As you sip a pina colada on the deck and dream of owning a vacation home like the one you're paying a king's ransom to rent, you may wonder just how much Uncle Sam is willing to throw into the deal.
Probably not a whole lot.
First, the good news. If you rent the place out for 14 or fewer days during the year, you can pocket the cash tax-free. Even if you're charging $5,000 a week, the IRS doesn't want to hear about it. The house is considered a personal residence, so you deduct mortgage interest and property taxes just as you do for your principal home. (You may deduct interest on up to $1.1 million of mortgage debt on first and second homes combined.)
Rent for more than 14 days, and you must report all rental income. You also get to deduct rental expenses, and that gets complicated because you need to allocate costs between the time the property is used for personal purposes and the time it is rented. If you and your family use a beach house for 30 days during the year and it's rented for 120 days, 80% (120 divided by 150) of your mortgage interest and property taxes, insurance premiums, utilities and other costs would be rental expenses. The entire amount you pay a property manager would be deductible, too. And you could claim depreciation deductions based on 80% of the value of the house. If a house is worth $200,000 (not counting the value of the land) and you're depreciating 80%, a full year's depreciation deduction would be $5,800.
You can always deduct expenses up to the level of rental income you report. But what if costs exceed what you take in? Whether a loss can shelter other income depends on two things: how much you use the property yourself and how high your income is.
If you use the place more than 14 days, or more than 10% of the number of days it is rented—whichever is more—it is considered a personal residence and the loss can't be deducted. (But because it is a personal residence, the interest that doesn't count as a rental expense—20% in our example—can be deducted as a personal expense.)
If you limit personal use to 14 days or 10%, the vacation home is considered a business and up to $25,000 in losses might be deductible each year. That's why lots of vacation homeowners hold down leisure use and spend lots of time "maintaining" the property. Fix-up days don't count as personal use. The tax savings from the loss (up to $7,000 a year if you're in the 28% tax bracket) helps pay for the vacation home. Unfortunately, holding down personal use means forfeiting the write-off for the portion of mortgage interest that fails to qualify as either a rental or personal-residence expense.
We say such losses might be deductible because such red ink was labeled "passive losses" years ago in a congressional attack on tax shelters. If your adjusted gross income is less than $100,000, up to $25,000 of such losses can be deducted each year to offset income such as your salary.
As income rises between $100,000 and $150,000, however, that $25,000 allowance disappears. Passive losses you can't deduct can be stored up and used to offset taxable profit when you ultimately sell the vacation house.
Bottom line: If you're thinking that buying a vacation home is the ticket to a big fat tax subsidy, you've had enough of that pina colada.