of Form 1040.
Step 2: Deduct on Schedule E 100% of any direct rental expenses (such as rental agency fees and advertising).
Step 3: Allocate the mortgage interest and property taxes between rental and personal use. Count all days the property was not actually rented as personal-use days. For example, say your property is rented for three months during the year, used by your family for two months, and vacant for seven months. Allocate 25% (3/12) of the mortgage interest and taxes to rental usage and 75% (9/12, which includes periods of vacancy) to personal usage.
Step 4: Deduct on Schedule E the allocable mortgage interest and property taxes from Step 3 (25% in this example).
Step 5: If there's any net rental income left after Step 4, deduct on Schedule E allocable indirect expenses -- maintenance, utilities, association fees, insurance, security, depreciation, and so forth -- but only to the point where you zero out the rental income. In allocating indirect expenses, consider only the actual rental and personal-use days and ignore days of vacancy. So in our example, 60% (3/5) of the maintenance, utilities, and so forth is allocable to rental usage and 40% (2/5) is allocable to personal usage. The 40% is a non-deductible personal expense. Sorry. Even so, the bottom line on your Schedule E will probably be zero, because the rental income will likely be fully offset by deductible expenses.
Step 6: Write off the personal-use percentage of mortgage interest and property taxes (75% in this example) as itemized deductions on Schedule A of Form 1040. Note that high-income folks can see their mortgage interest and property tax write-offs reduced under a phase-out rule.
Bottom line: This six-step procedure usually allows you to fully deduct all the mortgage interest and property taxes (part on Schedule E and the rest on Schedule A) and enough other expenses to cancel out your rental income. That's a pretty good result! Finally, you're allowed to carry over any disallowed indirect expenses to future years when you can deduct them against rental profits on Schedule E (if you ever have any).
Tax-smart strategy for Category 1 properties
If your property fits solidly into Category 1 for the year and your expenses exceed the rental income (the usual situation), you will probably come out ahead tax-wise by renting it out for some additional days. That way, you'll receive more rental income (good for cash flow), and you can probably still offset all the rental income with allocable mortgage interest and property taxes, direct rental expenses, and indirect expenses. So you'll have that much more tax-sheltered rental income, which is always a good thing. But make sure to keep your property in Category 1 status by having enough personal-use days to exceed 10% of the rental days. If necessary, mixing in a few more personal-use days (maybe between now and the end of the year) should not be too much of a hardship.
Stay tuned for Part 2
You now know the tax angles for Category 1 vacation homes, but we still have two more categories to cover. Please tune back in for the rest of the story in next week's column.