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Know This if You Have Rental and Personal Use of a Vacation Home



When you have both rental and personal use of a home at the beach or in the city, you have what the tax law calls a vacation home.


That’s the beginning of the story.


In this section, you learn how the tax law treats a mixed-use vacation home that the law classifies as a personal residence.


The TCJA included two important changes that can negatively affect vacation homes treated as personal residences.


But there’s more. How you use your vacation property during the year can also affect your federal income tax results.


Here’s what you need to know, starting with the necessary background information.


Limits on Property Tax Deductions


Before the TCJA, you as an individual taxpayer could claim itemized deductions for an unlimited amount of personal state income and local property taxes. That was then. This is now.


For 2018-2025, the TCJA limits itemized deductions for personal state income and local property income taxes to a combined total of only $10,000, or $5,000 for those who use married filing separate status.1


The state income and local property tax limits come into play when you have a vacation home that’s classified as a personal residence.


Limits on Qualified Residence Interest Expense Deductions


For 2018-2025, the TCJA also placed new limits on the amount of home mortgage debt for which you can claim itemized qualified residence interest deductions. Before the TCJA, you could deduct interest on up to $1 million of home acquisition indebtedness (meaning debt you incurred to buy or improve a first or second residence), or $500,000 if you used married filing separate status.


Before the TCJA, you could also deduct the interest on another $100,000 of home equity indebtedness, or $50,000 if you used married filing separate status.

So, before the TCJA, the debt limit for deductible home mortgage interest was really $1.1 million, or $550,000 if you used married filing separate status.


2018-2025 Rules for Deducting Interest on Home Acquisition Debt


For homes purchased during 2018-2025, the TCJA generally allows you to treat interest on up to

$750,000 of home acquisition indebtedness incurred to buy or improve a first or second residence as deductible qualified residence interest. If you use married filing separate status, the debt limit is halved to $375,000.2


Grandfather Rules for Home Acquisition Debt


Under one grandfather rule, the TCJA change does not affect interest deductions on up to $1 million of home acquisition indebtedness that you took out


  • before December 16, 2017, or

  • under a binding contract that was in effect before December 16, 2017, as long as your home purchase closed before April 1, 2018.


Under a second grandfather rule, the TCJA change does not affect interest deductions up to $1 million of home acquisition indebtedness that you took out before December 16, 2017, and then refinanced later—to the extent the initial principal balance of the new loan does not exceed the principal balance of the old loan at the time of the refinancing.3

Deducting Home Equity Loan Interest Is Generally Off Limits for Now


For 2018-2025, the TCJA generally suspends the prior-law provision that allowed you to treat interest on up to $100,000 of home equity indebtedness, or $50,000 if you use married filing separate status, as deductible qualified residence interest.4


But you can treat home equity indebtedness as home acquisition indebtedness, subject to the

$750,000/$375,000 limit, if the loan proceeds were used to buy or improve your first or second residence and the loan is secured by that residence.


TCJA Impact on Vacation Properties Not Rented During the Year


If you own a vacation property that you don’t rent out at all during the year, you treat the property as a personal residence for federal income tax purposes. As you know from above, the TCJA changes can reduce or eliminate your allowable itemized deductions for vacation home property taxes and mortgage interest.


For instance, say you pay heavy state income taxes. In this scenario, you may lose all your property tax deductions and likely some income tax deductions too.


Vacation Properties Rented for Less Than 15 Days Get a Special Tax Break

Do you rent out your vacation property for less than 15 days during the year and use it for personal purposes for more than 14 days during the year? If the answer is yes, you qualify for a special tax break.


You need not declare a penny of the rental income on your Form 1040, because the rental activity is completely disregarded for federal income tax purpose.5 Nice!


The only drawback is that you get no deductions for other expenses attributable to the rental period, such as advertising and cleaning costs. This beneficial tax-law quirk has been around for many years and, thankfully, it survived the TCJA.


Tax-Law Definition of Vacation Home


We will call vacation properties that you use partly for rental purposes and partly for personal purposes during the year mixed-use vacation properties. Under the vacation home rules, those mixed-use properties will be classified as either


  • personal residences (where special allocations are necessary) or

  • rental properties (where special allocations also are necessary).


To keep this section from turning into a book, we will cover only the mixed-use vacation home personal residence here. You have such a mixed-use personal residence, whether in the city or at the beach, when you6


  • rent it for more than 14 days during the year and

  • use it for personal purposes for more than the greater of 14 days or 10 percent of the days that you rent the home out at fair market rates.


