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The Beach Condo Rental Tax Write-Off? Not So Fast

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With the winter storms this year hitting the northeast and  providing more than a little snow to the southern states (where any snow is considered a winter storm), many clients are already looking forward to some beach time this summer. I have clients ask me all the time about buying a beach house or condo with the intent of having a summer vacation spot, as well as a beneficial tax expense—assuming it’s a rental property for part of the year. 

However, just because the condo tax break option makes sense in theory, doesn’t mean it will work out, especially for high income clients.

So let’s discuss the mostly unknown hook, line and sinker of the IRS law on the personal beach condo purchase/rental property tax write-off.   

Rental Property (aka Beach Condo) is primarily/simplistically identified in one of two ways: 

  1. Property rented less than 15 days a year and used personally as a vacation home
    This type of property is considered a non-rental property; therefore, nothing should be filed on Schedule E of the 1040 relative to rental income or expenses. Fortunately, according to IRS publication 527, any income and expenses received from a vacation home/rental property with less than 15 days of rent are excluded from tax reporting (both income and expenses).

    While this may be beneficial from an income exclusion standpoint, most beach condo purchasers are usually geared toward personal tax write-offs rather than the rental income production, leaving this option very limited as a true tax benefit against a client’s current income earnings. 

    This option doesn’t prevent the client from deducting mortgage interest, property taxes and/or a casualty loss on the common Schedule A. However, all these write-offs are subject to the limitations of Schedule A and/or the specific line item limitations within the schedule’s deductions.

    Therefore, before all the expense of improvements for new carpet, new appliances, any remodeling, grass cutting, maintenance, insurance costs, utilities or anything else is spent, it might be a good idea to explain to your client that none of those expenses will provide a tax write-off benefit with this option.

  2. Property rented more than 15 days and used personally as a vacation home
    This type of property is deemed both rental and personal; therefore, requiring expenses to be divided between rental use and personal use. For specific details on dividing expenses, see IRS publication 527; but in simplistic terms, the division of expenses is done pro rata to the number of days rented versus not rented (note well: days RENTED versus NOT rented, as that is a big difference from personal days used versus the rest of the year).

    Here’s where the gray area comes into play: depending on whether you had a net profit from rental activities or a net loss determines to what extent you can actually tax deduct all expenses or not.

    If you had a net profit (including all rental expenses and depreciation), you’re allowed to deduct all of your rental expenses.

    If you had a net loss from rental activities, this is where your rental expenses are limited (usually up to rental income), with all excess expenses allowed to carry over to future years. 

    While each of these examples seem somewhat straightforward and simple, now comes the hard lesson that most high income earners only learn on the back end of the beach condo purchase rather than the front end. 

Exception for Rental Real Estate with Active Participation
First we have to define “active participation,” which involves the taxpayer owning at least 10% of the rented dwelling, and being involved in the management decisions, even if outsourcing the rental services to another business.

When the beach condo no longer becomes primarily a personal use dwelling and active participation is involved, the exception of passive loss write-offs becomes a reality, at least for some people.

The exception allows for up to $25,000 in rental activity losses to be written off against non-passive income (which is any earned income wages, or retirement income, investment income, etc.). The hook, line and sinker is when the loss writeoff exception becomes limited or excluded all together, based on a client’s modified adjusted gross income (MAGI).

See IRS publication 527 for MAGI details, but for simplicity’s sake, we’re going to assume (MAGI = AGI). Therefore, if a client’s MAGI is in excess of $100,000, the losses/expenses written off are limited to 50% of the difference between MAGI and $150,000. However, once the MAGI of the client reaches $150,000, the exception for loss writeoffs has been completely eliminated and forced to carry over as future losses, which then can only be used to offset future rental income! Hook, line and sinker!

So the point is to be very careful in advising your high-net-worth or high income-earning clients when they want to buy that beach condo or any rental property with the expectation of renting it and writing off all those first or second year improvements/expenses. They’ll be extremely disappointed at tax filing time if they can’t benefit from their cash outflow expense.