Overview of complex tax rules
Whether it is a beach house, a cabin in the woods or some other place, a vacation home can be a valuable source of tax breaks, as well as rest and relaxation. For example, you can deduct property taxes along with your mortgage interest (assuming the combined acquisition debt of your main home and vacation home does not exceed $1 million).
Hypothetical situation: You decide to rent out your vacation home this upcoming summer when your family is not using it. The rental income you will receive can offset some of the costs of ownership. Of course, this income is taxable, but you may claim offsetting deductions for a portion of your expenses.
Now suppose you run a loss on the rental—your rental-related expenses (including mortgage interest and property taxes allocable to the rental) exceed the income you receive. Under the passive-activity loss rules, you can use losses from a rental activity only to offset income from other passive activities. If you are an active participant in the rental (e.g., you make management decisions), the tax consequences depend on your income level and the extent of your family’s personal use.
- If your income does not exceed $100,000, you can use the loss to shelter up to $25,000 of your salary and other income, as long as you keep your personal use to a minimum. Your family’s personal use cannot exceed the greater of 14 days or 10% of the rental time. Downside: When you keep your personal use below these limits, you lose a portion of your mortgage interest deduction (the portion allocable to your personal use).
- If your income exceeds $150,000, the tax law says you cannot qualify for the $25,000 loss write-off. In this case, your total rental deductions cannot exceed your rental income, regardless of the amount of your personal use. However, if your personal use is greater than 14 days or 10%, you receive an additional deduction: the portion of your mortgage interest you do not claim as a rental expense.
- If your income is between $100,000 and $150,000, things are not so clear-cut. The $25,000 loss write-off is gradually phased out in this income range. The closer you are to the $150,000 level, the more likely it is that you will get little in the way of a loss write-off. So you will probably want to increase your personal use—the same strategy for those with incomes above $150,000. Result: You will be able to deduct more of your mortgage interest.
On the other hand, if you are closer to the $100,000 level, most of your loss write-off will be intact. So you should try to keep your personal use below the 14-day/10% mark.
Note: There is a unique tax opportunity if you rent out the home for two weeks or less during the year. Although no expenses are deductible, all of the rental income is effectively tax-free.
Reminder: This is just a brief overview of the basic tax rules. This area is extremely complex, so be sure to seek professional guidance in this area.