Vacation Home Tax Strategies
Renting out your dream property can be a nightmare.
By Bob Barry, CFP

Tax breaks can make owning a vacation home far more affordable, but if you rent out the home, the federal tax rules can get downright tortuous. The basic tax deductions for a second home are similar to the deductions for your principal residence, with minor exceptions. For example, you may deduct the mortgage interest paid on acquisition indebtedness of up to $1 million, but only on one additional home, not on a third or fourth home. (For tax purposes, a second home can be a boat or recreational vehicle as long as it has permanent sleeping, cooking, and toilet facilities.)

You also may deduct real estate taxes (or personal property taxes in the case of boats or motor homes) and points. You must deduct points over the life of the loan; you can't deduct them up front as you can with your principal residence.

Many owners rent out their vacation homes to help offset costs. Renting can provide certain tax benefits, but it adds enormous tax complexity and may eliminate some of the valuable tax breaks mentioned above. Here are the three basic rental situations. (Consult with your financial planner or tax advisor to determine if renting your second home works best for you.)

1. The simplest strategy is to rent out your vacation home for no more than 14 days a year. You don't have to declare the rent paid as income, and you may take the basic tax deductions mentioned above for mortgage interest and property taxes. On the downside, you can't deduct any fees associated with renting the property, such as property management and maintenance fees.

2. If you rent out the home for more than 14 days a year, the tax rules get complicated. First, all rental income is subject to tax, including those first 14 days you didn't have to report before. However, now you can deduct expenses associated with renting, including depreciation, a portion of your homeowner's insurance, utilities, and property management fees. How much you can deduct and how you deduct it, however, depend on how much you personally use the property.

You can classify your vacation home as rental property and take the regular rental deductions by limiting your personal use to 14 days or less, or no more than 10 percent of the total number of days you rent out the property, whichever is greater. For example, if you rent it out 200 days, you can use it up to 20 days for personal use, and it still will qualify as rental property.

What happens if expenses exceed rental income? Now you're into something called "passive income" rules and the vacation home exception to this rule, which is too lengthy to explain here. In brief, the rules allow you to deduct the losses against other income, unless you have an annual adjusted gross income of more than $100,000.

3. If you personally use your vacation home for more than 14 days a year, or more than 10 percent of the total rental days, it reverts to personal residence status, and you must allocate expenses between rental and personal use. Precisely how you allocate these expenses depends on their nature. For example, time the home stands vacant is treated as personal time for some expense allocations but not others.

Renting your vacation home can have significant tax consequences and requires careful financial analysis.

Being off one rental or personal-use day could end up costing you thousands in tax breaks. By treating your vacation home as rental property, you lose a portion of your home mortgage deduction. For many homeowners, that trade-off is fine. But others, particularly higher-income homeowners, may lose more in mortgage interest deductions than they gain in rental expense deductions. They may be better off treating the vacation home as a second home and not rental property.