Vacation Homes Under the New Tax Law

Patricia P. Greenhouse, CPA (Aug, 2018)

Upon returning home from that great summer vacation the idea of buying a second home in those beautiful locations may be on your mind, along with the sounds of the waves and Jimmy Buffet.  While there are many economic (pricing and carrying costs) and lifestyle factors to consider with the second home purchase decision, the tax implications should also be carefully considered. Navigating the tax complexities of these decisions has not become any simpler under the Tax Cuts and Jobs Act (TCJA) signed into law December 22, 2017. 

What are some of the changes that effect the deductions for home ownership under the TCJA (effective for tax years 2018-2025)?  First, the deduction for mortgage interest on acquisition indebtedness is limited to underlying debt of up to $750,000 ($375,000 for married taxpayers filing separate).  Prior to the TCJA the limit on home acquisition debt was $1,000,000.  Under the grandfather provisions, the lower limit does not apply to any acquisition indebtedness incurred before December 15, 2017.  Additionally, the deduction for home equity indebtedness has been eliminated.  Prior to the TCJA the home equity debt was limited to $100,000.  To understand the changes a distinction must be made between home acquisition debt and home equity debt.  The IRS has defined home acquisition debt as loan proceeds used to buy or improve your first or second residence as long as the loan is secured by that residence. Thus a home equity line of credit (HELOC) may be home acquisition indebtedness if it meets these criteria.

The total state and local tax (SALT) itemized deduction is capped at $10,000 ($5,000 for married filing separately).  The limitation does not apply when paid or accrued in carrying on a trade or business activity. Finally, the standard deduction is increased to $24,000 for married individuals filing a joint return, $18,000 for head-of-household filers and $12,000 for all other filers. 

Historically, many individuals try to cover some of the costs of a second home by renting the property. Under certain circumstances the second home owner can retain more deductions by renting.  If there is no personal use, then all the income and expenses are reported on Schedule E and subject to the passive loss limitations.  However, you may deduct up to $25,000 per year in losses depending on your adjusted gross income and your level of active participation.  If there is both personal and rental use of the home (mixed use) then special rules may apply. Generally there are limits on certain expenses up to the rental income generated (other than items that would be deductible as an itemized deduction on Schedule A even if the home were not rented out).

Under the rules of IRC Section 280A, (rules governing rental of a vacation home) there are 3 scenarios which may apply based on the number of days rented and the number of days of personal use as follows:

  1. If the home is rented 14 days or less, it is treated entirely as a personal use property. Any rent received is not included as income for tax purposes.  The downside is that you can only deduct property taxes and mortgage interest on the second home on Schedule A.  There are no deductions for other expenses (insurance, utilities, maintenance, etc.) or for depreciation. 
  2. If the home is rented for 15 days or more, it will be treated as rental property and the rental activities are considered as a business. All the rental income is included in income and you can deduct rental expenses and depreciation, based on an allocation between personal use days and rental days. 
  3. However, if the home is used personally more than 14 days or 10% of the total days the home was rented, it will be treated as a dwelling unit used as a home.  Essentially it is deemed that you have used the home too much and the expenses are subject to an ordering and limited to the rental income (no loss allowed).  Any expenses limited under this rule are carried forward to future years, but remains subject to the net income limitation.

The impact of the 14-day rule is significant and it’s important to track and document your usage.  Days spent working substantially full time, cleaning, painting, repairing, and maintaining the home, are not considered as personal use days, even if family members use the property for recreation on the same day.  However, any day the home is rented to anyone at less than the fair rental price it is considered a personal use day.  Days rented to family members are considered personal use days unless the fair rent is charged and the unit is the family’s main home (IRC Sec. 280A(d)(3). 

Prop Reg. 1.280A-3(d) provides the ordering on deductions when the property is classified as a dwelling unit used as a home.  The rental portion of the expenses for a mixed use dwelling are deductible in the following order:

  1. Qualified residence interest, taxes, casualty losses, and rental activity not attributable to operating or maintaining the dwelling such as rental agency fees and advertising.
  2. Other operating expenses
  3. Depreciation

In general the expenses for a mixed use property are allocated based on the number of days rented at fair rental value divided by the total number of days the property is occupied.  The Tax Court has upheld a method for allocating interest and taxes other than by dividing days rented by days occupied [Bolton, 51 AFTR 2d83-305 (9th Cir. 1982)].  In this case the taxpayers allocated mortgage interest and taxes based on the number of days in the year, but allocated maintenance expenses based on the number of days the property was occupied.  The effect of the Bolton/Tax Court method would be to allocate a smaller amount of interest and taxes to the rental activity.  This allows a greater amount of operating expenses to the deducted in the current year assuming the income limit applies.  Thus this method increases the current year deductions when combining both the Schedule A and the rental deductions. 

Consider the following example:

  1. Rental income $3,500
  2.  Personal use 30 days and rental use 91 days totaling 121 days.
  3. Interest and taxes $4,000

 

Tax Court method

IRS Method

Rental income

$3,500

$3,500

Interest and taxes allocated to rental activity

 

 

     $4,000 x 91/365 (use 25%)

($1,000)

 

     $4,000 x 91/121 (use 75%)

 

($3,000)

Deduction limitation on other operating expenses

$2,500

$500

 

 

 

 

Combined deductions

 

 

Schedule A

$3,000  ($4,000 – $1,000)

$1,000 ($4,000 – $3,000)

Schedule E (limited to rental income)

$3,500   ($1,000 + $2,500)

$3,500 ($3,000 + $500)

Combined

$6,500

$4,500

 

 

 

 

Now we return to the beginning – what does this all mean under the new tax act?  Under the TCJA and the limitation on the itemized deductions for both mortgage interest and SALT, as well as the higher standard deductions using the Bolton/Tax Court method might not be advantageous. If there are not sufficient itemizable expenses to exceed the higher standard deduction there would be no tax benefit of shifting the mortgage interest and taxes to Schedule A. 

The provisions apply to various dwelling units including a house, an apartment, a condominium, a mobile home, a boat, or other type of vacation home.  There are several other considerations to keep in mind such as the net investment income tax on rentals, capital gain if sold, and possible state filing implications.  Now that your head is spinning and you want to go back to the beach and Jimmy Buffet, please contact us to help you navigate these tides.  A second home should lead to an increased quality of life, a place to relax and enjoy.  The professionals at Dermody, Burke and Brown CPAs can help you with the tax implications.  

 

The information reflected in this article was current at the time of publication.  This information will not be modified or updated for any subsequent tax law changes, if any.

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