You’ve long dreamed of a summer cottage on the beach or a winter chalet nestled in the mountains, and you’ve decided to make your vision a reality by purchasing a vacation home in your ideal location. Don’t get so caught up in the beauty of your purchase that you forget about the tax breaks that can make owning a vacation home more affordable.
If you’re looking to claim the most tax breaks possible, you need to carefully track the amount of time you and your family spend at your vacation home. There are three basic scenarios of vacation home use and a different tax treatment applies to each.
Personal v. rental use
The tax treatment of your vacation home depends on the number of days you rent it at fair market value and the number of personal use days. In addition to the days you use the home, you must count as personal use any part of a day that the residence is used for personal purposes by a relative and by any individual who rents the residence for less than fair market rent.
In addition, any day that your vacation home is used by your parents or grandparents, children or grandchildren, or siblings is counted as personal use – even if the family members paid fair market rent.
On the other hand, days you spend working on your vacation home are not counted as personal use days if they are primarily spent making repairs or getting the property ready for tenants. Bear in mind that for tax purposes, a second home can be a boat or even recreational vehicle as long as it has permanent sleeping, cooking, and toilet facilities.
Scenario #1: Use often, rent seldom
If you rent your home for less than 15 days during the year, any rental income you collect is tax-free. You don’t even have to report the income on your tax return. You can still deduct property taxes and mortgage interest whether or not the property is used to produce income. However, you cannot deduct any rental-related expenses.
Scenario #2: Use seldom, rent often
If your personal use of your vacation home doesn’t exceed 14 days a tax year or 10 percent of the total number of days it is rented out at fair market value, whichever is greater, your vacation home qualifies as a rental property. As the owner of a rental property, you must report the entire rental income you receive. However, you may qualify to deduct expenses related to renting, such as depreciation, utilities, repairs, and property management fees.
If you end the year with a net profit from the rental income, you may deduct all your rental expenses. However, if you had a net loss, your deduction will be limited by the passive activity rule. A passive activity involves the conduct, trade or business in which you are not materially participating.
An exception applies if you actively participate in managing rental activities. In such cases, you can deduct up to $25,000 in rental losses against other non-passive income, such as wages. This deduction begins to phase out when your adjusted gross income (AGI) exceeds $100,000. The passive activity loss not used cannot be carried forward to future years.
Scenario #3: Use some and rent some
If you and your family personally use the place more than 14 days a year or, if greater, 10 percent of the number of days it is rented to others at fair market value, your vacation home is treated as a residence.
You must report all rental income on your tax return and you may be able to deduct your rental expenses, but only up to the total amount of rental income.
You cannot use the excess rental expenses to offset income from other sources. You can, however, carry the excess expenses forward to the next year and treat them as rental expenses for the same property up to the amount of rental income for the year.
Work with a CPA
With proper planning and professional advice, you can maximize tax benefits and your personal enjoyment of your vacation home. A CPA can help you determine the best strategy.
(Updated and reviewed 2016)