If you have a home that you both rent out and use personally, you have a tax code-defined vacation home.
Under the tax code rules, that vacation home is either
- a personal residence or
- a rental property.
The tax code classifies your vacation home as a rental property if
- you rent it out for more than 14 days during the year, and
- your personal use during the year does not exceed the greater of (a) 14 days or (b) 10 percent of the days you rent the home out at fair market rates.
Count actual days of rental and personal use. Disregard days of vacancy, and disregard days that you spend mainly on repair and maintenance activities.
For vacation homes that are classified as rental properties, you must allocate mortgage interest, property taxes, and other expenses between rental and personal use, based on actual days of rental and personal occupancy.
Mortgage Interest Deductions
Mortgage interest allocable to personal use of a rental property does not meet the definition of qualified residence interest for itemized deduction purposes. The qualified residence interest deduction is allowed only for mortgages on properties that are classified as personal residences.
Schedule E Losses and the PAL Rules
When allocable rental expenses exceed rental income, a vacation home classified as a rental property can potentially generate a deductible tax loss that you can claim on Schedule E of your Form 1040. Great!
Unfortunately, your vacation home rental loss may be wholly or partially deferred under the dreaded passive activity loss (PAL) rules. Here’s why.
You can generally deduct passive losses only to the extent that you have passive income from other sources (such as rental properties that produce positive taxable income).
Disallowed passive losses from a property are carried forward to future tax years and can be deducted when you have sufficient passive income or when you sell the loss-producing property.
“Small Landlord” Exception to PAL Rules
A favorable exception to the PAL rules currently allows you to deduct up to $25,000 of annual passive rental real estate losses if you “actively participate” and have adjusted gross income (AGI) under $100,000. The $25,000 exception is phased out between AGI of $100,000 and $150,000.
The Seven-Days-or-Less and Less-Than-30-Days Rules
The IRS says the $25,000 small landlord exception is not allowed
- when the average rental period for your property is seven days or less, or
- when the average period of customer use for such property is 30 days or less, and significant personal services are provided by or on behalf of the owner of the property in connection with making the property available for use by customers.
“Real Estate Professional” Exception to PAL Rules
Another exception to the PAL rules currently allows qualifying individuals to deduct rental real estate losses even though they have little or no passive income. To be eligible for this exception,
- you must spend more than 750 hours during the year delivering personal services in real estate activities in which you materially participate, and
- those hours must be more than half the time you spend delivering personal services (in other words, working) during the year. If you can clear those hurdles, you qualify as a real estate professional.
The second step is determining whether you have one or more rental real estate properties in which you materially participate. If you do, those properties are treated as non-passive and are therefore exempt from the PAL rules. That means you can generally deduct losses from those properties in the current year.
Meeting the Material Participation Standard
The three most likely ways to meet the material participation standard for a vacation home rental activity are when the following occur:
- You do substantially all the work related to the property.
- You spend more than 100 hours dealing with the property, and no other person spends more time on this property than you do.
- You spend more than 500 hours dealing with the property.
In attempting to clear one of these hurdles, you can combine your time with your spouse’s time. But if you use a management company to handle your vacation home rental activity, you’re unlikely to pass any of the material participation tests.