Summer is here and vacations are being planned. It is common in the Wilmington area for individuals and couples to own secondary rental homes for coastal vacationers. At the end of the year rental income is reported on the individual tax return and taxed at ordinary income tax rates. Taxpayers can deduct mortgage interest, real estate taxes, maintenance, utilities, insurance, etc to help offset the amount of rental income that is taxed. In addition to those items the building portion of the rental property can be deducted through depreciation over 27.5 years.
The act of owning and renting out is treated as a passive activity for tax purposes (unless you are a real estate professional). If the rental property is operating at a loss those passive losses are typically only deductible against other passive income. In practice, taxpayers can only deduct rental losses if they have other passive income to offset those losses (ex. limited interests in partnerships). Fortunately there is a special allowance to deduct rental losses up to $25,000 for each year on the individual tax return. This special allowance is allowed in full until adjusted gross income exceeds $100,000. The allowance is reduced until it is completely disallowed once income exceeds $150,000 and the losses are suspended. If income is above these marks all is not lost because when the property earns income or the property is sold these suspended losses can be used to help offset the taxable income.
Other than higher income limiting losses, taxpayers need to be careful of personal use days. A rental property is considered a partial personal residence if the owner uses it for more than the greater of:
- 14 days
- 10% of the total days it is rented to others at a fair rental price
Personal use can include use by yourself, family members, or a friend if you rent to them below fair rental price. This can be a huge disadvantage for tax purposes so we recommend limiting the personal use to the above. If the property is used more than the above limits than any losses will be disallowed and expenses will have to be allocated between rental and personal use. However, the personal portion of mortgage interest and real estate taxes can be deducted as itemized deductions. Keep in mind that the reverse of this rule is true as well. If a taxpayer’s personal residence is rented for fewer than 15 days reporting rental and rental expenses is not required.
The rules on vacation rentals can be confusing, but consult a tax professional if you are planning on purchasing a rental property or converting your primary residence to a rental property.