Counting Days of Use


To determine if your mixed-use property is subject to the vacation home rules, you count only actual days of personal and rental occupancy. Ignore days of vacancy. Also ignore days that you spend mainly on repair and maintenance activities.7


Personal use generally means use by the owner (that would be you), certain family members, and any other party (family or otherwise) who pays less than fair market rental rates. For this purpose, family members are defined as the owner’s brother, sister, spouse, ancestor, or lineal descendent.


Family Trouble


Use by a family member generally counts as personal use whether or not the family member pays fair market rent.8


Swap Trouble

If the home is used by another person under a reciprocal arrangement (“I use your vacation property and you use mine”), such use is considered personal use—whether or not the other person pays you fair market rent to use your property and whether or not you pay fair market rent to use the other person’s property.9


Example: The mixed-use vacation home personal residence.


You own a beachfront vacation condo. During the year, you rent it out for 180 days. You and members of your family stay there for 90 days. The property is vacant the rest of the year except for seven days at the beginning of winter and seven days at the beginning of summer, which you spend maintaining the property. Your condo falls into the tax code-defined personal residence because


  • you rented it out for 180 days, which is more than 14 days and

  • you had 90 days of personal use, which is more than 14 days and more than 10 percent of the rental days.


Disregard the 14 days you spent maintaining the place.


Variation. Say you had only 14 days of personal use. Now your condo is considered a rental property, rather than a personal residence, and it triggers a different set of allocation possibilities and disallowance rules.


Tax-Law Definition of Rental Property


Remember, tax law classifies your mixed-use home as a rental property rather than a vacation home for federal income tax purposes if


  • you rent it for more than 14 days during the year and

  • your personal use during the year does not exceed the greater of: (a) 14 days or (b) 10 percent of the days you rent the place out at fair market rates.


Remember also that you count only actual days of rental and personal use. Disregard days of vacancy, and disregard days spent mainly on repair and maintenance activities.


Key point. As stated earlier, this section does not cover the separate set of federal income tax rules that apply to mixed-use properties classified as rental properties.


Personal Residence Allocations to Personal and Rental Use


When the vacation home rules make your mixed-use property a personal residence, the TCJA limitations on itemized deductions for property taxes and mortgage interest come into play for 2018-2025.


The fundamental principle determining when your vacation home is a personal residence is that expenses allocable to rental use of the property cannot exceed the gross rental income from the

property. In other words, rental expenses cannot cause a tax loss on Schedule E of your Form 1040 for the year in question.10


Fair enough, but we need a procedure to allocate expenses between personal and rental use. The tax code provides such an allocation procedure and also the related tax return treatments, which are as follows.11


Step 1. Determine your gross rental income. Gross rental income equals gross receipts from rental reduced by expenditures to obtain tenants, such as Realtor® fees and advertising expenses. Report the amounts on Schedule E of your Form 1040.


Step 2. Use the actual days of rental and personal use to allocate both interest from the home acquisition indebtedness and the real property taxes to rental and personal use. Deduct the rental portion to the extent it does not exceed gross income on Schedule E. Deduct the personal interest and property taxes on Schedule A.


Key point. In the unusual circumstance where Step 2 shows a loss, recalculate Step 2 applying the interest limitation rules and the $10,000 cap on taxes. If such a calculation shows a loss, it’s deductible as a loss and you carry over to next year the expenses under Steps 2 and 3 below.


Key point. In some cases, you will deduct none of the property taxes allocable to personal use on Schedule A because you either claim the standard deduction or suffer from the $10,000 limit on state income and local property taxes. You will see an illustration of this in the sidebar at the end of this section.


Step 3. Deduct on Schedule E (to the extent they do not exceed the remaining gross income) expenses allocable to rental use (other than those that would result in an adjustment of basis) such as property insurance, HOA fees, utilities, and maintenance.


Step 4. Deduct depreciation and other adjustments to basis to the extent such deductions do not exceed gross income from the rental. If depreciation is limited, reduce the tax basis of your residence only by the currently deductible amount.


Step 5. Carry over any disallowed expenses allocable to rental use from Steps 3 and 4 to your next tax year. In that year, the expenses are again subject to limitation based on that year’s gross rental income.12


Presumably, if you sell the property, you can use any gain attributable to the rental-use portion of the property to “free up” prior-year disallowed expenses allocable to rental use. (The IRS has given us no guidance on this.)


Two Methods for Allocating Interest and Taxes


The IRS position is that you should use only actual days of personal and rental occupancy to allocate vacation home expenses.13 As mentioned earlier, you disregard days devoted mainly to repairs and maintenance.

