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Let's face it. We live in a beautiful part of the world and other less fortunate people love to visit our home.
Now, with the advent of services like Airbnb, it's becoming easy to rent out a room or personal residence. What is less easy, is the tax treatment afforded income earned though this activity, and what related expenses can be deducted.
You would think it would be simple — pick up amount received as income and deduct related expenses. Right? Well, maybe. If you have a property that's used exclusively for rental that may be true, but what about the spare bedroom in your personal residence, or the income earned last summer when you rented out your home to a nice Italian couple? What expenses can be used to offset that income? What is rental and what is personal?
Special rules, commonly referred to as “vacation home rules” apply to the rental of any personal residence. The IRS defines a vacation home as a dwelling unit, and the definition is not limited to a single-family home or condo, but includes trailers, boats, or other similar property.
Generally, if you rent a dwelling unit, the tax treatment of the income, and related expense, will fall into one of three categories:
• Fewer than 15 rental days;
• More than 15 rental days and limited personal use;
• More than 15 rental days and personal use above the limit.
If you rent your house — or second home, or boat, or other dwelling unit — for fewer than 15 days a year, the activity is not considered a rental, and the income is not taxable. If you incur any direct expenses, these would not be deductible. If these expenses exceed your income, the net loss is not deductible.
If you rent the same property for 15 days or more, and your personal use does not exceed the greater of 14 days, or 10% of the total rental days, then the property is considered a rental instead of a personal residence. Rental income will be taxed by the government, and related expenses can be deducted against income. Expenses must be allocated between rental and personal based upon the combined total number of days the dwelling unit is used. Because the dwelling unit is now considered a rental, the personal portion of home mortgage interest will not be deductible as an itemized deduction.
If rental use is more than 14 days, and personal use exceeds the greater of 14 days, or 10% of total rental days, the dwelling unit is again considered a personal residence. Under these circumstances, rental income is required to be reported as taxable, and related expenses can be deducted against income, but these expenses can only reduce net income from the rental to zero.
There is also a defined order as to how the expenses are deducted. The order is as follows:
1. Mortgage interest and taxes;
2. Operating expenses;
3. Depreciation.
Because the property is also considered a residence, generally mortgage interest and taxes would be deductible as an itemized deduction. To maximize deductions, it's advantageous to allocate less mortgage interest and taxes to the rental activity, and more to operating expenses and depreciation, since the last two are not deductible for a personal residence.
This is where things get interesting. The IRS has provided guidance that the ratio used to allocate all expenses is based on the total number of days the property is used for rental and personal purposes. This allocation does not consider the number of days the property is vacant.
The U.S. Tax Court has ruled otherwise. In Bolton v. Commissioner, the court ruled that mortgage interest and taxes could be allocated using the full 365 days per year. This method produces a smaller allocation of mortgage interest and taxes to the rental property, thereby allowing a larger percentage of operating expenses and depreciation.
What about the rental of a room in my home? How does that fit into the three categories? Personal use of a dwelling unit is defined as any use of all or part of the property. If you are only renting one room, and continue to use the property when that room is rented, you will always fall into either category one or three. If you rent the room for fewer than 15 days, the income will be nontaxable. If you rent the room for more than 15 days, the income will be reportable, but expenses limited to the extent of income.
Pamela Schuneman, C.P.A., is a practicing tax accountant in Sarasota. She has 33 years of experience helping her clients navigate the vast federal tax system and has worked with businesses as varied as Fortune 500 companies to small sole-proprietors. Contact her at [email protected]
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