Tax Laws Complicate Vacation Home Rental

QUESTION: We own a condominium on the ocean which we only use during the summertime. We are considering renting it out on a periodic basis, but have been told that there are complex tax rules regarding the so-called “vacation home.” This is not our principal residence. Can you assist us by giving an explanation of the vacation home rules?

ANSWER: As the summer months approach, our thoughts turn to taking pleasurable vacations at our second home. We really should not be thinking about the taxable consequences of our actions, but since 1986, when the Tax Reform Act was passed by Congress, such consequences are very much in mind.

As this column has noted on numerous occasions, the tax laws are complex, and you should discuss your specific case with your own tax advisers.

Prior to tax reform, if you owned a second home and rented it out, you could take all sorts of deductions, including depreciation.

However, in 1986, Congress put severe limitations on real estate deductions for investment property. Congress created the concept of “passive activity.” Under this concept, if your adjusted gross income does not exceed $100,000, you can fully deduct up to $25,000 of losses from all rental activities in which you participated actively.

This could include your vacation home rental property. The $25,000 loss permitted by law is reduced $1 for every $2 of adjusted gross income in excess of $100,000. In other words, once your adjusted gross income reaches $150,000, you are no longer able to deduct losses that exceed your rental income.

Thus, the paper losses which were so popular prior to 1986 have, for all practical purposes, been eliminated if your adjusted gross income is more than $150,000.

Now let us look to whether your property is a residence. The vacation home or residence has been broadly defined to include a house, apartment, condominium, mobile home, boat or similar property. As long as the property contains facilities for cooking, sleeping and toilet use, the property will be considered your residence.

However, you must also use the property for more than 14 days during a taxable year or more than 10% of the number of days during the year for which the home is rented out at a fair rental value, whichever period is greater. Thus, if you rent your property for 85 days during the year, you must still make sure that you use the property for your own personal use for more than 14 days during the same taxable year.

If the vacation home is rented out for fewer than 15 days during the taxable year, you do not have to pay tax on any rental income.

You are not entitled to deduct business expenses attributable to the rental--such as advertising and management fees--but you are still able to deduct the real estate taxes, mortgage interest, and casualty losses.

In effect, since you are renting this property for less than 15 days, it is considered a true second home. The interest deductions are subject to other tax rules which are not the subject of this column.

If the property is considered a residence (i.e. it meets the 14 day/10% test) and if you rent the property out for 15 or more days, the amount of business rental deductions cannot exceed rental income.

Additionally, according to the IRS, the expenses are further limited to a percentage that represents the total days used divided by the total days rented. However, the tax court has rejected the IRS formula and takes the position that since mortgage interest and real estate taxes are assessed on a yearly basis, the tax court would permit the allocation by dividing the total number of days rented by the total number of days in the year.

Let’s look at the following example. You rent your property for 85 days a year, and use it for 30 days during the year. You have received a total rental income of $5,000, and your expenses are: interest, $4,000; taxes, $800; and other business expenses, $4,000.

If you take the IRS formula, you have a percentage allocation of 74% (85 divided by 115), but if you follow the tax court opinion, you have an allocation of 23% (85 divided by 365). In actual dollars, it works out as shown in the accompanying chart.

It should be pointed out that the tax court opinion has been affirmed on appeal by both the 9th and 10th Circuit Courts of Appeals, covering California, Hawaii, Colorado, Kansas and other states. In the East, the IRS will no doubt press its interpretation against taxpayers.

Additionally, any deduction not allowed because of the personal use limitation may be carried forward and deducted in a succeeding tax year, again subject to the maximum deduction amount for that later year.

As you can see, although the IRS formula gives you deductions of $6,248 in our example, the tax court ruling gives you deductions of $8,696.

Finally, if you do not use the property for the greater of 14 days or 10% of the rental days, this is treated as an ordinary business investment in real estate, which is subject to the passive loss rules.

VACATION HOME TAX DEDUCTIONS

Comparison of expenses allowed by the IRS, left, versus those allowed in California and other states by two U.S. Courts of Appeals.

IRS Court Gross Rental Income $5,000 $5,000 Less Interest ($4,000) -2,960 -920 Property Tax ($800) -592 -184 Remaining Income $1,448 $3,896 Less Expenses -1,448 -3,896 Net Income 0 0 Balance of Itemized Deductions Interest $1,040 $3,080 Taxes 208 616 Total Allowable Deductions 6,248 8,696