So you bought that Cape house you’ve always dreamed of, but you’re not ready to use it full time, or even just for the full summer – so you have the idea to rent it out when you’re not using it – seems like a good idea – kind of like “free money” because you’re already paying for it. This arrangement is quite common, and the multitude of capable Property Management Services and Rental Real Estate Agents on Cape, as well as the proliferation of online rental services can make the process seem pretty easy – and lucrative.
But… you know who else has thought of this? The IRS. So they made rules. It’s what they do. While the extra income can be a boost, the rules can be quite complex – this doesn’t mean you shouldn’t do it, you just need to be aware of the rules BEFORE you start the process.
The primary factor in how these rules are applied is a days count. How many days did you use the personally and how many days was it rented?
Rental income is taxable, unless it isn’t… the IRS gives a small break if you rent your primary or vacation personal residence for 14 days or fewer in a year, sometimes referred to as the “Masters Exception” due to its popularity in areas surrounding Augusta National Golf Club during the tournament. In this scenario, your rental income is tax-free. Since the income is tax free you cannot take expenses against it, but you can take the real estate taxes and mortgage interest as itemized deductions on Schedule A as applicable.
If you go past the 14 day limit, you have to report your rental income on Schedule E and pay income taxes on it – however, now you can begin to take expenses against the income – and here is where the complexity begins – how much of your expenses, and if any ordering of those expenses applies, depends on whether the property qualifies as a “business” or “personal residence” in the eyes of the watchful IRS, and that depends on the proportion of personal use to the amount of time the property is rented.
- Property considered a business – if you use your vacation home for 14 days or fewer in a year, or less than 10 percent of the days it’s rented.
- Property considered a personal residence – if you use your vacation home for more than 14 days or more than 10 percent of the days it’s rented.
So OVER 14 days is a bright line test, but under gets murky. For example, on Cape Cod, with an approximate 75 day rental season – if you used the property for 1 week (7 days) even if you rented the rest of the season (68 days) the property would qualify as a “personal residence” as your usage is over 10% even though you didn’t get to 14 days.
What constitutes “Personal Use”? Primarily the following:
- Usage by a person who has ownership interest in the property, or a family member (siblings, half-siblings, spouses, parents, grandparents, children and grandchildren) of an owner.
- Any time the property is rented at less than fair market value.
- Charitable gifting of the property. e.g. you give a weeks stay to a charity to auction off.
- 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”).
- NOTE: Time you spend at the property repairing and maintaining DOESN’T count as personal-use time.
So your ability to deduct expenses against the income depends upon the ratio of personal days to rental days. To figure the pro-ration rate, divide the number of rental days by the total days used for both personal and rental purposes. This method applies to all rental expenses.
Property Considered as Personal
If you rent out your home for at least 15 days and the days of personal-use qualify your home as a residence, then “vacation-home” rules apply. These rules limit deductible expenses to rental income, and you need to deduct your expenses in a specific order, as follows:
- The rental portion of: (the personal use portion may be able to be an itemized deduction)
- Qualified home mortgage interest
- Real-Estate taxes
- Casualty losses
- Rental expenses directly related to the rental property itself, to include:
- Legal and professional fees
- Pro-rated expenses related to operating and maintaining the rental property (landscaping, utilities, repairs and maintenance, etc.) are deductible up to the amount of rental income minus the deductions for items 1 and 2 above.
- Pro-rated depreciation of the fixed assets (the home itself, improvements, furniture, etc.). This is deductible up to the amount of rental income minus the deductions for items 1, 2 and 3 above.
You can carry over expenses you can’t deduct due to the rental income limit. You can use the carryover in one of these future time periods:
- First year you have sufficient income from the property
- When you sell the property
Tax Cuts & Jobs Act of 2017 Note: if the property is qualified as personal it is disqualified from receiving any benefit and further deduction from Section 199A.
Property Consider a Business
Now, if you rent out your home for at least 15 days, and the days of personal-use DON’T qualify your home as a residence, then you simply prorate the expenses of owning and maintaining the home and deduct those against the rental income. In this instance, deductions aren’t limited by rental income, i.e. you can have a loss, and that loss may be able to offset other income – subject to the usual passive-activity loss limitations (we’ll save that for later!).
- IRS Interview tool: Is My Residential Rental Income Taxable and/or Are My Expenses Deductible
- IRS Tax Topic 414
- IRS Tax Topic 415
- IRS Publication 527