Vacation Homes

The definition of a vacation home falls under the definition of a dwelling unit, which includes a house, apartment, condominium, mobile home, boat or similar property (Sec. 280A(f)(1)(A)). It must have basic living accommodations, such as sleeping space, toilet and cooking facilities. The property must provide shelter and accommodations for eating and sleeping, regardless of size. Sec. 280A also defines vacation home expenses and provides special rules that limit the rental expense deductions that a taxpayer can take. Because the ownership of a second home may have both personal and profit motives, the IRS may disallow or limit deductions for expenses related to the rental of a vacation home that the taxpayer also used as a residence. Two specific criteria are used to determine which rules to follow: (1) how often does a taxpayer use the vacation home and (2) how often does he rent it out?

How Often Does a Taxpayer Use a Vacation Home?

The first category deals with vacation homes that a taxpayer rents often, but still uses for a reasonable amount of time. This includes homes that are rented longer than 14 days a year and personally used by the taxpayer for more than 14 days or 10% of the rental days (whichever is greater). "Personal use" is use of the vacation home by the taxpayer or family members and anyone else who pays less than market rental rates (Sec. 280A(d)(3)(A)).

The Service considers vacation homes qualifying under these criteria as personal residences (Sec. 280A(d)(1)). The fact that the IRS treats these vacation homes as personal residences is extremely beneficial to taxpayers. The benefits include interest deductions of up to $1 million of mortgage debt on two personal residences and an additional $100,000 for home-equity loans. Taxpayers can deduct mortgage interest on both a primary residence and a vacation home. Another benefit is that taxpayers can deduct property taxes, regardless of the number of homes owned.

Although the vacation homeowner receives great benefits from a vacation home, the calculation of the deductible expenses is difficult. There are two types of deductions. The first deduction involves expenses incurred during the rental period, while the second involves expenses incurred during the time the taxpayer uses the house. The taxpayer must first allocate interest and property taxes between rental and personal use. The problem is that there are two allocation formulas available (depending on jurisdiction). The Service uses one formula, while the Ninth (Bolton, 694 F2d 556 (1982)) and Tenth (McKinney (1983)) Circuits allowed taxpayers to use a different allocation formula.

Basically, the formulas differ as to the number of days in the denominator. The IRS uses only the number of days that a taxpayer uses a vacation home for the year, while the courts use the total number of days in the year. In McKinney, the Service disputed whether the Tax Court used the correct formula in its decision to allocate interest and taxes between rental and other use, urging that it should have used the statutory formula provided in Sec. 280A(e)(1). The Tenth Circuit case quoted the Ninth Circuit's decision in Bolton and upheld the formula applied by the court in that case. As a result, the Tenth Circuit held that the allocation of interest and taxes to rental use should be the number of rental days divided by the number of days in the year multiplied by the total interest and taxes paid.

Assume a homeowner uses his vacation home for 60 days each year, and rents it out for 90 days. According to the IRS, the total days used would be 150 (90 days of rental plus 60 days of personal use). The allocation for rental use would be 60% (90 days of rental use/150 total days used), while the remaining 40% would be considered personal. Taxpayers could deduct the rental part of the interest and taxes on Schedule E, while deducting the personal part of the interest and taxes on Schedule A as itemized deductions.

Under the Ninth and Tenth Circuits' jurisdictions, the 215 days that the home is vacant is considered personal use. Therefore, the allocation for 90 days' rental use is 24.7% (90 rental days /365 total days). As a result, only about 25% of the interest and taxes applies to the rental period, while approximately 75% (275 days) applies to personal use. Just as before, taxpayers can deduct the rental part of the interest and taxes on Schedule E, while deducting the personal part of the interest and taxes on Schedule A as itemized deductions. Use of the courts' ratio allocates less interest and taxes to rental use, thus allowing taxpayers to deduct more of the other expenses against the rental income. It also allows a greater portion of the interest and taxes to be deducted as itemized expenses.

Even though a taxpayer may incur a loss on a vacation home, these losses are not deductible for tax purposes. In most cases, no matter which allocation formula is used, there would be no tax liability caused by the rental, because the interest and tax allocation would bring the net rental income to zero. If the rental income exceeds this allocation, deducting the other rental expenses incurred can further reduce rental income. The net rental income is reduced to zero so as not to incur any tax liability. This is accomplished by decreasing income first by the appropriate percentage of the interest and tax expenses incurred while renting. The appropriate percentage is based on the Service's or the circuit courts' allocation formula. In the case of any remaining net rental income, taxpayers can deduct a percentage of operating expenses (e.g., maintenance, utilities and insurance). The denominator for these other expenses is based on the number of days used (not 365 days), regardless of which allocation method is used to compute the deduction for interest and taxes. If a profit still remains, depreciation could be taken to the extent of the remaining profit. This percentage makes the calculation of the deductible expenses difficult to compute, because the percentage used for the other operating expenses is not necessarily the same as the percentage used for interest and taxes.

Because the period that a vacation home was vacant is ignored in the calculation, there is a slight variation in calculating other operating expenses under the Service's approach. Under the facts above, the house was occupied for a total of 150 days, 90 days rental and 60 days personal use. As such, 90 days (60%) of the operating expenses belong to the rental period, and 60 days (40%) belong to personal use. The IRS considers the 40% of personal-use operating expenses nondeductible. On Schedule E, the taxpayer will report 100% of the rental income, 60% or 25% of the interest and taxes (depending on the approach) and 60% of the other operating expenses. However, the other operating expenses are limited to net rental income. In other words, a vacation home cannot create a taxable loss and, as a result, Schedule E can never show a loss.

