Vacation/Second Home Rental: How do I report it and how do I avoid paying tax?
So you’ve got this great idea of having someone else pay for your vacation/second home by renting it out. Well, it’s not a bad idea but make sure you understand the tax consequences and use this tip on how to avoid paying some of the tax generated from receiving income on your property.
In general if are receiving income from renting out a “dwelling unit” like a house or apartment you can deduct certain expenses? Some common expenses include:
- Mortgage interest,
- Real estate taxes,
- Casualty losses
- Insurance, and
All of these things reduce the amount of rental income that is subject to tax. Just like a profit and loss for any business your revenue less expenses equals your net income. You are essentially running a mini small business. You generally report the income and expenses on your form 1040 using Schedule E (Supplemental Income and Loss). If you are only trying to rent for a profit and do not use it as a personal residence at any point during the year and your rental expenses are more than your rental income you will show a loss on your tax return. This loss might be limited by what the IRS call’s “At-Rick” or “Passive Activity Loss Rules.” For more info on limits of your losses check here Publication 925, Passive Activities and At-Risk Rules.
If you use your rental property as a personal residence at some point during the year other limitations will apply to the amount of expenses that you can deduct. You are considered to use a property as a personal residence if during any tax year you use it for the greater of 14 days or 10% of the total days you rent it to others (at a fair rental price – discounted rents for friends and family don’t count.).
You might have two personal residences during any given tax year. For example if you live in your primary residence 8 months, this residence is considered a personal residence. Then if you live in a condo down south for the other 3 months of the year, your condo is also considered a personal residence. For tax purposes a day of personal use at any property is defined as any day that it is used by:
- You or any other person who has an ownership interest in it
- A member of your family or family of any other person with an ownership interest in it, unless the family member uses it as his or her main home and pays a fair rental price
- Anyone under an agreement that lets you use some other dwelling unit
- Anyone at less than fair rental price
If this is the case (used for both rental and personal purposes) you need to divide your total expense between the rental use and the personal use based on the number of days for each purpose. For example if you have $10,000 of expenses and you rent it out for half of the year you only get to deduct $5,000. You will not be able to deduct your rental expenses in excess of the gross rental income limitation which is your gross rental income less the rental portion of mortgage interest, real estate taxes, casualty losses, and rental expenses like realtor’s fees and advertising costs. However, you may be able to carry forward some of these rental expenses to the next year. (Subject to gross income limitation for that year). If you itemize your deductions on From 1040 Schedule A you might still be able to deduct your personal portion of your mortgage interest, real estate taxes, and casualty losses. However you cannot choose to add more to your schedule A then the percentage personal use would allow.
There is a special rule where you can avoid paying tax on your rental income if you rent it for fewer than 15 days. If this is the case you do not have to report any of the rental income on your tax return (but you also can’t deduct any expenses). Therefore, if you can find a short-term rental income you can effectively receive the rent tax free. That’s about as good as it gets when the IRS is involved.