Dear Carrie: My husband and I are considering buying a small vacation home and are also contemplating renting it out part of the year to help cover the cost. Can you explain the tax rules for rental income, and are we entitled to any tax deductions? -- A Reader
Dear Reader: This is a really timely question. Renting vacation homes, or even a part of your primary residence, is becoming more common thanks to a variety of online sites that make it easy to market property and attract renters. But just because it's easier to attract renters doesn't mean there aren't other obstacles.
A vacation home can provide you and your family with precious R & R, and it can also be a source of income in the right circumstances. But unfortunately the tax rules for renting out your home can be mind-numbingly complex, depending on your intentions and circumstances.
That's not to say you shouldn't do it. It just means you need to be aware of the rules before you get too far into the process. I can give you some basics, but I urge you to talk to your tax adviser so you understand how the rules apply to your specific situation. You might also want to consult IRS Publication 527, which spells everything out in detail.
That said, here are some of the key points to consider.
THE AMOUNT OF TIME YOU RENT OUT YOUR HOME
Rental income in general is taxable. But the IRS gives you a small break if you rent your second home for 14 days or fewer in a year. In this case, your rental income is tax-free. You don't even have to report it on your tax return -- no matter how much it is.
If you go past the 14-day limit, you have to report your rental income and pay taxes on it. You can deduct rental expenses, but here's where it starts to get complicated -- because the amount of expenses you can deduct depends on whether the property is a business or a personal residence in the eyes of the IRS. And that depends on the proportion of personal use to the amount of time you rent the property.
Once again, 14 days comes into play. If you use your vacation home for 14 days or fewer in a year, or less than 10 percent of the days it's rented, it's considered a business. If you use it for more than 14 days, or more than 10 percent of the days it's rented, it's considered a personal residence.
So let's say you decide to spend the month of June (30 days) at your vacation home. You've passed the 14-day limit. Even if you have the good fortune to rent it out for 90 days the rest of the year, it's still considered a personal residence.
WHAT CONSTITUTES PERSONAL USE
To make things even more confusing, the definition of personal use includes not only use by the owners of the property but also extends to use by family members, days you may have donated the use of the house, or days that you rent it out for less than fair market value.
So if you give your out-of-town relatives a generous break on the rent, or you donate two weeks to a local charity auction, that time would be considered personal use.
On the other hand, the days you spend at the house doing maintenance do not count as personal use. If you spend a weekend, a week or even a month fixing up the property, that time is off the books.
EXPENSES THAT CAN BE DEDUCTED
The reason all this is important goes back to taxes and expenses. If the property is considered a personal residence, you can deduct things like mortgage interest and property taxes. But when it comes to expenses, you have to apportion eligible deductible expenses (i.e., cleaning, repairs, utilities) according to the amount of personal or rental usage.
To determine the percentage of expenses you can deduct, divide the number of days rented by the total number of days of usage (personal days plus rental days). Using our previous example, 90 divided by 120 equals 75 percent. Therefore you could deduct 75 percent of eligible expenses up to the total amount of the rental income. If your expenses exceed the rental income, you can't take a loss on a personal residence, but you can carry excess expenses forward to the following year.
If you limit your personal use to 14 days, or 10 percent, the property is considered a business. Not only can you deduct all eligible expenses but you might be able to deduct losses up to $25,000 in the current or future tax years. You can also write off depreciation.
STATE TAX CONCERNS
For the record, state and local laws vary on collecting sales taxes or hotel taxes, even on short-term rentals. So you'll need to look into your own state's requirements.
There's a lot to think about, but don't let it spoil your fun. Just make sure to talk to your tax adviser and keep good records. Then, hopefully, you can sit back and relax.