Just like the ocean every day, the economic tide is changing. Between the real estate markets, which have strengthened in areas across the country, and favorable interest rates, the idea of owning a vacation home is becoming a reality for many families. There are many tax advantages to owning a vacation home; however first you must determine if your vacation home will be treated as a residence or as a rental property.
To determine if a vacation home is treated as a residence, you must determine if personal use exceeds the greater of 14 days or 10% of the total days the property is rented at fair market rent.
Limited-Rental Use Rule
The 14 day threshold is one of the most significant advantages that the owner of a vacation home, treated as a residence, can take. A special limited-rental use rule allows a taxpayer to exclude from income any rents collected relating to their vacation home if it was rented for less than 15 days during the entire year. This can be a significant tax break for people who own property in popular vacation locations or any area that is near major sporting or social events (e.g., Philadelphia Papal Visit 2015). There is one caveat to the limited-rental use rule; you cannot claim any offsetting rental-related deductions.
Vacation Home Rental Property
If you are the type who loves the idea of the beach and going on extended vacations, but just can’t seem to get away from work, then you will most likely fall into the second category; vacation home used as a rental property. Your vacation home will be treated as a rental property for any tax year where your personal use of the property does not exceed the greater of 14 days or 10% of the days the property is rented at fair market rent during the year.
When renting your vacation home you can take allocable deductions (allocable to the rental portion of use), up to or in excess of the income that property generates. Any losses the rental property creates will generally be considered passive. Passive losses can only offset other passive income until the property is disposed of. If you actively participate in the rental activity then you may be able to shelter up to $25,000 of non-passive income with losses. This $25,000 special passive loss exception begins to phase out when a taxpayer’s AGI exceeds $100,000 and disappears completely when their AGI reaches $150,000. Any losses that cannot be utilized in the current year carry forward to subsequent years where they can offset passive income or eventually offset any gains on the disposition of the property.
The active participation standard can be satisfied without regular and substantial involvement in the operations. Instead, you must only participate in a significant way, such as deciding on tenants and setting rental terms. It is important to note something that many overlook; the $25,000 special passive loss exception is not available if you utilize a management company or real estate agency to manage all aspects of the rental property.