The interest expense and real estate taxes can deduct on both a primary home and a second home. To qualify as a home, the property must have sleeping accommodations, cooking facilities, and a toilet. The second home for many people is a vacation home, such as a cabin at the lake, a condo in a ski resort, a beach house, a recreational vehicle, or a boat with living quarters.
The costs of owning a second home can be significantly reduced if the home is rented out. This allows your clients to also deduct part of the cost of utilities, insurance, maintenance and repairs, as well as depreciation expense for the part of the year they rent out the home. The disadvantage of renting out a vacation home is tenants do not take care of the home the way your clients would.
There are two sets of rules that apply to homes your clients use personally. First, if your client rents out their primary home or second home for less than 15 days, they do not pay tax on the rental income and they cannot claim deductions.
| When the city’s hotels were full for the Super Bowl, your client rented their home to a family who came to see the game. They charged $2,000 for 8 nights. The $2,000 is tax-free. Your client is not required to report the income on his/her return and cannot deduct any rental expenses. |
The second set of rules applies if your clients rent out their home or second home for more than 14 days. The emphasis switches from how much they rent the home to their personal use of the home. If your clients use their home personally for more than 14 days or 10% of the rental days, whichever is greater, then they cannot claim expenses greater than their income. In other words, your clients cannot claim a loss from renting their primary home or second home if they personally use the home a lot.
If your clients use the home less than 15 days or 10% of the rental days, whichever is greater, they can deduct expenses in excess of their rental income. The home is treated as a rental home and, subject to the passive loss rules, your clients can claim a loss.
In calculating your clients’ rental deductions, they cannot deduct expenses related to their personal use. They also must take the deductions in a certain order. The first deductions your clients can take are the ones they can take anyway, such as mortgage interest and taxes. The second deductions they can take are operating expenses, such as utilities, insurance, and repairs and maintenance. Finally, depreciation can be deducted.
To calculate income or loss from renting out a home, one of two methods can be used — the Court Method or the IRS Method. The only difference between the two methods is the way they treat the deduction for interest and taxes. Under the Court Method, you determine the rental portion of interest and taxes by dividing the number of rental days by the 365 days in a year. Under the IRS Method, you determine the rental portion of interest and taxes by dividing rental days by the total of rental and personal-use days. The example below shows both methods.
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Your client uses his/her vacation home for 54 days during the year and rent it out for 146 days. Their rental income is $14,600 ($100 x 146 days). Their expenses are interest of $12,000, taxes of $2,000, utilities of $2,400, and insurance of $800. He/she bought the home for $150,000 ($130,000 for the home and $20,000 for the land). Court IRS Rental income $14,600 $14,600 Utilities and insurance Income before deduction Depreciation expense Rental income 3,213 0 Deductions for interest Total reduction in income $(5,187) $(3,780) Difference $(1,407) In this example, you can deduct $1,407 more depreciation under the Court Method than under the IRS Method. At a 28% tax rate, you will save $394 ($1,407 x 28%). The Court Method is advantageous here because the personal use is more than 14 days and 10% of the rental days. Consequently, the rental deductions cannot exceed the rental income. Because the Court Method allows you to prorate the deduction for interest and taxes over 365 days instead of the 200 (146 + 54) days of rental and personal use, the rental income is more than the rental deductions, including all of your depreciation expense. The interest and taxes that are not deductible as rental expenses are still deductible as itemized deductions on Schedule A. Under the IRS Method, you allocate more of the interest and taxes to the rental property. As a result, the rental deductions are more than the income and $1,407 of the depreciation deduction is disallowed. In this example, you are better off using the Court Method because the deductions are limited if you use the IRS Method. In many cases, however, you are better off using the IRS Method. The IRS Method shifts interest and taxes to deductions in arriving at adjusted gross income (AGI). If the rental deductions are not limited to the rental income because your client did not personally use the home too much or have more rental income than deductions, they save more tax by deducting interest and taxes as deductions in arriving at AGI. When AGI is lowered, more medical and miscellaneous deductions can be deducted. You may also reduce your client’s state income tax since many states use AGI as the starting point for their tax calculations. |
Decide which method is best for your clients in the first year they deduct rental expenses. You cannot switch methods from year to year. Most people use the Court Method because they want to use the home themselves.
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How much does it cost to own a vacation home? Referring again to the example above, cash flows are as follows: Inflows: Outflows: Interest $12,000 Net cash outflow $2,348 Ignoring the costs of acquiring the vacation home and using the rental assumptions above, it costs you $2,348 per year to own a vacation home you use personally for 54 days. If you did not rent out the vacation home, you would pay $14,480 ($18,400 - ((12,000 + 2,000) x 28%)) per year. |
There are additional advantages of renting out vacation homes. Trip expenses, such as transportation, can be deducted to maintain the home. Furthermore, days spent maintaining the home do not count as personal-use days.
There are also some things to watch if your client owns a vacation home. Use of the vacation home by any family member counts as a personal-use day. Also, rental to anyone for less than a fair rental amount counts as a personal-use day.
Some people are very concerned about deducting losses from a vacation home. They keep the personal use of their vacation home under 15 days or 10% of the rental days, whichever is greater. Others use the vacation home as much as they want and view any rents they receive as reducing their costs of owning the home.
Julie Welch (Runtz), CPA, CFP, and Randy Gardner, LLM, CPA, CFP, are the authors of 101 Tax-Saving Ideas, 10th edition.
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