Know This if You Have Rental and Personal Use of a Vacation Home

When you have both rental and personal use of a home at the beach or in the city, you have what the tax law calls a vacation home.

That’s the beginning of the story.

In this article, you learn how the tax law treats a mixed-use vacation home that the law classifies as a personal residence.

In an upcoming article, you will learn how the tax law treats a mixed-use vacation home that the law classifies as a residential rental property.

The Tax Cuts and Jobs Act (TCJA) included two important changes that can negatively affect vacation homes treated as personal residences.

But there’s more. How you use your vacation property during the year can also affect your federal income tax results.

Here’s what you need to know, starting with the necessary background information.

Limits on Property Tax Deductions

Before the TCJA, you as an individual taxpayer could claim itemized deductions for an unlimited amount of personal state income and local property taxes. That was then. This is now.

For 2018-2025, the TCJA limits itemized deductions for personal state income and local property income taxes to a combined total of only $10,000, or $5,000 for those who use married filing separate status.

The state income and local property tax limits come into play when you have a vacation home that’s classified as a personal residence.

Limits on Qualified Residence Interest Expense Deductions

For 2018-2025, the TCJA also placed new limits on the amount of home mortgage debt for which you can claim itemized qualified residence interest deductions. Before the TCJA, you could deduct interest on up to $1 million of home acquisition indebtedness (meaning debt you incurred to buy or improve a first or second residence), or $500,000 if you used married filing separate status.

Before the TCJA, you could also deduct the interest on another $100,000 of home equity indebtedness, or $50,000 if you used married filing separate status.

So, before the TCJA, the debt limit for deductible home mortgage interest was really $1.1 million, or $550,000 if you used married filing separate status.

2018-2025 Rules for Deducting Interest on Home Acquisition Debt

For homes purchased during 2018-2025, the TCJA generally allows you to treat interest on up to $750,000 of home acquisition indebtedness incurred to buy or improve a first or second residence as deductible qualified residence interest. If you use married filing separate status, the debt limit is halved to $375,000.

Grandfather Rules for Home Acquisition Debt

Under one grandfather rule, the TCJA change does not affect interest deductions on up to $1 million of home acquisition indebtedness that you took out

• before December 16, 2017, or
• under a binding contract that was in effect before December 16, 2017, as long as your home purchase closed before April 1, 2018.

Under a second grandfather rule, the TCJA change does not affect interest deductions up to $1 million of home acquisition indebtedness that you took out before December 16, 2017, and then refinanced later—to the extent the initial principal balance of the new loan does not exceed the principal balance of the old loan at the time of the refinancing.

Deducting Home Equity Loan Interest Is Generally Off Limits for Now

For 2018-2025, the TCJA generally suspends the prior-law provision that allowed you to treat interest on up to $100,000 of home equity indebtedness, or $50,000 if you use married filing separate status, as deductible qualified residence interest.

But you can treat home equity indebtedness as home acquisition indebtedness, subject to the $750,000/$375,000 limit, if the loan proceeds were used to buy or improve your first or second residence and the loan is secured by that residence.

TCJA Impact on Vacation Properties Not Rented During the Year

If you own a vacation property that you don’t rent out at all during the year, you treat the property as a personal residence for federal income tax purposes. As you know from above, the TCJA changes can reduce or eliminate your allowable itemized deductions for vacation home property taxes and mortgage interest.

For instance, say you pay heavy state income taxes. In this scenario, you may lose all your property tax deductions and likely some income tax deductions too.

Vacation Properties Rented for Less Than 15 Days Get a Special Tax Break

Do you rent out your vacation property for less than 15 days during the year and use it for personal purposes for more than 14 days during the year? If the answer is yes, you qualify for a special tax break.

You need not declare a penny of the rental income on your Form 1040, because the rental activity is completely disregarded for federal income tax purpose. Nice!

The only drawback is that you get no deductions for other expenses attributable to the rental period, such as advertising and cleaning costs. This beneficial tax-law quirk has been around for many years and, thankfully, it survived the TCJA.