Key point. There’s a controversy regarding how to allocate mortgage interest and property taxes that could otherwise be claimed as itemized deductions. Two appeals courts decisions say that to allocate these two expenses, vacation home owners can count actual rental occupancy days as rental days and all other days—including days the property is vacant—as personal days. This is what we will call the Bolton/McKinney method for allocating those two expenses.14


Before the TCJA, using the Bolton/McKinney method was often beneficial because


  • it allocates more mortgage interest and property taxes to Schedule A (where you could usually currently deduct those expenses under the pre-TCJA rules) and

  • it allocates less mortgage interest and property taxes to Schedule E, which allowed you to currently deduct more of your other expenses allocable to rental use (property insurance, HOA fees, utilities, depreciation, etc.) on Schedule E when applying the rental income limitation.


But with the TCJA’s limitations on itemized deductions for mortgage interest and state and local taxes, using the Bolton/McKinney method might be counterproductive. Or it might be helpful. It depends on your specific situation. Confusing?


You bet! See the SIDEBAR at the end of this section for some examples that help clarify things.


Impact of TCJA Increases to Standard Deduction Amounts


Using the IRS-approved method to allocate more vacation home mortgage interest and property taxes to Schedule E might be beneficial if your increased standard deduction ($25,900 for 2022 for married joint-filing couples, $19,400 for heads of households, and $12,950 for singles)15 would make using the alternative Bolton/McKinney method counterproductive.


That’s because the Bolton/McKinney method shifts more interest and taxes to Schedule A, but if you still don’t have enough itemizable expenses to exceed your standard deduction, the amounts shifted to Schedule A will never deliver any tax benefit.


On the other hand, using the IRS-approved method to shift more interest and taxes to Schedule E will deliver a tax benefit, although it may be only a future benefit if the shifted expenses are not currently deductible due to the rental income limitation.


Takeaways


When you use a property for both personal and rental purposes, you need to know the vacation home rules.


And for years 2018-2025, the TCJA limits on itemized deductions for qualified residence interest and property taxes add to the decision-making matrix.

For example, because of the TCJA, some vacation home owners might benefit from using the Bolton/McKinney method for allocating mortgage interest and property taxes. Others might benefit from using the IRS-approved method. Now, because of the TCJA, you need to run the numbers to find out.


In any given year, you may be able to micro-manage the number of rental and personal-use days. Your usage pattern may differ from the pre-pandemic norm. That usage pattern can potentially result in better or worse tax outcomes for you, especially when it flips your place from a rental to a residence or vice versa.


For instance, you and family members may be anxious to spend more time at your property at the beach and less time in the big city. That could put the property firmly into personal residence status and possibly increase your allowable itemized deductions for qualified residence interest and property taxes.


But if you’re adversely affected by the TCJA limitations on qualified residence interest expense and property taxes, adding more personal-use days may simply result in more lost deductions (a distasteful result).


On the other hand, rental demand for your place may be so high that it’s impossible to ignore the opportunity to collect more rental income. That could put the place firmly into rental property status and make it subject to a different set of federal income tax rules that apply to rental properties. We’re covering these in an upcoming issue.


Under those rules, you can usually offset all of your rental income with allowable deductions on Schedule E of Form 1040. If so, adding more rental days could result in more tax-sheltered rental income, which would be a good thing.


SIDEBAR: Three Examples of How to Allocate Vacation Home Expenses


Example 1. Allocating vacation home expenses.


Wanda is a married joint-filer who owns a beachfront condo in Florida that’s rented out three months during 2021 at market rates, used by Wanda and her family for two months, and vacant for the remaining seven months because the family deems it too hot and humid.


The property is a residence under the vacation home rules because it’s rented more than 14 days and used for personal purposes for more than 14 days and more than 10 percent of the rental days.


The property’s income and expenses for 2021 are as follows:


  • Gross rental income $21,000

  • Interest on vacation home acquisition debt $16,000

  • Property taxes $8,000

  • Other expenses $20,000

  • Depreciation $15,000


Using the five-step procedure explained earlier, the first step is to allocate interest and property taxes. Using the Bolton/McKinney method, 25 percent (3/12) of the interest and property taxes are allocable to rental use and 75 percent (9/12, which includes the seven months of vacancy) are allocable to personal use. So, $12,000 of interest (75 percent x

$16,000) and $6,000 of property taxes (75 percent x $8,000) can potentially be written off as itemized deductions on Wanda’s Schedule A.


