Vacation Home Rentals Under the TCJA
Vacation Home Rentals Under the TCJA
Just got back from a long weekend down at your vacation home at the Jersey Shore? Visited friends with a second-home who were bragging about this fantastic investment that “pays for itself” and looking into maybe making your own “no brainer” investment in a mixed-use vacation home? In either case, this article is for you! So, let’s explore how mixed-use vacation home/rentals work under the TCJA and what the ground rules are for deducting associated expenses.
Many families that have a vacation home use the property to double as a rental, to offset the cost. These mixed-use vacation homes usually have their own mortgage, and can be the straw that breaks the camels back in a financial crunch.
The TCJA may affect the taxation of your mixed-use vacation rental property in a number of significant ways. First, the $10,000 cap on itemized deductions for state and local taxes (“SALT”) and home mortgage interest means that for most people in the tri-state area, there will be no deduction for the mortgage on your second property. But, before dwelling on that, you need to figure out the relative deductions available between personal and business uses.
Sec. 280A provides a method for allocating expenses between personal residential use and rental use. Sec. 280A provides the “IRS method” for allocating expenses. But, there is also something called the “Bolton” method or the “Court” method. There is a bit of a controversy over which method is correct, and the debate deals with the number of days over which expenses are proportioned, whether “total days” or “used days” are counted for calculation purposes. More on that later.
First, it is important to define terms. What expenses are deductible on your mixed-use property? There are two broad categories. First, there are “carrying costs” or “ownership” expenses, which consist of mortgage and property taxes. Second, there are “maintenance” and “depreciation” expenses that apply to business or income-producing property only.
Business Expenses: Section 212(2) allows a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year for the management, conservation, or maintenance of property held for the production of income. But, personal use is not deductible.
NonDeductible Personal Use: Section 262(a) provides that no deduction is permitted for personal, living, or family expenses. Your mixed-use property has both business and personal aspects, which is why you need to figure out how to allocated the “carrying costs” and “maintenance” categories of expenses across these separate uses.
Expense Allocation: Under Section 280A(e)(1), personal use for even a single day triggers application of the allocation rules.
Limitations on Deductions for Business Purposes
One obvious limitation is that you cannot run up expenses that are more than the total rental income generated by the rental use of your property and generate a refund. This would be to allocate business expenses toward your personal use of the home.
Expenses allocated to rental days are deductible only to the extent of rental income. I.R.C. § 280A(c)(5).
Calculating the Deduction Using the IRS Method
IRS Method: The IRS calculates the expenses attributable to rental as a percentage of total days rented over total days used. IRS Publication 527, Residential Rental Property goes into detail on the calculation of the IRS Method.
Example 1: Let’s say that you rent your property for 120 days and receive $10,000 o rental income. You also use your vacation rental for 30 days during the year. Let’s say your property taxes are $6,400, mortgage interest is $1,500, maintenance expenses are $2,000, and depreciation is $7,000.
Here the rental days would be 120 days % 150 total days used. That is a proportion of 80% rental. Thus, under the IRS Method, 80% of the allowable expenses for maintenance and depreciation could be allocated to the rental or business use for the property.
Taking the 80% allocation, $5,120 of real estate taxes and $1,200 of mortgage interest could be deducted. That totals out to $6,320.
Taking the 80% allocation, $1,600 of utilities and maintenance and $5,600 of depreciation could be deducted. That totals out to $7,200.
Total deductible expenses here would be $13,520.
But, that exceeds the $10,000 of rental income! So, the excess $3,520 would not be deductible, but all of the rental income would be effectively non-taxable.
What this example shows is that with an expensive property that is predominantly used as a rental, it is very possible that the income from the property will simply offset some costs and won’t be subject to tax. But, at the other end of the spectrum, as the percentage of personal use increases, the amount of rental income applicable to costs decreases, and you will not get full credit.
Example 2: Let’s say that you rent your property for 90 days and receive $9,000 of rental income. You also use your vacation rental for 30 days during the year. Let’s say your property taxes are $3,200, mortgage interest is $4,000, maintenance expenses are $2,000, and depreciation is $3,000.
Here the rental days would be 90 % 120 total days used. That is a proportion of 75%. Thus, under the IRS Method, 75% of the allowable expenses for maintenance and depreciation could be allocated to the rental or business use for the property.
Taking the 75% allocation, $2,400 of real estate taxes, and $3,000 of mortgage interest could be deducted. That totals out to $5,400.
Taking the 75% allocation, $1,500 of maintenance and $2,250 of depreciation could be deducted. That totals out to $3,750.
Total deductible expenses here would be $9,100.
Thus, in this example, again, rental income would be completely zeroed out by allocated expenses.
Example 3: Let’s say that you rent your property for 60 days and receive $9,000 of rental income. You also use your vacation rental for 60 days during the year. Let’s say (same as Example 2 above) your property taxes are $3,200, mortgage interest is $4,000, maintenance expenses are $2,000, and depreciation is $3,000.
Here the rental days would be 60 % 120 total days used. That is a proportion of 50%. Thus, under the IRS Method, 50% of the allowable expenses for maintenance and depreciation could be allocated to the rental or business use for the property.
Now, taking the 50% allocation, $1,600 of real estate taxes, and $2,000 of mortgage interest could be deducted. That totals out to $3,600.
Taking the 50% allocation, $1,000 of maintenance and $1,500 of depreciation could be deducted. That totals out to $2,500.
Total deductible expenses here would be $6,100.
Thus, in this example, unlike the two above, $2,900 of rental income is left over and subject to tax at your marginal tax rate, which if you are at the highest tax rate of 37% for a total tax bill of $1,073.
Historically, you could carry over some of the mortgage interest and property tax expenses onto your Schedule A. But, with the $10,000 cap on SALT taxes, this is no longer an option for most.
Why You Should Be Aware of the Bolton Method
The Tax Court and two appellate courts have rejected the Service’s formula, because it makes more sense to allocate interest and property tax expenses ratably over the entire year, rather than the “days used” as in the IRS calculation. Bolton v. Commissioner, 77 T.C. 8 (1981), affirmed, 694 F.2d 556 (9th Cir. 1982); McKinney v. Commissioner, 41 T.C.M. 1272 (1981), modified by 42 T.C.M. (CCH) 467, affirmed, 732 F.2d 414 (10th Cir. 1983). See also Ruggiero v. Commissioner, 74 T.C.M. 662 (1997). Where interest and taxes are concerned, it does not make sense to use a proportional figure of “days used.” In upholding the Tax Court’s position, the Ninth Circuit noted that “‘the number of days rented/total number of days used’ fraction is not appropriate for allocating expenses such as interest and property taxes.” 694 F.2d at 561.
Practitioners use both methods, and in this instance, the IRS method is often the more beneficial to the taxpayer.
If you have questions about how to get the maximum allowable deductions for your vacation home and other tax planning matters for multiple properties please give us a call at (201) 529-8024 or e-mail me at [email protected]
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