Now is a good time to plan how to use your vacation property for the rest of this 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 taxes on next year's return.
This is the second installment of our two-part series on tax planning for vacation homes that are used for both personal and rental purposes.
First, you need to figure out which of the three categories your vacation property belongs in, because each category has its own set of federal income tax rules.
The category depends on how much personal and rental use you have during the year. For tax purposes, personal use 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 that 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"), whether the other party pays market rent or not.
Category 1: Rented more than 14 days with substantial personal use too
Your vacation home falls into Category 1 if you rent it out for more than 14 days during the year, and personal use exceeds the greater of: (1) 14 days or (2) 10% of the rental days. For example, a vacation home that is rented for 30 days during the year and used by your family for a month falls into Category 1. I covered the tax angles for Category 1 properties in last week's column.
Category 2: Rented more than 14 days with limited personal use
You have a Category 2 vacation property if you rent it more than 14 days during the year and personal use does not exceed the greater of: (1) 14 days or (2) 10% of the rental days. For example, if you rent your property for 210 days and vacation there for 21 days, you have a Category 2 property on your hands. (If you vacation there 22 days, the property falls back into Category 1.)
Category 2 vacation homes are treated as rental properties for federal income tax purposes.
Follow this six-step procedure to handle the rental income and expenses for your Category 2 property.
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 mortgage interest, property taxes, and indirect property expenses between rental and personal usage based on actual days of rental and personal use. Ignore days the property is vacant. Indirect expenses include maintenance, utilities, association fees, insurance, security, depreciation, and so forth. In our example, 210/231 of the mortgage interest, property taxes, and indirect expenses would be allocated to rental use and 21/231 would be allocated to personal use.
Step 4: Deduct on Schedule E the allocable expenses from Step 3.
Step 5: If your Schedule E shows a profit, stop here. Your tax work is done, and you will owe some tax on the profit. But if Schedule E shows a loss, you now have to figure out whether that potential write-off is limited by the dreaded passive loss rules. In general you can only deduct passive losses to the extent you have passive income from other sources (such as rental properties that produce positive income). However, a favorable exception allows you to write off up to $25,000 of passive rental real estate losses even if you have no passive income. To qualify, you must actively participate in renting the property and have adjusted gross income (AGI) under $100,000. Unfortunately, this exception is phased out between AGI of $100,000 and $150,000. Even worse, the IRS says the exception is completely unavailable if the average rental period for your property is seven days or less, which is often the case in resort areas. For these reasons, many owners of Category 2 properties find their hoped-for tax losses disallowed by the passive loss rules. However, you're allowed to carry over any disallowed passive losses to future tax years when they can be deducted if: (1) you have enough passive income from other sources or (2) you sell the vacation home. For more on how the passive loss can affect your vacation home, see: http://www.marketwatch.com/story/landlords-read-this-before-you-file-your-taxes-2015-06-02.
Step 6: In this step, we finally deal with mortgage interest, property taxes, and indirect operating expenses allocable to periods of personal use (21/231 in our example). Unfortunately, you cannot deduct the personal-use portion of mortgage interest from a Category 2 home, because a Category 2 home doesn't qualify as a personal residence for mortgage interest deduction purposes. So 21/231 of your mortgage interest goes up in smoke. Ditto for 21/231 of your indirect expenses. However, you can deduct 21/231 of the property taxes as an itemized deduction on Schedule A of Form 1040 (subject to a phase-out rule for high-income folks).
Tax planning advice: With a Category 2 property, you may benefit tax-wise from slipping in some extra vacation days during the year. Doing so could move your home from Category 2 back into Category 1, where you can usually deduct all the mortgage interest and property taxes (part on Schedule E and part on Schedule A) and usually shelter any remaining rental income with allocable indirect operating expenses on Schedule E (as covered in last week's vacation rental article).
On the other hand, you may have plenty of passive income or AGI below $100,000 and no problem with the seven-day rule. In these scenarios, you can currently deduct your entire rental loss on Schedule E. If the non-deductible mortgage interest allocable to personal use would be a relatively small amount, consider minimizing your vacation days during the year in order to maximize the deductible rental loss on Schedule E.
Category 3: Rented less than 15 days with more than 14 days of personal use
For a Category 3 vacation home, the tax rules are blessedly simple. The property is considered a personal residence. Period. That means you need not report any of the rental income on your tax return. That is not a misprint! You don't have to declare a penny of rental income from a Category 3 property. Of course, you also cannot deduct any expenses attributable to the rental period (rental agency fees, advertising, cleaning, utilities, and so forth). You can usually write off all the mortgage interest and property taxes as itemized deductions on Schedule A (subject to a phase-out rule for high-income folks). If your vacation home happens to be located near a major event -- like a big golf tournament -- you may be able to rent it out for few days at outrageous rates, and pay zero federal income tax on the deal with full IRS approval. Nice.