Summer is in full swing and PK Law thought it an appropriate time to discuss the tax implications of owning a vacation home. The general benefits of such ownership are obvious: a cheaper family vacation over the short term; appreciation in value of the home; and securing rental income.
Income taxation of a vacation home is something akin to a seesaw:
Too much personal use and the rules of Internal Revenue Code (“IRC”) §280A limit deductions for the rental income without affecting deductions for the property’s personal use portion.
If the property is treated as rental property, then the owner’s rent-related deductions will be restricted by the passive activity loss rules, not the vacation home rules, and deductions for the personal use portion will be adversely affected.
Is the Vacation Home a Residence?
Yes, if the home’s personal use exceeds the greater of 14 days or 10% of the days the property is rented to others during the year at a fair rental. The personal and rental portions must be treated separately.
Rental Income and Expenses. Income from vacation home rental 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. Deductions cannot exceed rental income less certain other deductions related to the rental activity itself (e.g. advertising and broker’s commissions) and deductions such as mortgage interest and real estate taxes which are deductible regardless of the rental. To the extent rental deductions exceed income, the “excess expenses” may be carried forward for use in future years.
Personal portion. Real estate taxes and mortgage interest allocable to personal use of the home, as defined above, may be deducted based upon the home being a “qualified residence” subject to the rules on those deductions.
Expenses are allocated between personal and rental use. The IRS and United States Tax Court have differing views on the method to be used in allocating expenses and whether some expenses must be allocated between personal and rental use.
Limited Rental Use. Vacation home rental for less than 15 days during the year need not be reported, but rental home deductions may not be claimed. This may advantageous in the rental of a home for a high-demand event venue such as the Super Bowl.
A Tax credit may be available for residential energy efficient property installed in vacation home used as residence.
Is the Vacation Home a Rental Property?
Yes, if the annual personal use of the property doesn’t exceed the greater of 14 days or 10% of the days the property is rented out during the year at a fair rental. The owner’s deductions are restricted by the IRC §469 passive loss rules, not by the vacation home rules.
Rental portion. When a vacation home is treated as rental property, its income and deductions generally are automatically treated as passive in nature, subject to certain exceptions. If so, the “passive activity” rules of IRC §469 are applied to the rental income. (Bearing in mind the difference between the use of the term “active participation” in the rental activity and “material participation”, the latter of which often comes to mind in discussing passive activity income.)
Personal portion. The owner may take an itemized deduction for the real estate taxes allocable to personal use of the vacation home. However, if personal use does not exceed the greater of 14 days or 10% of the time the unit is rented out, the home is not treated as a qualified residence and any interest paid on a mortgage secured by the vacation home, and allocable to personal use, will be treated as nondeductible personal interest.
Tax-Free Sale of Vacation Home
An owner may sell a residence and move into what had been a vacation home. Both homes may be subject to the “home sale exclusion” rules if certain requirements are met and subject to certain limitations.
Tax-Deferred Exchange of a Vacation Home
Under IRC §1031, no gain or loss is recognized on the exchange of property held for productive use in a trade or business or for investment if the property is exchanged solely for property of like kind that is to be held either for productive use in a trade or business or for investment.
It’s well settled that personal residences can’t be exchanged tax-free under IRC §1031 because they aren’t held for productive use in a trade or business or for investment. However, Rev. Proc. 2008-16, states that the IRS won’t challenge on personal use grounds whether a dwelling unit is relinquished or replacement property under the IRC §1031 rule requiring such property to be held for productive use in a trade or business or for investment if certain requirements are met.
Taxpayers also should be aware that if they acquire a home in a IRC §1031 exchange in which any gain wasn’t recognized, the IRC §121 exclusion does not apply to the sale of the home by the taxpayer (or by any person whose basis in the property is determined, in whole or in part, by reference to the basis in the hands of the taxpayer) for the 5-year period beginning with the date of acquisition.
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