Vacation rental tax rules are indispensable piece of information for the owner of the property. There are two types of rental properties, either a second home that is used for only rental purpose or a vacation home that is rented when not used by you or your family. Both of these rental activities lead to rental income which is taxed according to the rules of the Internal Revenue Service (IRS).
Each form of income allows some expenses which can be reduced from it to arrive at the taxable income. However, there are differences in the allowed expenses. Further, there are also differences relating to the section in which such income is reported on your income tax return.
For a detailed explanation of vacation rental tax rules, you can go through the Publication 527 of the IRS. It was published in 2019 and there have been no updates since then. However, going through the entire publication might get highly tedious, therefore, it’s always helpful to know the main points. You should always consult a tax professional to ensure compliance with all applicable laws and regulations.
Let’s understand the basic points related to rental income, how it is taxed, which expenses are allowed as tax deductions and all such important points.
For a quick summary of the most important VR tax rules, check out the slides below:
Components of Rental Income:
- Any rent received in advance forms part of the rental income for the year in which you receive it. It doesn’t matter for which period to which it pertains it will be taxed in the year it is received.
- The lease cancellation fee is paid by the tenant for shortening the period of stay at the property. Such a fee is considered as a rental income and therefore, should be taxed.
- Expenses paid by the tenant are indirectly an income for you so they are included in the rental income, however, if such expenses are deductible, then they are deducted from the total income after adding them in the rental income.
- Any service offered by the tenant isan incomefor you because you are saving an expense. These services could be anything such as painting the house. The fair value of such service is added to your rental income.
- Security deposit is not included in the rental income if returned to the tenant at the end of the lease. However, if some part of it is kept by the owner, it is a part of the rental income and is taxed.
- If the property is leased with an option to buy, the payments up till the date of the sale are considered as rental income
- You only need to report the rental income in proportion to your ownership in the property. If you own 50% of the property, and the remaining is owned by your friend, then both of you need to report only 50% of the income, and accordingly, only 50% of the expenses are deducted.
- If you use the property as your home and also rent it then there is one additional rule. If you don’t rent it for more than 14 days, then you don’t need to report the rental income. Some deductions are still allowed.
Deductions are those expenses that reduce your rental income. These when deducted from the rental income, reduce it, and therefore tax is charged on the reduced income. To not misuse such deductions, the IRS has given a list of deductible expenses. Further, deductions are allowed in the period in which they are paid. However, those who use accrual accounting need to refer to publication 538 for more information.
Allowed expenses are as follows:
- Marketing expenses such as Advertising and commission
- Operating expenses such as Travelling, Depreciation, Cleaning, Repairs, Maintenance & Utilities
- Admin expenses such as Insurance, Mortgage Interest, and points, Management fee, Legal and professional fee
- Certain rules need to be followed while calculating some of these expenses, such as the Depreciation. Most of the time, the property is depreciated using the MACRS method as per the IRS regulations. It is always best to consult the tax professional for understanding how much depreciation can be taken.
- When you own a property that is a part of a multi-family complex, such as a Condominium, you pay for the maintenance of the common areas. These expenses are also allowed as deductions from the rental income.
- When the property is used for personal use and rental use, then the expenses need to be divided using a reasonable basis.
- If you don’t rent for profit, then you can’t:
- Deduct more expenses than your rental income
- Carry forward excess expenses to future years
- Deduct unforeseen losses
- Those properties which are changed from other users to rental use during the year, then the yearly expenses need to be divided on a pro-rata basis.
There was a reduction in the maximum amount allowed for deductions. Initially, the allowed limit of $1 million, was reduced to $750,000 on homes bought after December 16, 2017.
Further, the interest on home equity loans can now only be deducted if the loan proceeds are used for property renovations.
Once you are clear of all the deductions, you can calculate the taxable income by subtracting the deductions from the rental income.
Certain losses are unpredictable. These can be claimed as deductions from the rental income up to a certain limit set by the IRS. These limits vary with the property features, such as the cost basis of the property. Those losses which are deductible are:
- Casualty is the damage caused to the property due to unforeseen events such as an earthquake or a storm.
- Theft is as simple as it sounds when someone steals something from your property, you can claim it as a deduction.
- Sometimes, you may receive a claim from the insurance companies for the above unforeseen losses. If the claim amount is higher than the fair value of the property or stolen item, you have to pay tax on the differential amount. This differential becomes a part of your rental income.
How is income taxed as per vacation rental tax rules?
When the property is partly rented or not incorporated as an LLC or a Corporation, the rental income is taxed as a personal income. In the case of LLC, pass-through taxation is allowed. However, in the case of a corporation, a separate legal entity applies and the property pays its taxes and follows the corporate tax laws.
In addition to this, there are several state taxes and local laws which vary from one state to another, so, you need to be aware of them. These might sound high, however, they don’t form a very large percentage of your income. It is always best to consult a professional rather than failing to correctly calculate the tax.
So, in short, the process is to calculate the total rental income and deduct allowed expenses. This will lead you to taxable rental income. Use the applicable tax laws and calculate the tax on total income.
Reporting of rental income
There are specific forms that you need to file for the rental income. You need to find out which is applicable in your case according to the vacation rental tax rules.
For-profit properties with basic amenities require Schedule E but this is not applicable for non-profit properties. Those properties which are shared are also required to fill this form only. However, if your property is a business, which provides substantial service, then you need to file Schedule C.
For energy-efficient properties, there are some more benefits according to the vacation rental tax rules. If the property was in service before January 1, 2020, and install an energy efficiency system before the year 2022, then they can get a tax credit. This credit is equal to 30% of the tax paid. Energy efficiency can be achieved through any of the qualified means, such as Solar electrification, Solar water heating, Wind energy, Geothermal heat pump.
This sums up the process of vacation rental tax rules and those applicable to all rental properties. Make sure you have all the necessary paperwork to support your calculations. Delegating taxation to a professional is always helpful, however, don’t lose complete control. Question the calculations of the professionals so that you are clear on what leads to higher tax consequences.
You should ask your consultant for ways of reducing the taxes. Remember, knowledge of tax-saving methods is not tax evasion since it uses legal means to optimize your taxation. We hope this was helpful for you to gain a greater understanding of taxes and their impact on your vacation rental. Please feel free to post any questions or refer to the publication 527 on the IRS website to understand the nitty-gritty of the vacation rental tax rules. Also, be sure to stay updated on any changes to the tax laws on rental income.