This can turn out to be a tax-efficient strategy. And if you minimize your personal use of the home, you may even qualify for a tax loss if rental expenses exceed rental income.
Your deduction potential lies in one key fact: the number of personal days you use the home compared with the number of rental days.
Specifically, your deductions will be capped at the income from your rental activity if your personal use exceeds either 14 calendar days or 10 percent of the time the home is rented out, whichever is larger. (Deductions for rental use are claimed on Schedule E, Supplemental Income or Loss.)
Tax law says that any day the rental home is used by a family member counts as a personal use day by you. That’s true even if you collect fair-market rent from the relative.
So, if you let your sister’s family stay at your vacation home over the weekend, their use counts as personal use by you. Also, if the home is used by a non-relative as part of a barter agreement, that usage counts as personal use, too.
Finally, tax law says that any portion of a day spent at the vacation home generally counts as a full personal-use day, even if you’re there only a couple hours.
To maximize your tax-advantage, consider these different scenarios for your personal situation:
Example 1: High rental use, high personal use
Let’s say you rent out the home for three months during 2006 and use it personally for two months. Since the time the home is vacant is treated as personal use under the rules, you must allocate deductions for mortgage interest and property tax based on 25 percent rental use (three of 12 months).
However, don’t count the time the property was empty when you deduct other operating expenses. That means, using the scenario above, you can deduct 40 percent of the expenses (two of five months) against your rental income, while the remaining 60 percent are nondeductible.
Key limitation: You can’t deduct expenses above the amount of rental income, because you fail the 14 day/10 percent test explained above.
Example 2: High rental use, low personal use
Now, suppose you rent out the home for 100 days and you vacation at the home for just 10 days.
Since your personal use of the rental home doesn’t exceed the greater of 14 days or 10 percent of the rental time, all of your expenses—including operating expenses—are based on the total number of days the home is used. So, you can deduct 90 percent (90 rental days of the 100 total days) of your expenses against the rental income, even if it creates a tax loss for the year.
Another potential hurdle: the passive activity loss (PAL) rules. Essentially, the PAL rules limit deductions from your passive activities—such as rental real estate—to the amount of income from those passive activities.
You can still claim a rental real estate loss of up to $25,000 against non-passive income if you actively participate in the rental activity. (That $25,000 allowance is phased out for people with adjusted gross incomes (AGIs) between $100,000 and $150,000.)
You can carry over any disallowed losses to future years.
What constitutes active participation?
You’ll meet the requirement by participating in decisions, approving new tenants, arranging repairs, deciding on rental terms, etc. Strategy: If your rental business is in the black, use the home personally for an extra few days to purposely flunk the 14 day/10 percent use test.
That way, you can still deduct all your expenses attributable to rental use and the personal portion of your mortgage interest.
Example 3: Low rental use, high personal use
Say you decide to keep your second home as a personal retreat, with very minimal rental activity.
In that case, you’re eligible for a great tax deal.
That’s because, if you rent out the home less than 15 total days during the year, you don’t have to report any rental income on your 1040. That income is 100 percent tax-free as far as the IRS is concerned!
Of course, you get no offsetting deductions in the bargain either, but you can still generally deduct all the mortgage interest and property tax on Schedule A on your 1040.
Example: Say the PGA tour is hosting a tournament in town this summer. With rentals at a premium, you can charge $5,000 a week. So, you can pull down a quick $10,000 for a two-week rental without paying a dime in federal income tax.
Congress has proposed elimination of this tax break several times but has so far kept it intact.
Tip: Keep tabs on rental use versus personal use during the year. You might be able to jigger the tax results by adding or subtracting a day or two of personal use.
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