After reading Part 1 of Vacation Rental Property, you now have an idea of the expenditures and personal vs rental days that you have to track for the IRS. This blog will focus on the percentage of the aforementioned expenditures you can deduct. That is correct, in case you were wondering, you cannot deduct 100% of some of the expenditures related to your vacation rental property. The reason for this is that other homeowners who do not rent out their house do not get tax deductions for maintenance and the like, so the IRS says you can’t deduct the portion relating to your personal usage either.
Identify Residence vs Rental
You may remember that if you use the house personally for the greater of 14 days or 10% of the time rented that you get stuck under the vacation rental income reporting rules. If your personal usage is under the threshold, then the property is not considered a vacation home and is rather just a normal rental property. This is why determining the number of days a house is rented as well as used personally is imperative and it is very advantageous to get as many days to count as maintenance days vs personal use days.
Vacation Rental Expense Deductions
If you do go over the 14 days or 10% threshold, how do you compute the amount of your expenditures that can be deducted? The imperative thing to remember is that a vacation rental cannot deduct more in expenditures than income in a given year. The least amount of income that you can show on your return from the rental is $0. You cannot report a loss for taxes. If there are more expenditures than income, that amount carries forward until they can be applied to future income.
Additionally, the IRS requires expenses be deducted in a specific order:
1. Mortgage Interest & Real Estate Tax Deductions: The IRS requires that the portion of real estate taxes and mortgage interest related to the period the house was rented be deducted first. Why is this? These are the two items that may be able to be deducted elsewhere on your return as an itemized deduction (more on that later). Not allowing a loss on a vacation rental home and requiring the mortgage interest and real estate taxes to be deducted first minimize the amount of deductions a taxpayer can take in a single year.
How much real estate taxes and mortgage interest can you deduct? To muddle things even further there are two methodologies, the IRS Method and the Tax Court Method. The IRS uses one percentage and has lost in tax court more than once in favor of a different methodology. If you get audited the IRS will compute it one way but if you argued your case to tax court, they would likely use their mythology. So what is the difference?
The IRS says that you can deduct the allocable portion to the total days rented compared to the total days the property was used during the year.
For example, you use the property 30 days and rent it out 90 days in 2018. The IRS says that you can deduct 75% (90/120 total rental and personal days) of your property taxes and mortgage interest against your rental income.
Tax Court Method
The Tax Court says that you can deduct the allocable portion to the total days rented compared to the total days in the year.
For example, you use the property 30 days and rent it out 90 days in 2018. The Tax Court says that you can deduct 25% (90/365) of your property taxes and mortgage interest against your rental income.
Under either method, the amount not deducted against rental income was allowed to be deducted as an itemized deduction. However, for 2018-2026 many will not be itemizing their deductions due to the increase of the standard deduction as well as the $10,000 limit on income, sales and property taxes. In general this means that for the coming years you want as much of your real estate taxes and mortgage interest to be allocable to the rental as you will not be getting much/any benefit from them as an itemized deduction since you will likely not be itemizing.
This is where your choice of IRS vs Tax court method comes in handy. In the past since many taxpayers benefited from itemized deductions, it was more beneficial on a whole to use the tax court method since it would allow more non property taxes/interest to be used against your rental and show more itemized deductions. However for 2018-2026 there is little benefit to getting the amounts as an itemized deduction. Therefore, in general it is recommended to use the IRS method for apportioning your property taxes and mortgage interest.
2. Direct Rental Expense: These are expenses are 100% deductible as they are directly associated with the rental activity.
Cleaning Fees Between Renters (But not while in use personally)
3. Maintaining & Operating Property: The remainder of all of the other expenses are generally ones that you would have for the house whether you rented it or not. These are items such as: Insurance, Utilities and Supplies.
The proportion that can be deducted for these expenditures is the ratio of fair rental days/total days used. Total days used only includes the days considered personal and the days it was rented. Unfortunately, any days that the property was held out for rent but not actually rented are not factored into the calculation.
4.Repairs & Maintenance: Lastly, one topic that can become a little tricky is repairs and maintenance. General repairs and maintenance that are done either due to the age of the property or general upkeep need to be allocated similar to the above items. However, if a repair is needed due to the actions of a specific tenant then those expenses can likely be 100% deductible. Something like this could be a renter puts a hole in the wall or breaks a piece of furniture.
As you can see, reporting the rental activity from your vacation rental property is not easy and is full of nuance. Hopefully after this blog and the last one you have a better idea of the things you have to track as well as how to allocate your expenditures on your return and why your accountant is asking a lot of odd questions about its activity.
Would you like to discuss this topic further? Contact us at firstname.lastname@example.org or 716-633-7022.