Are you thinking of renting out that vacation home you never seem to use as much as you’d like? A little extra income would be nice too, especially if you can reduce any tax on that income by deducting certain related expenses.

Qualifying for tax treatment: 2 tests
First, for tax reporting purposes, renting out your vacation home assumes that the dwelling unit qualifies as a personal residence. To qualify, you must:

1. Use the property for personal purposes for more than the greater of either 14 days or 10% of the total days you rent it out to others at a fair rental price.
2. Rent the dwelling unit at fair value for 14 or more days during the tax year.

Both tests are measured on an annual basis, so one tax year you may rent out the property but not use it enough personally for it to qualify as a personal residence, in which case the home is considered strictly rental. In another, it may meet both tests. And in others, the home may not be rented out for 14 or more days. In the last scenario, special limitations apply to the deductibility of expenses (e.g. only prorated amounts of mortgage interest and real estate taxes may be deducted); however, this may be a non-issue since the income from renting property out for less than 14 days in a tax year is not even required to be reported.

Determining your deductions

Let’s say that this year you’ve met both tests. You know how much income you’ve received, but you’re not sure what can be deducted. What next?
Typically expenses can be divided into two categories: direct and indirect.

Direct Expenses

Direct expenses are those that strictly relate to your renting the property out. Examples of direct expenses include:

• advertising the property for rent
• commissions paid
• cleaning costs between renters
• any permits or licenses that the state may require
• any fees you may pay if you are having a third party handle property management for you.

Generally, 100% of direct expenses may be deducted against rental income.

Indirect Expenses

On the other hand, indirect expenses are those costs that you would incur regardless of whether or not you rented out your home. Such costs include:

• the cost of the home itself (which could be depreciated)
• mortgage interest
• real estate taxes
• insurance,
• repairs and maintenance
• landscaping
• utilities
• security costs

Since these expenses relate to both your personal use of the home and its rental use, they must be prorated between the two, as personal expenses are not deductible for tax purposes unless an exception applies (i.e. mortgage interest and real estate taxes may be deducted on Schedule A of your income tax return).

To figure the deductible indirect expense amount, the expense is to be multiplied by the percentage that results from dividing the total number of days the property was actually rented by the total number of days the home was used for both rental and personal purposes.

Example

I owned my vacation home for all of 2014. During the year, I rented it out for 21 days and used it personally for 30. As a result, in addition to 100% of any direct expenses, I would be able to deduct up to 41.18% (21 days divided by 51 days) of the indirect costs I paid during the year against the rental income I received on the property. My rental deductions may be limited, however, if they exceed my income for the year. In such a case, my excess losses would likely be carried over to the following tax year.

Though determining the deductibility of expenses may seem pretty cut and dry, reporting a rental is not always simple. It’s important to go over the details with your tax adviser as other considerations may apply to your specific situation.

Questions? Contact us.