The second step is to reduce the rental income by the mortgage interest and property taxes allocable to rental use. So, the $21,000 of rental income is reduced by $4,000 of interest (25 percent x $16,000) and $2,000 of taxes (25 percent x $8,000). These amounts appear on Wanda’s Schedule E as rental expenses along with the $21,000 of rental income. At this point in the five-step gauntlet, the interest and property taxes have been fully accounted for, and there’s still $15,000 of rental income remaining ($21,000 - $4,000 - $2,000) to be offset by other expenses allocable to rental use.


In the third step, the $20,000 of other expenses, such as HOA fees, property insurance, utilities, maintenance, and so forth, are allocated between rental and personal use based on actual days of rental and personal occupancy.


So, Wanda allocates $12,000 (3/5 of $20,000) to rental and 40 percent (2/5 or $8,000) to personal. The $8,000 is permanently non-deductible and has no effect on Wanda’s tax situation. At the end of Step 3, Wanda has $3,000 of gross income remaining for offset ($15,000 - $12,000).


In the fourth step, Wanda allocates $9,000 of depreciation to the rental (60 percent x $15,000). But she can deduct only $3,000 because of the gross income limitation.


In the fifth step, Wanda reduces the basis in her home by $3,000 and carries the remaining

$6,000 of depreciation to next year.


In this example, Wanda’s Schedule E shows a net of zero: $21,000 of rental income - $4,000 of mortgage interest - $2,000 of property taxes - $12,000 of other expenses - $3,000 of depreciation.


Summary. When all is said and done, $18,000 of Wanda’s $59,000 of mixed-use home expenses went to Schedule A, $21,000 went to Schedule E to be currently deducted against the rental income, $6,000 was carried over to 2022 for possible deduction on Schedule E, and

$14,000 is permanently non-deductible. This is not a terrible tax outcome.


Example 2. More on allocating vacation home expenses.


As stated earlier, the IRS wants taxpayers to allocate interest on vacation home acquisition indebtedness and property taxes in the same fashion as other expenses—using actual days of rental and personal occupancy. So, what happens if we do that with Wanda’s facts for 2022?


Assume the same basic facts as in Example 1, except this time Wanda uses the IRS-approved method to allocate all the vacation home expenses, including mortgage interest and property taxes.


Further assume that this time Wanda cannot claim any itemized deduction for the vacation home mortgage interest because she has an expensive principal residence with a big mortgage that soaks up all of her allowance for home acquisition indebtedness.


Finally, further assume that Wanda cannot claim an itemized deduction for any of the vacation home property taxes because property taxes on her expensive principal residence soak up her entire $10,000 allowance for state and local taxes.


Using the IRS-approved method on the mixed-use property results in allocating 40 percent of the interest and taxes, or $9,600 (40 percent x $24,000), to personal use with no resulting Schedule A deductions for the reasons stated above, and 60 percent, or $14,400 (60 percent x

$24,000), to Schedule E where that amount of interest and taxes can be currently deducted against rental income.


  • The $35,000 of other expenses are also allocated 60/40 between rental and personal used based on actual days of rental and personal occupancy. So, 60 percent of the

$35,000 of other expenses, or $21,000, is allocated to rental and 40 percent, or

$14,000, to personal. The $14,000 allocated to personal is non-deductible and has no effect on Wanda’s tax situation.

  • The $21,000 of other expenses allocated to rental use consists of $9,000 of depreciation (60 percent x $15,000) and $12,000 of other expenses (60 percent x

$20,000) such as HOA fees, property insurance, utilities, maintenance, and so forth. Wanda can currently deduct only $6,600 of the other expenses on Schedule E because of the rental income limitation ($21,000 rental income - $14,400 of allocable mortgage interest and property taxes = $6,600). The remaining $14,400 of other expenses allocable to rental use ($21,000 - $6,600) are disallowed for 2022.


Wanda accounts for the $14,400 of disallowed allocable rental expenses by carrying them forward to her 2023 return for possible deduction on Schedule E in that year. The carryover amount consists of $9,000 of depreciation and $5,400 of other expenses.


Outcome: When all is said and done after using the IRS-approved allocation method for Wanda’s $59,000 of mixed-use home expenses,


  • $9,600 of interest and property taxes were allocated to personal use with no Schedule A deductions allowed due to the TCJA limitations,

  • $21,000 was allocated to Schedule E and currently deducted against rental income,

  • $14,400 was carried over to 2023 for possible deduction on Schedule E in that year, and

  • $14,000 of other expenses allocable to personal use were permanently non-deductible.


