Published August 09, 2013
Owning a vacation home can be a wonderful thing, providing you and your family a private getaway with all the comforts of home.
It also could net you some extra money if you rent it when you're not there.
But if you're not careful, it also could cause you some tax troubles.
"If you have a vacation home, it can make a tax difference as to whether it was used as personal residence or not used at all by the owners," says Mark Luscombe, principal federal tax analyst at CCH in Riverwoods, Ill., a provider of tax information and services.
Basically, the amount of time you personally spend at your second home determines how much tax you might owe on rent, as well as deductions you can claim against the property.
There are three basic second-home tax situations.
You rent the property to others most of the year.
You rent the property to others for a very short time.
You use the property yourself and rent it when you're not there.
Here's a closer look at the tax implications of these scenarios.
Second home as full-time rental
You used to enjoy spending all your free time at your beach house, but now that the kids are grown and gone, you and your spouse have found other ways to vacation. So you've decided to lease out the vacation home more than you use it.
Of course, since taxes are involved, you must meet some specific requirements to take tax advantage of your rental vacation property. If you limit your personal use of your second home to 14 or fewer days or 10% of the time it's rented, you've essentially turned your second home into an investment.
And for many, it's an investment that can pay off.
"Nearly half of the people who finance their vacation homes are able to cover 75% or more of their mortgage by renting it out to travelers," says Jon Gray, senior vice president of HomeAway North America, an online vacation rental marketplace.
Gray says the average owner who finds renters via HomeAway leases the property for 19 weeks a year and brings in around $26,000 in rental income. "That's not an insignificant amount of money," says Gray.
Of course, that rental income is taxable. But you also can deduct many costs associated with your rented second home. Check out the table below to find some common rental expenses.
Common rental expenses
The Internal Revenue Service says the most common rental expenses are:
Property management fees.
Auto and travel expenses.
Cleaning and maintenance.
Legal and other professional fees.
Local transportation expenses.
When your deductible rental expenses exceed your rental income, you could wipe out any possible taxable income and even record losses that could help additionally at tax time.
Passive activity pitfalls
Your rental losses, however, could be limited. The IRS usually considers rental real estate as a passive activity; that is, you get income mainly for the use of property rather than for services provided.
And the tax code's passive activity rules mean that generally you can only use passive losses to offset passive income, not ordinary income such as wages. Any excess passive losses are carried forward to the next tax year.
There is one way to get around passive activity rules. If you are an active participant in your rental vacation home, says Luscombe, up to $25,000 of the home's expenses beyond the rental income could be deductible. There are income restrictions and a phaseout of this amount. If you make more than $100,000 ($50,000 if married filing separately), your deductible allowance is limited.
What constitutes active participation? You're deemed to have materially participated in a rental property if you (or your spouse) were involved in its operations on a regular, continuous and substantial basis during the tax year. This includes such things as personally maintaining the property and lining up renters, says Luscombe.
Short-term rental advantages
When you or your family spend time at your second-home retreat as well as rent it for part of the year, the tax rules change. But exactly how much depends on the precise breakdown of the days you and renters are in the house.
The best tax deal is for short-term rentals. These are situations where your property is rented for 14 or fewer days. Money received for two-week-or-less rentals is tax-free.
"This issue comes up every time there is a special event," says Luscombe. Residents head out of town to avoid the increased congestion caused by special events such as the Super Bowl or music festivals, lease their homes to visitors coming in for the festivities, and pocket the payments without any worry about reporting the income.
It doesn't matter if you got $20,000 for the week those football fans leased your condo near the stadium. The IRS isn't entitled to a cent.
Even better, this short-term rental income tax break isn't limited to second homes. If you rent your primary residence for two weeks or less, that income doesn't have to be reported on your tax return.
Hybrid home tax calculations
Tax rules are a bit trickier when you use your vacation home yourself for more than two weeks and also rent it out for a substantial part of the year. As with everything tax, meticulous record keeping is key.
To reduce taxes on any rent you collect, you'll want to deduct eligible expenses. But because the home has shared personal and rental use, you must allocate the costs.
For example, you spent 60 days last year during ski season at your mountain cabin. The hillside hideaway was rented for 180 days the rest of the year. You can deduct 75% of your vacation home's qualifying rental expenses against rent you collect: 180 rental days divided by 240 total days of property use.
But you can't claim rental losses in this situation -- only zero out your rental income.
And you'll report the personal portion of your expenses, including mortgage interest and property taxes on your second home, as usual on your Schedule A itemized deductions.
Don't forget local taxes
Finally, don't overlook any state and local taxes that might be assessed on the rental of your home, whether a primary residence or a second home.
"Generally, any short-term rentals, typically called transient rentals, even just for a weekend, have a state and local tax obligation," says Rob Stephens, co-founder of HotSpot Tax Services, a Greenwood Village, Colo., company that files state and local sales and lodging taxes for owners of vacation rental properties.
In Texas, if you rent your home for fewer than 30 days, you're subject to the state's hotel occupancy tax. It's called the transient occupancy tax in California. Florida counties collect a tourist impact tax on all rentals.
"As a practical matter, it gets very difficult for local jurisdictions to track and monitor this type of rental, so historically, we've seen a pretty high level of noncompliance," says Stephens.
But with state and local governments seeking every possible penny, tax revenue from such rentals is getting more attention. And the same technology that helps folks find short-term vacation home occupants also offers tax collectors a view of who's making potentially taxable residential rental income.