18 Jun Jon Cartu Reports Tax Reminders for Owners of Vacation Homes
Got a vacation home? There’s a big tax break if you rent it out—but a potential hit if you sell.
First, the break: Long-standing rules allow owners of vacation homes to rent out their cottages or condos, pocket the rent checks and completely sidestep taxes on the rental income.
I’ll use owner Olivia to illustrate how the rules work. Olivia qualifies for the rental-income exclusion only if she satisfies this seemingly-straightforward requirement: Rent out her place for less than 15 days during the year.
Olivia shouldn’t be complacent about the frequently-misunderstood rules; things end badly if she ignores the calendar and goes beyond the less-than-15-days limitation. She can’t claim the break and has to report all the rental income on Form 1040’s Schedule E.
IRS regulations show Olivia how she’s supposed to determine when days are rental and when they’re personal use. For example, her personal category includes days that she primarily spends to make or oversee repairs to the property or to prepare it for tenants. Olivia doesn’t have to count those kinds of days as rental.
Some IRS rules are helpful and others are hurtful when qualifying for the exclusion break for rental income relieves Olivia of the need to report income and expenses on Schedule E.
A rule that helps when Olivia uses the 1040’s Schedule A to itemize deductions: It’s okay for the Schedule A to include her vacation home-expenses for mortgage interest and property taxes.
A rule that hurts when Olivia’s Schedule A deductions are less than the standard deduction amount that’s authorized for someone who doesn’t itemize: The drawback to her sensible decision to use the more-advantageous standard deduction is that she can’t claim deductions for taxes and interest on her vacation property.
The owners who benefit the most from exclusion breaks for rental income: They’re the foresighted folks who acquire vacation homes (or year-round homes, for that matter) near annual events where rents soar for short periods. Some examples: Augusta during its Masters tournament; Des Moines during its presidential caucuses every four years; Indianapolis for the Memorial Day car race; and Louisville during Derby week.
The potential tax hit for sellers of vacation homes: Individuals who sell their main residences are able to exclude, meaning that they escape, taxes on profits of as much as $500,000 for married persons filing jointly and up to $250,000 for single persons and married persons filing separate returns.
Sellers of main residences qualify for profit exclusions only if they comply with two requirements: First, they own and use the dwelling as a principal residence for at least two years out of the five-year period that ends on the sale date. Second, they’ve not excluded gain on the sale of another principal residence within the two years that precede the sale date.
Less favorable rules kick in when sellers unload places that are second homes. At one time, a seller could occupy a vacation dwelling for two years and then claim the $500,000 exclusion. But the current law limits the amount of the exclusion when a second home becomes a principal residence.
The revised rules prohibit any exclusion for profit attributable to what the IRS characterizes as post-2008 periods of “nonqualified use.” Put more plainly, the agency means those periods during which the former second home wasn’t used as a principal residence.
Additional articles. A reminder for accountants who would welcome advice on how to alert clients to tactics that trim taxes for this year and even give a head start for next year: Delve into the archive of my articles (more than 350 and counting).