Maybe you own a vacation home as a getaway for the family during summers and long weekends. But now that the kids are grown, you’re not using the place much anymore.
Strategy: Rent out the home this summer. Although it can be a hassle, the tax benefits generally outweigh the inconvenience.
For starters, the rental income you receive can offset most or all of the carrying costs. What’s more, you can use rental expenses—repairs, utilities, insurance, depreciation and so on—to reduce the rental income for tax purposes. Depending on your situation, you might even be able to claim a tax loss.
However, if you’re not careful, you could fall into a tax trap for excessive personal use.
Here’s the whole story: If your personal use of the vacation home exceeds the greater of 14 days or 10% of the time the home is rented out, the deduction for rental expenses is limited to the amount of the rental income. In other words, no tax loss is allowed, although rental income in excess of rental expenses remains taxable.
On the other hand, the annual rental expenses may be 100% deductible, even if you show a loss for the year, as long as you stay below the 14-day/10% limit.
Example: Shift use for tax savings
Say you intend to rent out your lakeside cottage for 12 weeks (84 days) at an average rate of $2,000 per week for a total of $24,000 in rental income. Initially, you and your family plan to spend one week vacationing there plus five weekends during the year for an annual total of 17 personal days. The expenses attributable to the rental will come to $32,000, so you expect to show an $8,000 loss this year.
As things stand now, you can deduct only $24,000 in rental expenses. Reason: Your personal use exceeds the 14-day/10% limit. However, if you reduce the family’s annual personal use to 14 days or fewer, you can deduct the extra $8,000 (assuming you are not restricted by the passive loss rules).
The entire day is treated as a “personal use day” for tax purposes no matter how many hours the taxpayer spends at the vacation home. Furthermore, any day the home is used by a family member counts as a personal-use day, unless the owner is paid a fair rental value.
Strategy: Convert personal-use days into nonpersonal days. For instance, a day spent cleaning up the place for rental use or making repairs doesn’t count as a personal day if the work is your main reason for being there. It doesn’t matter if the rest of the family comes along for the ride.
Suppose you spend a couple of weekends in May getting the cottage in shape and then a weekend in the October winterizing the place. As a result, you are effectively spending the same amount of time at the vacation home without jeopardizing the loss deduction. But you’re not “out of the woods” quite yet (see below).
Tip: If you rent out a vacation home for two weeks or less during the year, all of the rental income is tax-free.
Take an ‘active’ role in rentals
Under the passive activity loss (PAL) rules, losses from passive activities such as real estate rentals generally can be used only to offset income from passive activities.
Strategy: Become an “active participant” in the vacation home rental activity. As a result, you qualify for a special rule that allows you to exempt up to $25,000 of losses from the PAL rules. The $25,000 exemption phases out for adjusted gross income (AGI) between $100,000 and $150,000.
The active participation requirement can be satisfied by regular, continuous and substantial involvement in the activity such as participating indecisions, approving new tenants, arranging repairs, deciding on rental terms, etc. To qualify for this special rule, you must own at least a 10% interest in the property.
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