So, a total of $23,600 ($9,600 + $14,000) is permanently non-deductible. Ugh!


Alternative: If under the facts in this example Wanda instead uses the Bolton/McKinney method to allocate mortgage interest and property taxes, $18,000 of those expenses (75 percent x $24,000) would be permanently non-deductible due to the TCJA limitations.


Wanda can currently deduct $21,000 of allocable rental expenses (including $6,000 of allocable mortgage interest and property taxes and $15,000 of allocable other expenses against rental income on Schedule E. $20,000 of disallowed other allocable rental expenses ($35,000 -

$15,000) would be carried over to 2023 for possible deduction on Schedule E.


So, using the Bolton/McKinney allocation method would result in “only” $18,000 of permanently non-deductible expenses ($12,000 of mortgage interest and $6,000 of property taxes), while using the IRS-approved allocation method would result in $23,600 of permanently non-deductible expenses as explained earlier in this example.


For the particular facts in this example, using the Bolton/McKinney method delivers a better tax result. But that won’t always be the case. You must run the numbers to find the best method for your specific situation.


Example 3. One more example.


Same basic facts as in Example 1, except this time assume that there’s no mortgage on Wanda’s mixed-use home. Further assume that she cannot claim any itemized deduction for the mixed-use home’s property taxes because taxes on her principal residence soak up her entire $10,000 allowance for state and local taxes.


So, in this scenario, we want to allocate the $8,000 of vacation home property taxes using the IRS-approved method based on actual days of usage. That way, we can allocate more property tax expense to Schedule E where it can be currently deducted.


Using the IRS-approved method results in allocating 40 percent of the property taxes, or

$3,200 (40 percent x $8,000), to personal use with no resulting Schedule A deductions for the reason stated above and 60 percent, or $4,800 (60 percent x $8,000), to Schedule E where that amount can be currently deducted against rental income.


  • The $35,000 of other vacation home expenses are also allocated 60/40 between rental and personal use based on actual days of rental and personal occupancy. So, 60 percent of the $35,000 of other vacation home expenses, or $21,000, is allocated to rental and 40 percent, or $14,000, to personal. The $14,000 allocated to personal is non- deductible and has no effect on Wanda’s tax situation.

  • The $21,000 of other expenses allocated to rental use consists of $9,000 of depreciation (60 percent x $15,000) and $12,000 of other expenses (60 percent x

$20,000) such as HOA fees, property insurance, utilities, maintenance, and so forth. Wanda can currently deduct $16,200 of the $21,000 on Schedule E because of the rental income limitation ($21,000 rental income - $4,800 of allocable property taxes =

$16,200). The remaining $4,800 of other expenses ($21,000 - $16,200) allocable to rental use is disallowed for 2021.


Wanda accounts for the $4,800 of disallowed allocable rental expenses by carrying them forward to her 2023 return for possible deduction on Schedule E. The carryover amount consists of $4,800 of depreciation.


Outcome: When all is said and done for Wanda’s $43,000 of vacation home expenses,


  • $3,200 of property taxes were allocated to personal use with no Schedule A deduction allowed due to the TCJA limitation,

  • $21,000 of expenses were allocated to Schedule E and currently deducted against rental income,

  • $14,000 of other expenses allocable to personal use were permanently non-deductible, and

  • $4,800 was carried over to 2022 for possible deduction on Schedule E. So, a total of $17,200 ($3,200 + $14,000) is permanently non-deductible.

The remaining $25,800 ($21,000 + $4,800) is deducted currently or carried forward to 2023 for possible deduction in that year.


For the particular facts in this example, using the IRS-approved method for allocating property taxes delivers a better result because it allows Wanda to deduct more property tax expense.


But as you know, you must run the numbers to find the best method for your specific situation.



1 IRC Section 164(b)(6).


2 IRC Section 163(h)(3)(F)(i)(II).


3 IRC Sections 163(h)(3)(F)(i)(III); 163(h)(3)(F)(iii).


4 IRC Section 163(h)(3)(F)(i)(I).


5 IRC Section 280A(g).


6 This definition is found in IRC Section 280A(d)(1). Note that properties covered by the Section 280A vacation home rules are not subject to the dreaded passive activity loss (PAL) rules, per IRC Section 469(j)(10).


7 Prop. Reg. Section 1.280A-1(e)(4).


8 The only exception is when the family member uses the home as his or her principal residence and pays fair market rent [IRC Section 280A(d)(3)(A)].



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