Tax-Law Definition of Vacation Home

We will call vacation properties that you use partly for rental purposes and partly for personal purposes during the year mixed-use vacation properties. Under the vacation home rules, those mixed-use properties will be classified as either

• personal residences (where special allocations are necessary) or
• rental properties (where special allocations also are necessary).

To keep this article from turning into a book, we will cover only the mixed-use vacation home personal residence here. You have such a mixed-use personal residence, whether in the city or at the beach, when you

• rent it for more than 14 days during the year and
• use it for personal purposes for more than the greater of 14 days or 10 percent of the days that you rent the home out at fair market rates.

Counting Days of Use

To determine if your mixed-use property is subject to the vacation home rules, you count only actual days of personal and rental occupancy. Ignore days of vacancy. Also ignore days that you spend mainly on repair and maintenance activities.

Personal use generally means use by the owner (that would be you), certain family members, and any other party (family or otherwise) who pays less than fair market rental rates. For this purpose, family members are defined as the owner’s brother, sister, spouse, ancestor, or lineal descendent.

Family Trouble

Use by a family member generally counts as personal use whether or not the family member pays fair market rent.

Swap Trouble

If the home is used by another person under a reciprocal arrangement (“I use your vacation property and you use mine”), such use is considered personal use—whether or not the other person pays you fair market rent to use your property and whether or not you pay fair market rent to use the other person’s property.

Tax-Law Definition of Rental Property

Remember, tax law classifies your mixed-use home as a rental property rather than a vacation home for federal income tax purposes if

• you rent it for more than 14 days during the year and
• your personal use during the year does not exceed the greater of: (a) 14 days or (b) 10 percent of the days you rent the place out at fair market rates.

Remember also that you count only actual days of rental and personal use. Disregard days of vacancy, and disregard days spent mainly on repair and maintenance activities.

Key point. As stated earlier, this article does not cover the separate set of federal income tax rules that apply to mixed-use properties classified as rental properties.

Personal Residence Allocations to Personal and Rental Use 

When the vacation home rules make your mixed-use property a personal residence, the TCJA limitations on itemized deductions for property taxes and mortgage interest come into play for 2018-2025.

The fundamental principle determining when your vacation home is a personal residence is that expenses allocable to rental use of the property cannot exceed the gross rental income from the property. In other words, rental expenses cannot cause a tax loss on Schedule E of your Form 1040 for the year in question.

Fair enough, but we need a procedure to allocate expenses between personal and rental use. The tax code provides such an allocation procedure and also the related tax return treatments, which are as follows.

Step 1. Determine your gross rental income. Gross rental income equals gross receipts from rental reduced by expenditures to obtain tenants, such as Realtor® fees and advertising expenses. Report the amounts on Schedule E of your Form 1040.

Step 2. Use the actual days of rental and personal use to allocate both interest from the home acquisition indebtedness and the real property taxes to rental and personal use. Deduct the rental portion to the extent it does not exceed gross income on Schedule E. Deduct the personal interest and property taxes on Schedule A.

Key point. In the unusual circumstance where Step 2 shows a loss, recalculate Step 2 applying the interest limitation rules and the $10,000 cap on taxes. If such a calculation shows a loss, it’s deductible as a loss and you carry over to next year the expenses under Steps 2 and 3 below.

Key point. In some cases, you will deduct none of the property taxes allocable to personal use on Schedule A because you either claim the standard deduction or suffer from the $10,000 limit on state income and local property taxes. You will see an illustration of this in the sidebar at the end of this article.

Step 3. Deduct on Schedule E (to the extent they do not exceed the remaining gross income) expenses allocable to rental use (other than those that would result in an adjustment of basis) such as property insurance, HOA fees, utilities, and maintenance.

Step 4. Deduct depreciation and other adjustments to basis to the extent such deductions do not exceed gross income from the rental. If depreciation is limited, reduce the tax basis of your residence only by the currently deductible amount.

