If you rent your vacation home for less than 15 days a year, the rental income is tax-free and you can deduct interest and property tax payments (and casualty losses) on the house, but not the rental expenses, for the entire year.
You do not deduct the following:
- Personal use days
- Any days that you stayed at the rental property to perform routine repairs and maintenance including:
- repairing the bathroom toilet
- shampooing carpets, floor cleaning
- painting, caulking
- shopping for furniture or supplies
- décor changes
- Meetings with property managers
- Meetings with association boards
Maintenance days are not counted as personal days, even if your friends or relatives joined you for recreational purposes. These type of days should not be considered personal days and should be documented on a calendar or written document including receipts.
If you rent your vacation home out for 15 days or more during the year, and personal use does not exceed the larger of 14 days or 10% of the rental days, you must include the rent in income. You get to deduct 100% of any property management fees in addition to rental expenses and it gets complicated because you need to allocate rental expenses between the days the property is rented and those used for personal purposes. If personal use is 30 days and rental use is 120 days, 80% (120 divided by 150) of your mortgage interest, property taxes, insurance premiums, utilities and other rental expenses. You can claim depreciation of 80% of the value of the house (no depreciation on the land part of the purchase).
If you limit your personal use to 14 days or 10% of the rental days, the vacation home is considered a business and up to $25,000 in losses may be deductible in each year. I say losses “may” be deductible because real estate losses are considered “passive losses” by the federal tax law. Passive losses can be used to offset taxable profit when you ultimately sell the vacation property.
Selling the Vacation Property:
Although the rule that allows home owners to take up to $500,000 of profit tax-free applies only to your principal residence, there is a way to extend the break to your second home: make it your principal residence before you sell. That's not as crazy as it might sound, nor is it as lucrative as it used to be.
Historically, retirees were selling the family home and moving full time into what had been their vacation home. Before 2009, this had a very special tax appeal. Once you live in that home for two years, up to $500,000 of profit could be tax free — including appreciation in value during the years it was your second home. Any profit attributable to depreciation while you rented the place, though, would be taxable. Depreciation reduces your tax basis in the property and therefore increases profit dollar for dollar.
In 2008 Congress cracked down on this break for taxpayers who convert a second home to a principal residence. Now a portion of the gain on a subsequent sale of the home is ineligible for the home-sale exclusion of up to $500,000, even if the seller meets the two-year ownership and use tests. The portion of the profit that's subject to tax is based on the ratio of the time after 2008 when the house was a second home or a rental unit to the total time you owned it.
This can still be a great deal if you've owned your second home for many years before the law changed. Let's say you have owned a vacation home for 18 years and make it your main residence in 2014. Two years later, you sell the place. Since the six years after 2008 the place was your second home (2009 and 2010) is 30% of the 20 years you owned the home, only 30% of the gain is taxed. The rest qualifies for the exclusion of up to $500,000.