Vacation home deductions on your tax return may seem challenging at first, but here are two methods you can opt to use when doing your taxes.  There has been some controversy surrounding this issue; however, either method is currently acceptable to the IRS.

To determine whether a property qualifies as a vacation home, use this simple rule:  You must have used the home personally for the greater of 14 days or 10% of the total days it is rented to others during the year. 

You must report the income you received from renting out the property on Form 1040, Schedule E.  Using the tax court method (method 1), mortgage interest and real estate taxes paid on the home are deductible; however, the portion of these expenses allocable to Schedule E is the percentage of time the home is rented out divided by 365 days.  What is left of real estate taxes and home mortgage interest will roll over to Form 1040, Schedule A.  Advertising and management fees are fully deductible.  Any other expenses associated with this property (utilities, home owner dues, etc.) are deductible up to the amount of income you received after the allocable mortgage interest and real estate taxes have been deducted.

The theory behind method 1 is that mortgage interest and real estate taxes accrue throughout the entire year, so 365 should be used as the denominator to apply the expenses.

Example 1 (Tax Court Method)

Jane and Joe, Kansas residents, own a home in Ft. Lauderdale, FL in which they spent 20 days of the year in 2006.  They rented the home to another family for 150 days of the year for a total rental income of $15,000.  The expenses they incurred were:

Mortgage Interest = $25,000
Real Estate Tax = $3,500
Advertising = $200
Utilities = $1,500
Home Owner Dues = $5,000

The expenses that are deductible are –

Mortgage Interest:
$25,000 x (150/365) = $10,274
The rest of the interest will roll to Schedule A ($14,726).

Real Estate:
$3,500 x (150/365) = $1,438
The rest of the tax will roll to Schedule A ($2,062).

Advertising:
$200 is fully deductible

Now, the other expenses are deductible up to the point of breaking even on Schedule E.  Jane and Joe can deduct $3,088 of the other expenses they incurred.  Any operating expenses that Jane and Joe were unable to deduct on this year’s return will be carried over to next year.

Example 2 (IRS Method)

Use the same information from the previous example.  Using the IRS method, the taxpayer must allocate the deductions to the amount of time the home was rented during the year versus the total amount of time the home was occupied during the year.  Home mortgage interest and real estate taxes can again be rolled over onto Schedule A.  In this example, the home was used for a total of 170 days during 2006, but only rented for 150 days.

Using this method, less expenses are allocated to Schedule A.  However, the taxpayer can ultimately decide which method is the most advantageous for him or her.

The expenses that are deductible are –

Mortgage Interest
$25,000 x (150/170) = $22,059
The rest will roll to Schedule A ($2,941).

Real Estate:
$3,500 x (150/170) = $3,088
The rest will roll to Schedule A ($412).

Advertising:
$200 is fully deductible

In this instance, Jane and Joe have already made the allowed deductions up to the point of rental income.  However, if Jane and Joe had made $40,000 of rental income rather than $15,000, the operating expenses are fully deductible on Schedule E up to the point of income made.  Having made $40,000 of rental income during the year, Jane and Joe would have taxable net income on their Schedule E.

Other deductible operating expenses include professional or legal fees, supplies, and repairs or maintenance.  You’ll get even more of a deduction by setting up the home as a depreciable asset.  Please note that tax laws and rules are subject to change per IRS notices and publications.  To obtain the most up-to-date information, visit www.irs.gov.

Enjoy your vacation home, but make sure you are taking full advantage of the allowable deductions.  If you would like us to review your tax situation, let us know by giving us a call or sending us an e-mail.