In the third and final installment of this series, I will discuss how taxes affect your vacation home.  The tax treatment can vary widely depending on how you use the property.  If you are considering a vacation home, you should understand all financial aspects of ownership, including taxes.  Read Our Vacation Home: Dream Come True or Financial Nightmare for advice on making the purchase decision.  If you are interested in renting out your vacation home, The Realities of Using Your Vacation Home as a Rental will guide you.  

As with any tax article, I must warn you that I am not an accountant or a tax professional.  This information is for educational purposes only, and you should verify everything I write with your tax professional before making any decisions.  

Vacation home

Residential Real Estate Categories 

The first step in understanding how your vacation home will be taxed is determining how you will use your property.  I think of all residential real estate as being divided into three categories: personal residences (primary, secondary, or vacation), rental properties (purely investment properties that you don’t personally use), and mixed-use (you rent it some and use it some).  The use of your property can change over time.   

1. Primary Residence, Second Home, & Vacation Home

A second home (vacation or otherwise) is taxed in the same manner as your primary residence.  You can deduct the interest portion of your mortgage payment as well as the property taxes from your active income . . . IF you itemize your deductions.  Please read The Myth of the Tax Write-Off for a discussion on this important point.  Remember not to let the tax tail wag the dog.  Don’t buy a second home for the write-off.  It doesn’t work that way.  Like your primary home, you can’t deduct any other expenses related to your second home if you are not renting it out.  You also cannot depreciate a primary, secondary, or vacation home.  

There is an exception in the tax code colloquially called the Augusta Rule that allows you to rent your personal home (primary, secondary, or vacation) for up to two weeks (14 days) per year without declaring the rental income on your taxes.  

2. Rental Property with No Personal Use

Pure rental properties have their own tax treatment.  You cannot personally use the property to qualify for this status.    

Income and Expenses

 Expenses related to the rental property are deductible against the income (rent, late fees, etc.).  Unlike a primary residence, your property taxes and mortgage interest payments are deductible even if you take the standard deduction.  You can either straight-line depreciate a residential real estate rental property over 27.5 years or potentially accelerate depreciation using a cost-segregation study. 

     

Passive-Active Loss Limitation 

It is common for a rental property to produce a net loss for tax purposes due to depreciation and operating expenses.  This is not bad; depreciation is only a paper loss for rental properties.  This allows you to avoid paying taxes on your rental income in the current year.  When you sell your property, the government will recapture the depreciation.  I discuss depreciation in The Financial Realities of My First Rental Real Estate Property.  Losses from rental property are considered passive and can generally only offset passive income.  

Active Income

To understand passive income, it helps to define active income first.  Active income is most commonly earned from a job or working as an independent contractor (salary, commissions, tips).  It also includes income from a business where you provide material participation.  

Although not technically active income, portfolio income (dividends, interest, capital gains, and other returns from stocks, bonds, and mutual funds) is treated the same way from a tax perspective.     

Passive Income

Passive (or unearned) income is loosely defined as net rental income or income from a business in which the taxpayer does not materially participate.  Unless you are a real estate professional, rental activity is generally considered passive, even if you materially participate.  As a working medical professional, it is unlikely you will qualify as a real estate professional, so this is only relevant if your spouse qualifies.  

Unless you or your spouse is a real estate professional, if the passive loss from your rental property is more than your collective passive income, the loss is carried forward to the future until you have enough passive income or sell the property at a gain.

3. Mixed-Use Property 

A mixed-use property is one in which you rent it out for more than 14 days a year, AND you have personal use.  You must declare the rental income on your taxes, and you can deduct the expenses at a prorated rate.  If you have mixed use of your vacation property, you almost certainly will need an accountant to help you with this process.  

What Counts as Personal Use?

You must know what counts toward personal use of your vacation property and what doesn’t.  Use of the property by the owner or a close relative of the owner (sibling, half-sibling, parent, grandparent, child, or grandchild) counts.  Any day the owner works full time repairing and maintaining (not improving) the property isn’t counted, even if other family members are simultaneously enjoying the property.  

What Counts as Rental Use?

Likewise, you need to know what counts toward the calculation of rental use.  You can only count a night as rented if you receive fair market value for the property.  If you heavily discount a stay for your friends, you can’t count it as rental use.    

Proration Rate

To figure the proration rate, divide the number of days you rented the home at fair rental value by the total days used for both personal and business purposes.  