Example 1: T owns a small fishing cabin on a lake. During the year, he personally uses the cabin a total of 30 days, and rents it out to fishermen for a total of 60 days, generating $5,500 in rental income. T incurs the following expenses: mortgage interest and taxes, $3,000; and utilities, maintenance and insurance, $4,500. The total depreciation on the property had it been used 100% for rental would have been $9,000. Because the cabin is used for personal purposes, the deductions on Schedule E are limited, as shown in Exhibit 1.

To further complicate the calculation, T must carry forward any remaining operating expenses that he cannot deduct against future rental income (Sec. 280A(c)(5)).

How Often Does a Taxpayer Rent Out a Vacation Home?

The second tax issue occurs when a taxpayer rarely uses the home for personal use. If the taxpayer does not have enough personal-use days to qualify the property as a residence, the rules and limits of Sec. 280A do not apply (Sec. 280A(d)(1)).

Provided a taxpayer demonstrates a profit motive, a vacation home will fall under rental property tax laws instead of personal residence tax laws, based on the taxpayer's limited use. Use is determined by a formula in which a vacation home must be rented for more than 14 days in a year and the personal use does not exceed 14 days or 10% of the rental days, whichever is greater (Sec. 280A(d)(1)).

If a vacation home is rented for 210 days and its owner occupies it for 21 days, the Service considers the home rental property, because the rental exceeds 14 days and the personal usage does not exceed 21 days (the greater of 14 days or 10% of the rental). If, however, the personal use was 22 days (thereby exceeding the 10% rule), the personal residence deduction rules would apply. Once the rental property is classified as a personal residence, deductibility of the various expenses must be computed based on the IRS's or the circuit courts' allocation formula. As a result, interest and property taxes can be allocated differently from other operating expenses; the same problem exists, however, because there are two allocation formulas available based on the judicial jurisdiction. The IRS uses one formula, while the Ninth and Tenth Circuits have allowed a different allocation formula. The Service computes the allocation deduction for mortgage interest and taxes by dividing the specific usage by the total number of days the taxpayer used the vacation home. The total number of days used in the assumed facts is 231 (210 rented + 21 personal), with 9.09% (21/231 days) personal use and 90.91% (210/231 days) rental use.

Under the courts' approach, the numerator would be the same, but the denominator would be 365. The taxpayer can deduct a percentage of all other operating expenses, such as maintenance, utilities, insurance, depreciation, etc. The denominator used for the other expenses is based on the number of days used (not on 365), regardless of what is used for interest and taxes.

Income or loss is determined on Schedule E by netting the rental portion of the expenses against the rental revenue. Even if a taxpayer ends up with a loss on Schedule E, there are still some remaining obstacles in determining whether the loss is deductible, notably the Sec. 469 passive-loss rules.

A rental activity is a passive activity even if there is material participation (with the exception of a real estate professional). A taxpayer can deduct passive losses in a given tax year only to the extent he has passive income from other sources (e.g., rental properties that produce gains). However, Sec. 469 allows taxpayers with adjusted gross income under $100,000 to take a deduction of up to $25,000 for passive rental real estate losses. The deduction is allowed if the taxpayer "actively participates" in the property (Temp. Regs. Sec. 1.469-5T). Active participation is less stringent than material participation. To actively participate means to participate in the day-to-day property management decisions or to arrange for others to provide services such as repairs. Management decisions could include active participation in approving new tenants, deciding rental terms or approving expenditures for capital or repair purposes. If a taxpayer cannot currently take passive losses, the Service allows a carryforward to offset future passive income.

In addition, the taxpayer must consider interest. The interest portion from personal use (21/231 under the facts) may not be deductible, because the vacation home does not qualify as a personal residence. As a result, the mortgage interest would be subject to the deduction limit for investment interest (Sec. 163(d)). Therefore, the taxpayer may simply lose that portion of interest. As part of tax planning, the taxpayer should consider using the vacation home for the necessary amount of days (as in the first scenario above), so that the IRS would treat it as a residence and allow a full interest deduction. To achieve the maximum expense deduction, the Schedule E loss needs to be weighed against the full interest deduction.

Example 2: T owns a small fishing cabin on a lake. During the year, he personally uses the cabin for 10 days and rents it out to fishermen for 60 days, generating $5,500 in rental income. T incurs the following expenses: mortgage interest, $3,000; taxes, $1,000; utilities, maintenance and insurance, $4,500. If the property were used 100% for rental, the total depreciation would be $9,000. Because the cabin is not considered a personal residence, the deductions on Schedule A are limited only to taxes (see Exhibit 2 for calculations).

In Example 2, if the large loss on Schedule E were allowed, T would achieve the maximum expense deduction if the vacation home were treated as rental property. Even though T loses the mortgage interest deduction on Schedule A, the loss on Schedule E is more beneficial and results in T maximizing total deductions.

One final possibility complicates the problem only slightly. If the rental period is minimal, the rental income is not taxable. The Service considers a vacation home a personal residence if a taxpayer rents it for fewer than 15 days a year and uses it for more than 14 days a year. The IRS ignores the rental for tax purposes, which means that the taxpayer does not have to report rental income and cannot deduct expenses (Sec. 280A(g)). The deductions of mortgage interest and taxes are identical to that of a taxpayer's primary residence; the Service allows a deduction of mortgage interest and property taxes on Schedule A. Further, taxpayers do not have to declare income from a vacation home rented for 15 days or fewer per year.

Conclusion

A vacation home can create a tax-reporting nightmare. The different allocation formulas for mortgage interest and taxes created by the Ninth and Tenth Circuits only complicates matters. Taxpayers must maintain accurate records and careful tax planning is essential.

From David Lavin, Ph.D., CPA, Associate Professor of Accounting, and Myron S. Lubell, DBA, CPA, Associate Professor of Accounting, Florida International University, Miami, FL (Neither associated with AFAi)