US Income Taxation of Income From Rental of Vacation Properties

Renting out your vacation property is  great way to ensure continually visiting your favorite spots across the world and earning a little cash inflow while sheltering your other taxable income. The US tax advantages of renting a vacation home you own can be substantial. They will often be based on your usage of the property and the time length at which the property is rented out. Let’s find out how it all works.

For the purpose of US tax, the term home not only include fixed property such as houses, but also boats, mobile homes and condominium. Generally speaking, if your property has basic living accommodations such as sleeping quarters, washrooms and a cooking facilities, you’ll be consider to hold a rental property under the context of US tax law.

Basic Concept of US Taxation of Rental Property

So let’s look at the following example to better understand rental income taxation:

Let’s say that you buy property (Building and Contents) for $600,000 and rent it for a monthly income of $1,000 (or $12,000 yearly)

Cost of Property

Cost of Building and Content = $600,000

Depreciation

Depreciation is the one of the best deductions you can use. When you buy an asset that produces income, such as a rental property, you can deduct a portion of its cost each year you own it. If it’s a physical asset, such as real estate or equipment, the deduction is called depreciation. Let’s find out how it works.

Since the cash flow of from the rental is only $12,000, when you subtract the depreciation expense, you end up with a loss of $26,000. In other words, your $12,000 of cash inflow is entirely tax free.

Furthermore,  you have a $26,000 of loss to use against other income. Therefore, with a tax rate of 35%, your loss of $26,000 will create close to $10,000 in tax refund. 

Please consult your tax advisor for more information on how much you can deduct on your individual tax return.

Classification of Property

It is paramount to establish the way a property ought to be classified in order to know the deductible expenses on a US income tax return. The IRS generally requires to file a Schedule E to be compliant with the tax treatment of your vacation home.

Ownership of regular rental property is a situation where 100% of the property income will be reported on the owner’s US income tax return. While all of the rental property income will be taxable, related deductions can be used to reduce that taxable income. In fact, if the activity yields a net loss, an allowable portion of this loss amount may be used against the taxpayer’s other type of income.

Otherwise your property will be classified as residence, rental property of vacation home with different income, deductions and rental loss shelter opportunity consequence.

What If I Want to Rent My Property Only For a Short Period? What Is The Tax Consequence?

There’s a great loophole yielding tax-free rental income. To take advantage of this tax-break is to rent the property for less than 15 days if you have spent more than 15 days in the vacation home. If that your case, any income earned from the rental property need not to be reported on the tax return, irrespective of the generated income.  The only drawback with that tax loophole is that the operating expenses including depreciation, insurances or home owner association fees will become none deductible since there is no reportable income to reduce or offset. Other expenses, however, such as mortgage interest or real estate taxes can be used as itemized deductions.

What If I Have Rented My Property For a Long Period? What Is The Tax Consequence?

This situation has two general outcomes depending on the number of days you’ve stayed in the vacation home and if you’ve rented the place for more than 15 days.

1/ I have spent less than 15 days in the vacation home (or less than 10% of the days rented)

If you’ve stayed less than 15 days in the vacation home (or less than 10% of the days rented) and rented it out for more than 15 days, then the home will have a classification of vacation home used as a rental property. In other words, related rental income is taxable and corresponding deductions are allowed. However, you’ll have to be extremely mindful in adequately identifying your expenses as indirect or direct for the following reasons:

Indirect expenses such as depreciation, mortgage interest, or real estate are all prorated based on the number of days property was rented out.

Direct expenses such as advertising and management fees will fully deductible against the taxable rental income.

2/ I have spent more than 14 days (or more than 10% of the days rented)

If you’ve stayed more than 14 days in the vacation home (or more than 10% of the days rented) and rented it out for more than 15 days, then the property will have the classification of a vacation home used as a residence. In other words, the income from the rental activities from the property will be reported on the owner’s tax return. The deductions will prorated on the basis of the number of days the property was rented out and will therefore be limited on how much deduction is allowed. The main difference between this situation and the one described in the previous point is that some prorated deductions that are not allowed may be taken on as an itemized deduction on schedule A of your return.

The expenses in this type of rental agreement will be limited to the income from the rental activities. In other words, losses like the one described in the previous example will be allowed. Additionally, there is a very specific way the IRS wants you to order your rental expense under the context described here. The IRS would typically require itemized deductions such as mortgage interest and real estate taxes are deducted first, to then be followed by direct expenses, operating expenses and depreciation. Speak to your tax counsel on how this works before finalizing how you file your return with the rental activity information.   

The IRS is very specific on how to use your home for US income tax purposes. If the main purpose of vacation home ownership is  to maximize your tax breaks, spend the least amount of time in the home. If, on the other hand,tax breaks are not of importance, just make sure to enjoy your vacation home, but also to track the number of days you use the home for personal use versus rental use. 

Need Additional Clarification on US Income Tax and Your Rental Property?

Please do not hesitate in contacting us should you need any additional information with regards to US expatriate taxes. We are always looking forward to hear from you.