Example:  If you rent the house for 100 days in the year and personally use it 14, your proration rate is 100/114.  You can deduct 87.7% of the rental expenses.  Your vacation home would not be considered a personal residence because you only used it for 14 days.    

There are two types of mixed-use properties, each treated differently for tax purposes.  One is where the property is considered a personal residence, and the other is where it is not.  

Personal Residence 

Your home is considered a personal residence if you use it for personal purposes for more than the greater of:

  • 14 days
  • 10% of the total number of days you rent the home (at fair market value)

Example:  If you rent the house for 220 days and stay there for 20 days, your personal use is more than 14 days.  Using the percentage criteria, your personal use is 9.1% (20/220), and your vacation home is not considered a personal residence.  If you rent the house for 180 days and stay there for 30 days, your personal use is 16.7% (30/180), and your vacation home is considered a personal residence.

3a. Mixed Use:  Home Considered a Personal Residence 

Since your property is mixed-use, you must declare the rental income on your taxes, and you can deduct the expenses at a prorated rate.  If your house is determined to be a personal residence, you can only deduct rental expenses up to the amount you claim as rental income.  You cannot claim a passive loss like you can with rental real estate. 

3b. Mixed Use:  Home Not a Personal Residence

Since your property is mixed-use, you must declare the rental income on your taxes, and you can deduct the expenses at a prorated rate.  If your house is not considered a personal residence, you can deduct all rental expenses, even if they exceed the rental income, creating a loss.  However, you are still subject to the usual passive-activity loss limitations outlined above.

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Location Matters

 The next thing you must consider regarding taxes on your vacation rental home is its location.   

 

Another State

 If you are using your vacation home as a rental property, the next thing to consider is where it is located.  If the home is in the same state as your residence, you will file your federal and state taxes (if applicable) as you always have.  However, if you purchase a rental property out of state, you will generally need to pay income tax in the state where your rental property is located.  You will file a non-resident tax return.  

State Income Tax

Since I live in Texas and our vacation home is in Hawaii, I must file a state income tax return in Hawaii.  I would be subject to Hawaiian state tax if the property produces taxable income.  Most states provide a tax credit for taxes paid to another state to avoid double taxation.  I would pay taxes first to Hawaii, then use the amount I paid as a credit toward my home state.  In my case, Texas has no state tax.  But if the situation were reversed, and I lived in Hawaii and had a rental property in Texas, I would pay nothing in Texas and then have to pay the state tax in Hawaii fully.  

If the situation involves two states with income tax, it depends on whether your property is in the lower or higher tax state.  For example, if you live in Illinois but own a rental property in Indiana, you would first pay the 3.15% flat tax rate in Indiana.  You would receive a credit for that amount on your Illinois state tax return.  Since the Illinois flat rate is 4.95%, you would owe an additional 1.80% to Illinois.  If you live in Indiana but own a rental in Illinois, you would be charged the 4.95% rate in Illinois and would not pay anything to Indiana.  Either way, you are collectively paying the higher tax rate.  

Another Country

If you own a vacation home in another country, it becomes even more complex.  In very simple terms, owning a rental property outside the U.S. works similarly to owning in another state.  You are responsible for paying taxes to the country where the home resides first.  Then, you will receive a foreign tax credit on your federal income taxes.  Another difference is the deprecation schedule.  While I wonder if this is a commentary on domestic construction quality, foreign houses are depreciated on your U.S. taxes over 30 years instead of 27.5 years for American homes.  I strongly recommend you consult a tax professional if you consider purchasing a vacation home outside the U.S.  

Conclusion 

To learn more about residential rental property taxes, including vacation homes, go to www.IRS.gov Publication 527 Section 5.  

Most people who decide to rent out their vacation home will fall into the mixed-use category as they will personally use the house and rent it out for more than 14 days.   In this case, you need to keep track of the following items.

  1. How many days of personal use did you have during the year?
  2. How many days was the property rented at market rate?  
  3. Is the property considered a personal residence?
  4. Calculate the proration rate.
  5. Use the proration percentage to calculate how much of your expenses you can deduct against your rental income.  
  6. You can carry forward passive losses if your property is not a personal residence.  If it is a personal residence, you cannot.  
  7. Talk to your accountant or tax professional to verify. 
  8. Don’t forget your sunscreen. 

This concludes our three-part series on vacation homes.  I hope the series helps you make the right decision for yourself and your family.  Vacation homes can be incredibly desirable but expensive and can derail your overall financial plans if you are not careful.    

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