Step 5. Carry over any disallowed expenses allocable to rental use from Steps 3 and 4 to your next tax year. In that year, the expenses are again subject to limitation based on that year’s gross rental income.

Presumably, if you sell the property, you can use any gain attributable to the rental-use portion of the property to “free up” prior-year disallowed expenses allocable to rental use. (The IRS has given us no guidance on this.)

Two Methods for Allocating Interest and Taxes

The IRS position is that you should use only actual days of personal and rental occupancy to allocate vacation home expenses. As mentioned earlier, you disregard days devoted mainly to repairs and maintenance.

Key point. There’s a controversy regarding how to allocate mortgage interest and property taxes that could otherwise be claimed as itemized deductions. Two appeals courts decisions say that to allocate these two expenses, vacation home owners can count actual rental occupancy days as rental days and all other days— including days the property is vacant—as personal days. This is what we will call the Bolton/McKinney method for allocating those two expenses.

Before the TCJA, using the Bolton/McKinney method was often beneficial because

• it allocates more mortgage interest and property taxes to Schedule A (where you could usually currently deduct those expenses under the pre-TCJA rules) and
• it allocates less mortgage interest and property taxes to Schedule E, which allowed you to currently deduct more of your other expenses allocable to rental use (property insurance, HOA fees, utilities, depreciation, etc.) on Schedule E when applying the rental income limitation.

But with the TCJA’s limitations on itemized deductions for mortgage interest and state and local taxes, using the Bolton/McKinney method might be counterproductive. Or it might be helpful. It depends on your specific situation.

Confusing?

You bet! See the SIDEBAR at the end of this article for some examples that help clarify things.

Impact of TCJA Increases to Standard Deduction Amounts

Using the IRS-approved method to allocate more vacation home mortgage interest and property taxes to Schedule E might be beneficial if your increased standard deduction ($25,900 for 2022 for married joint-filing couples, $19,400 for heads of households, and $12,950 for singles)15 would make using the alternative Bolton/McKinney method counterproductive.

That’s because the Bolton/McKinney method shifts more interest and taxes to Schedule A, but if you still don’t have enough itemizable expenses to exceed your standard deduction, the amounts shifted to Schedule A will never deliver any tax benefit.

On the other hand, using the IRS-approved method to shift more interest and taxes to Schedule E will deliver a tax benefit, although it may be only a future benefit if the shifted expenses are not currently deductible due to the rental income limitation.

Takeaways

When you use a property for both personal and rental purposes, you need to know the vacation home rules.

And for years 2018-2025, the TCJA limits on itemized deductions for qualified residence interest and property taxes add to the decision-making matrix.

For example, because of the TCJA, some vacation home owners might benefit from using the Bolton/McKinney method for allocating mortgage interest and property taxes. Others might benefit from using the IRS-approved method. Now, because of the TCJA, you need to run the numbers to find out.

In any given year, you may be able to micro-manage the number of rental and personal-use days. Your usage pattern may differ from the pre-pandemic norm. That usage pattern can potentially result in better or worse tax outcomes for you, especially when it flips your place from a rental to a residence or vice versa.

For instance, you and family members may be anxious to spend more time at your property at the beach and less time in the big city. That could put the property firmly into personal residence status and possibly increase your allowable itemized deductions for qualified residence interest and property taxes.

But if you’re adversely affected by the TCJA limitations on qualified residence interest expense and property taxes, adding more personal-use days may simply result in more lost deductions (a distasteful result).

On the other hand, rental demand for your place may be so high that it’s impossible to ignore the opportunity to collect more rental income. That could put the place firmly into rental property status and make it subject to a different set of federal income tax rules that apply to rental properties. We’re covering these in an upcoming issue.

Under those rules, you can usually offset all of your rental income with allowable deductions on Schedule E of Form 1040. If so, adding more rental days could result in more tax-sheltered rental income, which would be a good thing.

SIDEBAR: Three Examples of How to Allocate Vacation Home Expenses

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