If you own a home that you live in part of the year and rent out for part of the year, the expenses that you incur must be prorated between personal and rental use. To figure out the ratio of personal and rental use, you take the number of days someone rented the home and divide it by the total days of use (both personal days and rental days). Since vacation homes typically get this kind of treatment, the rules are known as the vacation home rules.
If the home is used as your primary residence and you rent it out for fewer than 15 days during the year, then you don’t need to report any income. If this is the case, though, you can’t deduct expenses associated with the rental. However, you can take the usual homeowner deductions for mortgage interest, real estate taxes, and casualty losses on Schedule A.
If you rent the home for 15 days or more, you must report the rental income on Schedule E. You can deduct expenses but they must be prorated, and they may be limited. If the home is considered a residence, the expenses that you deduct can’t exceed the rental income. However, if the home isn’t considered a residence, then the expenses that you deduct can exceed rental income, which would offset other income.
To be a residence, a home must pass both of the following tests.
It must provide basic living accommodations. This means that the home must have sleeping space, bathroom facilities, and cooking facilities. A residence may be a house, an apartment, a condominium, a mobile home, a motor home, or a houseboat.
It must pass the personal-use time test. A home is considered a residence if you use it for personal purposes for more than the greater of:
14 days; or
10% of the total number of days the dwelling is rented at fair rental value.
Example: Richard owns a house on the beach. Last year, he stayed in the house 21 days and rented it out at fair rental value for 230 days. The remainder of the year, the house was vacant. Because he didn’t use the home for personal purposes for more than 10% of the total number of days that he rented it, the home isn’t considered a residence:
10% X 230 days (Days of rental use) = 23
The amount of time you personally use a home includes use by:
Any person who has an ownership interest in the home, unless the home is rented to another owner as his or her principal residence under a shared equity financing agreement.
Example: Agnes and her two brothers, Michael and Malcolm, equally own a cottage at the lake. Their agreement allows each to use the cottage for three weeks of the year. The rest of the time, they try to rent it to vacationers. The three-week use by each sibling counts as personal-use days for the other two. So, each personally uses the cottage 63 days.
A family member of any person who has an ownership interest in the home, unless the family member uses the home as his or her principal residence and pays fair rental value. Family members include brothers and sisters, half-brothers and half-sisters, spouses, parents or grandparents, and children or grandchildren.
Example: If Richard (from a previous example) lets his brother stay in the house for a week at no charge, he must add seven additional days to his personal-use count. This means that he personally used the house for 28 days, and the home is now considered a residence because he used it for more than 23 days (10% of the total number of days that he rented it).
Any person who pays less than fair rental value to use the home (other than an employee who uses the home as lodging at the owner/employer’s convenience).
Any person who uses the home under a home exchange arrangement with the owner, regardless of whether or not the use is rent-free or paid.
If a tenant, who is paying fair rental value, allows the owner to stay in the dwelling, the time is considered personal use when determining whether the dwelling is a residence. However, when determining the ratio for prorating expenses (see Rental-Use Time), the time is counted as rental use.
Any time that you spend at the home repairing and maintaining it doesn’t count as personal-use time.
In addition to counting the days of personal use, you also need to count the number of days of rental use to determine the ratio to prorate expenses. Rental use is any day the dwelling is rented at a fair rental value. Unlike other rental real estate activities where the property is considered in use when it is ready and available for rent, only the days that you actually receive payment for are counted for calculating the ratio.
To figure out the proration rate, you take the number of days that you rented the home at fair rental value and divide it by the total number of days used for both personal and business purposes. This method applies to all rental expenses.
Example: You purchased a house on March 2 of last year to use as a vacation home. During the year, you spent 33 days there and rented it at fair rental value for 128 days. The rest of the year, the house was vacant. Your proration rate is 79.5%:
128 (Days of rental use) / 161 (Total use) = 79.5%
All the expenses that you incurred last year relating to the house must be prorated by this percentage before you deduct them from rental income.
Just to make things interesting, the Tax Court and the 9th and 10th Circuit Courts of Appeals have held that the correct proration ratio for mortgage interest, real estate taxes, and casualty losses is the days rented at fair rental value divided by the total number of days owned during the year.
Example: Continuing the previous example, if you use the Tax Court ratio, your real estate taxes, mortgage interest, and casualty losses are prorated at 41.96%:
128 (Days of rental use) / 305 (Days owned during the year) = 41.96%
If you rent out your home for at least 15 days and the days of personal-use qualify your home as a residence, the vacation home rules apply. These rules limit deductible expenses to rental income, and expenses must be deducted in a specific order.
The vacation home rules specify that expenses must be deducted in the following order:
The rental portion of qualified home mortgage interest, real estate taxes, and casualty losses. These expenses are deductible subject to the usual rules, but only the rental portion is subtracted from rental income. The personal portion is deductible on Schedule A and subject to the usual rules.
Advertising, commissions, legal fees, office supplies, and all other rental expenses not directly related to the rental property itself.
Expenses related to operating and maintaining the rental property (including interest that doesn’t qualify as home mortgage interest), up to the amount of rental income minus the deductions for items 1 and 2.
Depreciation and other basis adjustments to the home, including improvements, furniture, and so forth, up to the amount of rental income minus the deductions for items 1, 2, and 3. Expenses that can’t be deducted due to the rental income limit can be carried over and used in the first year the owner has sufficient income from the property, or until the property is sold.
If you didn’t personally use the home long enough for it to be classified as a residence, then you must prorate the expenses of owning and maintaining the home by the ratio of the number of days of rental use divided by the total number of days used for business and personal purposes. However, deductions for expenses aren’t limited by rental income. A rental loss may be used to offset other income, subject to the usual passive activity loss limitations.