Taxes: Rental of your residence or vacation home

The tax treatment of income and expenses related to renting your residence or vacation home varies, depending on how many days the property is used for rental purposes as opposed to personal purposes. A residence with personal and rental use generally falls into one of three categories:

Primarily a personal residence
Mixed rental and personal use
Primarily a rental property

A residence for this purpose includes a house, condominium, apartment, mobile home, boat, or similar property.

Case 1 – The home is primarily a personal residence

A residence falls into this category if it is:

Rented for fewer than 15 days during the year

In this case, the taxpayer does not report the rents received as income. It’s a rare case of truly tax-free income. The taxpayer accordingly cannot take any deductions on Schedule E for expenses associated with the rental of the property. However, the typical Schedule A deductions (mortgage interest, real estate taxes) can still be taken.

Example 1

Craig and Janet live year-round in a home near the beach. In the summer, they go on vacation for one week and rent the home for $2,800. Since they rent the house for fewer than 15 days, they do not report the $2,800 received as income on their Form 1040.

Example 2

Bob has a home near a country club which hosts a PGA golf tournament. Bob goes to visit relatives during the tournament and rents his home to a pro golfer for the week. Bob has no tax liability on the rent received.

Case 2 – Mixed rental and personal use

A residence falls into this category if:

It is rented more than 14 days during the year, and
The personal use days exceed the greater of:
- 14 days, or
- 10% of the days rented

The following are considered personal use days:

Days rented to anyone at less than the fair market rental value. Fair rental value depends on the location, size of the home, amenities, and other factors. Actual rates for similar properties can be a good indicator if available.
Days rented to family members are considered personal use days unless the taxpayer can establish that a fair market rental rate was received
If the property is owned by more than one person, personal use days by other owners or their families count as personal use days for each owner
If the dwelling is used under a reciprocal agreement that allows the taxpayer to use another dwelling, the days the taxpayer rents out his own unit are counted as personal days, even if he pays rent for the use of the other dwelling

Days that a taxpayer spends repairing and maintaining the dwelling on a substantially full-time basis are not counted as personal use days. “Substantially full-time” means for this purpose the lesser of eight hours, or two-thirds of the time the person is actually present on the premises.

Example 3

Steve owns a condominium at a ski resort. In 2013, Steve spent 10 days there skiing, and 5 days in the summer during which he performed maintenance tasks full-time. Steve rented the unit for 84 days, and allowed his brother to stay there rent-free for one week.

Steve’s personal days for the year are 17: the ten days he spent there himself, plus the seven days his brother was there at below fair market rental rate.

The rental days are 84.

The total days used are 101: 17 personal plus 84 rental days. The five days of maintenance are not included in either the personal use days, or the total use days.

Tax treatment

In this case, the taxpayer must report rental income and expenses on Schedule E. Expenses are limited to the amount of income reported. If expenses exceed income, they cannot be used to create a loss. The excess expenses can be carried forward to subsequent years, but they’re still subject to the net income limitation.

Further, the expenses must be deducted in a specific order. Items that may otherwise deductible on Schedule A must be taken first. The order is:

Qualified residential interest, taxes, casualty losses, and rental expenses other than operating or maintenance expenses (e.g. advertising to obtain tenants);
Operating expenses (including nonqualified residential interest), except depreciation
Depreciation expense

Proration of expenses

The expenses of a dwelling must be prorated between personal use and rental use. The expenses allocated to personal use are either nondeductible (e.g. insurance, maintenance) or deductible on Schedule A (e.g. qualified mortgage interest, real estate taxes). The expenses allocated to rental use are deductible (up to the amount of rental income) on Schedule E.

Some controversy exists regarding periods of vacancy. The IRS position is that periods of vacancy are ignored when allocating expenses. However, some court cases have allowed taxpayers to make allocations based on the full 365-day year regardless of periods of vacancy. The IRS position results in a greater allocation of mortgage interest and real estate taxes to the rental activity. The following example follows the IRS position.

Example 4

Begin with the same facts as in Example 3. Steve received $6,000 in rental fees. His total expenses were:

Qualified mortgage interest – $3,000
Real estate taxes – $1,500
Insurance, utilities, and maintenance – $4,500
Depreciation – $1,800

The rental proportion is 83.17% (84 rental days divided by 101 total days). The personal use proportion is 16.83%. Steve reports the following on Schedule E:

Rent received	$6,000
Qualified mortgage interest (3,000 * 83.17%)	-2,495
Real estate taxes (1,500 * 83.17%)	-1,248
Remaining income	2,257
Insurance, utilities, and maintenance (4,500 * 83.17% = 3,743, but limited to remaining income)	-2,257
Net rental income	$ -0-

The unused rental expenses are carried forward to future tax years:

Insurance, utilities, and maintenance: 3,743 – 2,257 = 1,486 carried forward
Depreciation: $1,800 * 83.17% = 1,497 carried forward

The personal use portion of the expenses is either deducted on Schedule A, or nondeductible:

	Schedule A	Nondeductible
Qualified mortgage interest (3,000 * 16.83%)	$505
Real estate taxes (1,500 * 16.83%)	$252
Insurance, utilities, and maintenance (4,500 * 16.83%)		$757
Depreciation (1,800 * 16.83%)		$303

Case 3 – Primarily a rental property

A residence falls into this category if:

Personal use does not exceed the greater of 14 days, or 10% of rental days

In this case, the property is considered a rental property. The tax treatment is:

All rents received are included on Schedule E
There are no ordering rules for taking deductions
Deductions are not limited to rents received. The deductions can create a loss. However, the loss may not be usable in the current year due to the passive activity loss rules.
Deductions still need to be prorated between personal use and business use
The personal amount of mortgage interest or real estate taxes is not deductible on Schedule A

Example 5

Facts are the same as in Examples 3 & 4, except the unit is rented at fair value for 323 days.

The rental proportion is 95%: 323 rental days divided by 340 total days (includes 17 personal use days). The personal use proportion is 5%. Steve reports the following on Schedule E:

Rent received	$6,000
Qualified mortgage interest (3,000 * 95%)	-2,850
Real estate taxes (1,500 * 95%)	-1,425
Insurance, utilities, and maintenance (4,500 * 95% – not limited to income)	-4,275
Depreciation (1,800 * 95%)	-1,710
Net rental loss (may be limited by the passive loss rules)	-$4,260

There are no unused rental expenses to carry forward.

The personal use portion of the expenses are not deductible on Schedule A.

	Schedule A	Nondeductible
Qualified mortgage interest (3,000 * 5%)		$150
Real estate taxes (1,500 * 5%)		$75
Insurance, utilities, and maintenance (4,500 * 5%)		$225
Depreciation (1,800 * 5%)		$90