Vacation Home or Rental Property? The IRS Viewpoint

What constitutes “personal use” for purposes of determining whether the expenses of a vacation rental home are deductible?

“Personal use” includes:

(1) use, for personal purposes, by the owner or by anyone who has an interest in the unit or by a brother, sister, spouse, ancestor, or lineal descendent of the owner or other person having an interest in the unit;

(2) use by a person under an arrangement that enables the owner to use some other unit whether or not the owner pays rent to use the other unit and regardless of the length of time the owner uses it; and

(3) use by any individual with rent set at less than fair rental value. Fair rental is determined by taking into account factors such as comparable rents in the area. This third requirement does not apply to an employee to whom the premises are furnished for the convenience of the employer, under IRC Section 119. Nonetheless, it has been held that days of rent-free use of units in a rental pool by prospective renters are not personal use days, where unit owners have no control over such use and the use was an ordinary and necessary business use. Where the owner of a vacation home donated a week’s use of the home to a charitable auction, the use of the home by the successful bidder was treated as personal use.

Use by the owner on any day on which the principal purpose of the use is to perform repair or maintenance work on the unit does not constitute personal use. Whether the principal purpose is to perform repair or maintenance work depends on all the facts and circumstances, including the amount of time devoted to repair and maintenance, the frequency of the use for repair and maintenance purposes during the tax year, and the presence and activities of companions. A day on which the taxpayer engages in repair or maintenance on a substantially full-time basis will not be considered a day of personal use by the taxpayer. 

If a family member makes the unit rented a principal residence, it is not personal use by the owner. However, the preceding exception does not apply if the family member also has an interest in the dwelling unit unless the rental is pursuant to a “shared equity financing agreement.” A shared equity financing agreement is an agreement under which two or more persons acquire “qualified ownership interests” in a dwelling unit, and the person(s) holding one or more of such interests is entitled to occupy the dwelling unit for use as a principal residence, and is required to pay rent to one or more other persons holding qualified ownership interests in the dwelling unit. A qualified ownership interest is an undivided interest for more than fifty years in the dwelling unit and appurtenant land being acquired in the transaction to which the shared equity financing agreement relates.

A dwelling unit subject to these rules includes a house, apartment, condominium, mobile home, boat, or similar property that provides basic living accommodations such as sleeping space, toilet, and cooking facilities.

Are investments in real estate subject to the passive loss rules? How do the passive loss rules impact an investor in real estate?

Rental real estate activities will generally be considered passive activities subject to the passive loss rules. However, if the personal use of a residence that is also rented out exceeds fourteen days or, if greater, 10 percent of the rental days, the rental activity is not treated as a passive activity. In addition, a real property business of a taxpayer is not automatically considered a rental activity subject to the passive loss rules for a taxable year if during the year (1) more than one-half of the personal services performed by the taxpayer in trades or businesses during the year is in real property trades or businesses in which the taxpayer materially participates, and (2) the taxpayer performs more than 750 hours of service during the year in such real property trades or businesses. Few investors, for example, in real estate syndications will qualify for this exception.

In general, the passive loss rules limit the amount of the taxpayer’s aggregate deductions from all passive activities to the amount of aggregate income from all passive activities; credits attributable to passive activities can be taken only against tax attributable to passive activities. The rules are intended to prevent taxpayers from offsetting income in the form of salaries, interest, and dividends with losses from passive activities.

The benefit of the disallowed passive losses and credits is generally not lost, but rather is postponed until such time as the taxpayer has additional passive income or disposes of the activity. If an individual actively participates in a rental real estate activity subject to the passive activity rules, the individual may use up to $25,000 of losses and the deduction-equivalent of credits to offset nonpassive income. An individual need not actively participate in a rental real estate activity to obtain the $25,000 rental real estate exemption with respect to taking the low-income housing or rehabilitation tax credits.

If the investment is not rental property, the real estate activity will generally be considered a passive activity subject to the passive loss rule unless the taxpayer materially participates in the activity. The $25,000 rental real estate exemption is not available with respect to nonrental property.

Are the expenses of a vacation rental home deductible if the owner’s personal use of the property does not exceed fourteen days or 10 percent of rental days?

The IRS provides rules for the disallowance of certain expenses in connection with renting out a vacation home. Different rules apply depending on the amount of personal use and rental use.

An individual who makes part-time use of a dwelling and rents it out during other parts of the year may take deductions for depreciation and expenses, but subject to some limitations. If the individual’s personal use (discussed below) does not exceed the longer of fourteen days per year or 10 percent of the number of days the unit is rented at fair rental, the taxpayer may deduct all ordinary and necessary expenses allocable to rental use even if a loss is shown (provided the activity is engaged in for profit and subject to the passive loss rules). 

Interest, taxes, and casualty losses not allocable to rental use can be deducted as personal expenses (to the extent otherwise allowable) if the individual itemizes deductions. The Service uses the same ratio for allocating interest and taxes between personal and rental use as it does in allocating other expenses.

However, if it is determined that the activity is one “not engaged in for profit,” the amount of deductions is limited to the amount of gross rental income. (If deductions are limited to gross rental income, the order in which deductions are allowed is the same as that applicable where personal use exceeds the longer of fourteen days or 10 percent of the rental days. Whether the activity is engaged in for profit depends on all the facts and circumstances involved. If the gross income exceeds the deductions attributable to the rental use for at least three of the five consecutive tax years ending with the current tax year, the rental use is presumed to be for profit. 

If the personal use does not exceed the greater of fourteen days or 10 percent of rental days, the rental activity will generally be subject to the passive loss rules.  However, if the individual actively participates in the rental real estate activity, as much as $25,000 of losses (and the credit-equivalents of such losses) from the rental activity could be used to offset nonpassive income of the taxpayer.

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