How the Tax Law Treats Residence Rentals

It’s common practice for clients to rent out their vacation homes when they are not being used for personal R&R. The rental income can cut the costs of owning and maintaining a second home. But these days, some of your clients may be cashing in on short-term rentals of their primary homes. Clients who live in or near vacation destinations or who live in the vicinity of major events can now connect with renters through advertising sites like Craigslist or rental sites like Airbnb. For example, many Philadelphia residents jumped into the short-term rental market when Pope Francis visited that city in 2015.

Unlike typical vacation home landlords, these clients may be unfamiliar with the tax law rules on rentals of a residence.

Rule #1

Short-term rentals. Under a longstanding tax rule, many short-term home rentals are essentially tax-free. The IRS says that when a home is rented for less than 15 days during a year, there’s no need to report the rental income or expenses. The rental income and rental expenses are simply ignored for tax purposes. Home-related expenses, such as mortgage interest and property taxes, are deducted as usual if the client itemizes deductions.

Once rentals hit the 15-day mark, two other rules come into play depending on whether the property qualifies as a personal residence or as investment property.

Rule #2

Personal residence rentals. If a personal residence is rented for 15 days or more during the year, all the rental income is included in income. Expenses are allocated between personal and rental use based on the number of days the home is used for each purpose. Otherwise deductible expenses attributable to personal use (mortgage interest, property taxes) can be written off if the client itemizes deductions. All expenses attributable to rental use are deductible—but only up to the amount of gross rental income.

A home is treated as a personal residence for a tax year if it is used for personal purposes for more than the greater of (1) 14 days or (2) 10 percent of the total days it is rented at a fair rental price.

Days of personal use generally include any days the home is used by your client or a family or by anyone at less than a fair rental price. However, days your client spends on repairs and maintenance are not personal use days, even if family members use the property for recreational purposes on the same day.

KEY POINT: This rule is not likely to come into play when a client rents out his or her primary residence on a short-term basis. But it can crop up with vacation home rentals. For example, if a client uses a vacation home for a three-week vacation each year (21 days), the home will be treated as a personal residence only if rental use is limited to a total of 30 weeks (210 days).

Rule #3

Investment property rentals. If a client’s property does not qualify as a personal residence, it’s considered an investment property. In that case, it is subject to the passive loss rules. Rental deductions are not limited to the amount of rental income, but any overall loss on the rental is deductible only to the extent of income from other passive investment sources. There is, however, an important exception: If a client has adjusted gross income of $100,000 or less and is actively involved in rental of the property (for example, by making repairs, approving tenants, and the like), the client can write off up to $25,000 of the net rental loss against non-passive income, including his or her salary. The $25,000 exception is phased out a rate of 50 cents for each dollar of income between $100,000 and $150,000.

TAX TIP: By fine-tuning personal use of the home, homeowners can pick the rule that will yield biggest tax deductions.

Example: Ben and Ann Spencer have adjusted gross income of about $95,000. The Spencers own a beach home that they use for three weeks each summer and rent for the remaining 12 weeks of the season. Their annual rental income is $18,000. Their total annual expenses for the home, including mortgage interest, taxes, maintenance and depreciation, come to $40,000. Of that amount, $8,000–including $4,000 of mortgage interest and $800 of property taxes—is allocable to personal use. The remaining $32,000 is allocable to the rental. The Spencers’ three weeks of personal use puts the vacation home in the personal residence category. Therefore, the Spencers can deduct the $4,800 of mortgage interest and taxes attributable to their personal use (the remaining expenses attributable to personal use are nondeductible). In addition, they can deduct their rental expenses—but only up to the amount of their rental income. Total deductions: $22,800. 

Change of plans: The Spencers limit their annual vacation to just two weeks and rent the home for an additional week, increasing their rental income to $25,500. Based on their new mix of rental and personal use, they allocate $5,320 of expenses, including $2,660 of mortgage interest and $532 of property taxes, to their personal use. The remaining $34,680 of expenses are allocable to the rental.

Cutting back on vacationing makes the home an investment property. The Spencers lose some deductions on the personal side; they can deduct the $532 of property taxes attributable to personal use, but not the $2,660 of mortgage interest. (Mortgage interest attributable to personal use is deductible only if the home qualifies as a personal residence.) However, they pick up substantial deductions on the rental side. They can deduct their rental expenses up to the amount of their $25,500 of rental income. In addition, because the Spencers’ adjusted gross income is below $100,000, they can deduct their $9,180 loss on the rental ($34,680–$25,500) against other income. Total deductions: $35,212.

Flip side: Assume the Spencers’ adjusted gross income exceeds $150,000. In that case, they may want to do more vacationing, rather than less. Reason: Whether the home is classified as a residence or an investment property, their rental deductions will be limited to their rental income. But by boosting their personal use, they can increase the amount of deductible mortgage interest and taxes attributable to personal use.

Editor’s note: If you have self-employed clients, be sure to read Mike D’Avolio’s article, “Helping Your Self-Employed and On-Demand Clients Implement a Great Financial Strategy” to get more information on serving this ever-growing segment.