If you own a vacation home or other residence that you rent out to others when you are not using it, it is important to understand the tax treatment of these properties. In some cases, small adjustments in the mix of personal and rental use can have a significant impact.

Three Scenarios

Residential properties generally fall into one of three categories:

1. Personal residences used mostly by their owners;
2. Personal residences with substantial rental use (“mixed use” properties); and
3. Rental properties used occasionally if at all by their owners.

The first step is to determine whether you own a “personal residence.” Under the tax code, a home is a personal residence if personal use during the year exceeds the greater of: (1) 14 days; or (2) 10% of the days it is rented to others at fair market rent — the keyword here is “rented to others.” This does not mean available for rent; it means actually occupied by renters.

If personal use does not exceed this threshold, the home is deemed a rental property. Personal use generally means use by you or your close family members, as well as by certain others who pay less than fair market rent.

Let’s take a brief look at the tax treatment of the three scenarios described above.

Personal residence used mostly by owner

If your home is a personal residence that you rent out for fewer than 15 days per year, you are not required to report or pay tax on the rental income. This can be a significant benefit, especially if the home is in a sought-after location that commands substantial rental dollars even for just a few days or a couple of weeks. You are not permitted to deduct expenses associated with rentals, but if you itemize, you can claim the usual deductions available to homeowners — such as mortgage interest, property taxes, and casualty losses — on Schedule A (subject to the usual rules for deducting those expenses).

Mixed use property

If your home is a personal residence but you rent it out for 15 days or more per year, then you must report the rental income on Schedule E and allocate expenses between personal and rental use. The personal portion of interest, taxes and casualty losses is deductible on Schedule A, while the rental portion of these and other expenses is deductible on Schedule E. Rental expenses are limited to the amount of rental income (that is, they cannot create a loss) and are subject to strict ordering rules where mortgage interest and property taxes are used first to offset rental income, and operating expenses and rental depreciation are applied next. If operating expenses and rental depreciation create a net rental loss, then that loss is carried forward to future years.

Rental properties

If your home is considered a rental property, you are still required to allocate expenses between personal and rental use, but because the home is not a personal residence, you are not entitled to deduct the personal portion of interest, taxes and casualty losses. Under the passive loss rules, however, if you actively participate in rental activities and your modified adjusted gross income is within specified levels, you may be entitled to deduct up to $25,000 in rental losses against nonpassive income, such as wages or investment income. To be considered actively participating, a taxpayer must own at least 10% of the value of all interests in the property at all times during the tax year and must actively participate in the operations of the rental property, such as making management decisions or arranging for others to provide services. Management activity that qualifies under the active participation test would include approving new tenants, setting rental policies and terms, and approving capital expenditures or repairs.

Related Read: Turning a Vacation Home Into a Tax Benefit

Planning Opportunities

The rules summarized above are complex, but with the help of your ORBA advisor, you may be able to identify planning opportunities that can reduce your tax bill. For example, suppose that you own a home that you use 18 days a year and rent out 120 days a year. If your potential rental losses outweigh the personal portion of your homeowner deductions, you may be better off reducing your personal usage to 14 days and converting the home to a rental property. Or, if you rent out your personal residence for only a few weeks a year, you might consider reducing rentals below 15 days to take advantage of tax-free income.

For more information, contact Kathy Jeziorski at [email protected] or 312.670.7444. Visit ORBA.com to learn more about our Real Estate Group.