Tax Bonuses Earned From Renting Out Second Homes
While the charms of second or third homes are usually sized up in terms of mountain views or proximity to shorelines, the possibility of cutting carrying costs through rental income is an added attraction. Better yet: Owners of vacation properties—whether a pied-à-terre, a chalet, or even a yacht—can score significant tax savings on rental income if they organize their affairs properly.
But real estate tax rules are detailed, and it may require meticulous record-keeping to maximize tax benefits. “This isn’t something most taxpayers have shown to be very good at, and it can make life very unpleasant in an IRS audit,” says Jere Doyle, a senior wealth advisor at BNY Mellon.
The facts: Total mortgage interest up to $1.1 million is deductible on primary homes and one vacation home, combined. Mortgage interest isn’t deductible on third or more properties. Property taxes are deductible on all homes, no matter how many you own.
The tax implications of using your property for rental income depend primarily on how often you use the property personally, versus renting it out. The simplest scenario is the best: If you rent your property for 14 days or less, you get a tax freebie—the income doesn’t have to be reported to the Internal Revenue Service. “For Super Bowl weeks or major golf tournaments, if you want to rent your home for 14 days or less, that’s tax-free rental income, even if it’s $10,000 a week,” says Stephen White, regional leader of wealth planning at BMO Private Bank.
If you rent for more than 14 days, all rental income—including the first 14 days—must be reported. So carefully consider the value you’ll get from renting beyond 14 days. If you rent for, say, 21 days, your after-tax income may end up about equal to 14 days of tax-free income, Doyle says, adding that the record-keeping involved for the tax-filing process is onerous, and the headaches may not be worth it.
But if you collect rent for an entire season, income can be significant and well worth the tax-preparation process. To be able to claim deductions against rental income, you must allocate annual expenses related to the property between personal and rental use. Utilities, housekeeping, maintenance, and insurance are among the deductible expenses. If your annual expenses on a property are $40,000, and you rent your property for 60 days of the year and use it yourself for 40 days, you can deduct 60%, or $24,000 of expenses.
Any costs associated with using the home as a rental, such as for a property manager or for towels and sheets used only by renters, are fully deductible. If your expenses exceed rental income, you can only deduct the losses if you are actively involved in the business side of your vacation home. Otherwise, your losses are considered passive and can generally be deducted only against passive income, such as other rental income. But passive losses can be carried forward for years and used to offset capital gains when the property is sold.
Don’t claim that you’re actively involved simply because you raked your own leaves one day and replaced a broken windowpane. Active involvement means screening tenants, establishing rental terms, overseeing the rental periods, and more. The IRS may scrutinize wealthy homeowners who claim to be actively involved in their rental properties. “You don’t see many people with a net worth of $5 million or more placing ads and managing the rental aspects of their vacation homes,” Doyle says.
If you use your property for less than 10% of the period that you rent it out, the IRS will deem the property a rental business, and you can deduct all property expenses against rental income, without allocating between personal and business use. Losses are still passive, unless you’re active in the business. You can also get some benefits from depreciating the value of the property, but think this through. Every depreciation claim lowers your cost basis, which means higher capital-gains taxes if and when you sell the property. Keep in mind, too, that if family members use the property, it’s considered personal use—unless they pay a fair rent. “It’s critical to stick to business formalities, especially when involving family members,” says Todd Angkatavanich, a partner at Withersworldwide.
There are other taxes to consider: If you live on the coast but have a chalet in Colorado that you rent out, you must file a return in Colorado. “Many people aren’t aware of occupancy or sales taxes,” says BMO’s White. The rules vary state by state. There is no sales tax on beach rentals in Delaware. In Maine, on the other hand, if you rent your home for 15 to 27 days a year, you’ll owe a 9% sales tax on your rental income.
Upshot: When renting out your second home, it’s the details that can invite scrutiny from tax authorities—or help you squeeze out some attractive benefits.
Source: barrons.com
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