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Vacation Property: Rental and Resale

CPAs should be aware of a new provision that reduces the gain exclusion on sale of a residence that was previously used as a vacation home (or rental).

October 2008
by Donald Williamson/The Tax Adviser

Today’s housing market is dismal, but savvy investors can profit from the decline in home prices by buying houses now and selling them when the market changes direction. Some of the better bargains are in locations where short-term vacation rental is more attractive than a longer lease. Often, a long-term tenant may not be consistent with the investor’s plan to cash in relatively soon. Moreover, if the property is in a favorite vacation spot, the owners can use the property themselves.

With this in mind, practitioners need to be up to speed on the vacation rental rules. Practitioners should also be aware of a new provision effective January 1, 2009, that potentially reduces the gain exclusion on sale of a residence that was previously used as a vacation home (or rental).

Vacation Rental

The tax treatment of vacation rental property depends on how many days the taxpayer rents the property and the taxpayer’s level of personal use. Personal use includes vacation use by relatives (even if they pay the full rental rate) and use by nonrelatives if less than market rate rent is charged (Sec. 280A(d)(2)).

If the taxpayer rents the property fewer than 15 days during the year, the IRS considers the rental activity de minimis (Sec. 280A(g)). Under the de minimis rule, rent received is not included in taxable income (no matter how substantial the amount). However, only property taxes and mortgage interest are deductible — no deduction is allowed for operating costs or depreciation. (Mortgage interest is also, of course, subject to several limits.) If the taxpayer rents out the property for more than 14 days, rent must be included in income. On the bright side, operating expenses and depreciation can be deducted subject to the following rules (Prop. Regs. Sec. 1.280A-3(d)(3)). First, the taxpayer must allocate expenses between personal use days and rental days. For example, if a house is rented for 90 days and used personally for 30 days, 75 percent of the use is rental (90 days out of 120 total days of use). The taxpayer allocates 75 percent of maintenance, utilities, insurance and other property-related expenditures to rental. The taxpayer also allocates 75 percent of depreciation, interest and taxes for the property to rental. The personal use portion of taxes is separately deductible. The personal use portion of interest on a second home is also deductible where (as is the case here) the personal use exceeds the greater of 14 days or 10 percent of the rental days. However, the taxpayer cannot take depreciation on the personal use portion.

If the rental income exceeds these allocable deductions, the taxpayer reports the rent and deductions to determine the amount of rental income included in taxable income. If the expenses exceed the income, the taxpayer may be able to claim a rental loss, depending on how many days the house was used for personal purposes.

Here is the test: If the house was used personally for more than the greater of (1) 14 days or (2) 10 percent of the rental days, the taxpayer cannot claim the loss (Sec. 280A(d)(1)). In this case, the taxpayer can still use deductions to offset the rental income but cannot go beyond the income to create a loss. Unused deductions are carried forward and may be deductible in future years (Sec. 280A(c)(5)). If the taxpayer is limited to using deductions only up to the amount of rental income, he or she must use the deductions allocated to the rental portion in the following order: (1) interest and taxes, (2) operating costs and (3) depreciation (Prop. Regs. Sec. 1.280A-3(d)(3)).

Under Sec. 280A(e)(2), the general deduction limitation does not apply to deductions, such as interest and taxes, that would be allowable for the tax year whether or not the unit was rented. Because interest and taxes will be deductible regardless of the rental income limitation, a taxpayer will in general want to deduct the smallest amount of interest and taxes possible as rental expenses in order to increase the amount of operating costs that can be deducted.

Prop. Regs. Sec. 1.280A-3(d)(3) states that the same total-fair-rental-days-total-days-used formula applies to allocate the portion “of any item” to rental use. However, the Tax Court, Ninth Circuit (Bolton, 694 F.2d 556 (9th Cir. 1982)) and Tenth Circuit (McKinney, 732 F.2d 914 (10th Cir. 1983)), have held that the proper ratio is the number of rental days to full number of days in the year. The courts apply the logic that while maintenance costs increase with use and therefore relate to the amount of time the property was actually used, interest and taxes accrue over the course of the year without regard to actual use. The method embraced by these courts increases the denominator of the allocation ratio, which will generally reduce the amount of interest and taxes that the taxpayer must deduct as rental expenses.

If the taxpayer passes the personal use test (i.e., the taxpayer did not use the property personally more than the greater of the amounts listed above), expenses must still be allocated between the personal and rental portions. In this case, however, if rental deductions exceed rental income, the taxpayer can claim the loss. But the loss is passive and may be limited under the passive loss rules.

Example: A vacation home is rented for 60 days and used personally for 20 days. Rent collected is $8,000. Expenses are $6,000 in interest and taxes, $3,600 operating costs and $4,800 depreciation, for a total of $14,400. Personal use is 25 percent (20 out of 80 total use days), so 75 percent of the expense is allocated to rental ($14,400 × 75% = $10,800). Thus, there is a rental loss of $2,800 ($8,000 income – $10,800 expenses).

Because personal use (20 days) exceeds the greater of (1) 14 days and (2) 10 percent of rental days (six), the loss is disallowed. The taxpayer can deduct only $8,000 of expenses (up to the rental income). The taxpayer must first deduct the rental portion (75%) of the interest and taxes ($4,500 (75% of $6,000)), then 75 percent of the operating costs ($2,700 (75% of $3,600)), which totals $7,200 ($4,500 + $2,700). Therefore, the taxpayer can deduct only $800 of depreciation.

Reduced Gain Exclusion

Under Sec. 121(b)(4) (enacted as part of the Housing Assistance Tax Act of 2008, P.L. 110-289), for periods of use beginning on January 1, 2009, if a home is used as a vacation property (or general rental) then later is converted to a residence prior to resale, gain attributable to the period of time it was not used as a principal residence (nonqualified use) cannot be excluded.

Gain is allocated to periods of nonqualified use in proportion to the days of nonqualified use to the total days the property is owned. For example, for a property owned for five years, used as a vacation home three years, then used as a principal residence for two years, 60 percent of the gain could not be excluded.

Taxpayers might get some comfort from the facts that:

  1. any use prior to 2009 will not be treated as nonqualified use and
  2. a period of absence generally counts as qualifying use if it occurs after the home has been used as a principal residence.

Conclusion

The vacation home rules have always been confusing and with the enactment of Sec. 121(b)(4) they have become more convoluted for clients who convert a vacation home to a principal residence. Practitioners should remember the key elements of de minimis use, personal use, allocation and limitation of deductions and always consider the court-sanctioned alternative allocation of interest and taxes. They should also keep in mind the potential for reduced gain exclusion on subsequent conversion and sale. Rules old and new, from the IRS and from the bench, come together and are all relevant to maximizing the tax benefit to clients who are expanding their real estate investments.

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Donald Williamson, J.D., CPA/ABV, Zainer Rinehart Clarke, Santa Rosa, CA is a contributing writer for The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA, The Tax Adviser or the AICPA CPA Insider™.

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