As the economy improves, consumers are returning to luxuries they may have eliminated in hard times. Josh Sickler, of Sikich LLP, suggests a few tax considerations for your luxury purchases.
The economy is improving, which means consumers are starting to pay for the luxuries they once may have eliminated. These luxuries may include renting vacation homes in ideal locations, and possibly a renewed interest in owning properties that can generate some rental income while providing the family with a place to rest and relax. However, a taxpayer who owns a vacation home or is thinking of buying one should be aware that the tax aspects of using and renting a vacation home can be complicated. The following reviews the special tax rules that apply to vacation homes and suggests some planning moves.
Tax-free vacation home income: A taxpayer who rents his or her vacation home for fewer than 15 days during the year doesn’t report rental income and can’t claim offsetting vacation home deductions.
Vacation home used as a residence: A vacation home is treated as a residence during a tax year if personal use exceeds the greater of 14 days or 10 percent of the days the property is rented to others during the year at a fair rental. Although the property is considered a residence, the owner still must treat the rental portion of the vacation home separately from the personal portion.
Rental portion: Rentals are included in income on Schedule E, but may be offset with deductions for the rent-related portions of expenses such as utilities, maintenance, upkeep, mortgage interest, real estate taxes and insurance. The owner also may claim a depreciation deduction relating to the rental use.
However, deductions can’t exceed rental income less:
• Deductions related to the rental activity itself, such as advertising and broker’s commissions
• Deductions (such as interest and real estate taxes) allocable to the rental use which would be deductible whether or not the vacation home was rented out
Excess expenses are carried forward and may be used in a future year when there’s additional rental income.
Personal portion: The owner deducts on Schedule A the real estate taxes and mortgage interest allocable to personal use of the home. Because personal use exceeds the greater of 14 days or 10 percent of the days it is rented out during the year, the vacation home is a qualified residence for purposes of the mortgage interest deduction.
Allocating expenses: The IRS says that all expenses are apportioned between rental and personal use based on the number of days used for each purpose. However, the Tax Court, as well as the Ninth and the Tenth Circuits, maintain that interest and taxes are allocated to rental use based on the ratio of actual rental days to total calendar days. All other expenses (e.g., utilities and maintenance) are allocated based on the ratio of rental days to total days of use.
Vacation home used as rental property: A vacation home is treated primarily as rental property for a tax year in which personal use of the unit doesn’t exceed the greater of 14 days or 10 percent of the days the property is rented out during the year at a fair rental. In this situation, the owner’s deductions are restricted by the passive loss rules, not by the vacation home rules.
Tax-free sale of vacation home: A taxpayer may sell his or her regular home at retirement and move into what had been his or her vacation home. If the vacation home is later sold, gain on the sale of both homes is eligible for the up-to-$250,000 exclusion ($500,000 for qualifying married taxpayers) if each is owned and used as a principal residence for at least two of the five years preceding the sale date of each home, and two years elapse between the sales. However, that part of the gain attributable to depreciation for post-May 6, 1997 periods isn’t eligible for the exclusion. Short temporary absences for vacations or other seasonal absences, even if the taxpayer rents out the property during the absences, are counted as periods of use for purposes of the two-out-of-five year ownership and use requirement.
Josh Sickler is a manager with Sikich LLP, a leading accounting, advisory, technology and managed services firm. Founded in 1982, Sikich has an office in Rockford and is headquartered in Naperville, Ill.