A taxpayer with the financial means to do so may purchase a second home as a vacation home, a rental property, or a combination of the two. A taxpayer may own a second home outright or may share ownership with others through a timeshare or fractional ownership arrangement. Or a taxpayer may rent out their home or part of their home using an online service such as Airbnb. The nontax benefits of owning a second home include a fixed vacation destination, the ability to trade the use of the home with an owner of a home in a different location, the opportunity to generate income through rentals, and the potential appreciation of the second home as an investment. The nontax costs of owning a second home include the initial purchase cost, maintenance costs, the hassle of dealing with rent- ers or property managers, and the downside risk associated with holding the second home as an investment.
The tax consequences of owning a second home depend on whether the home quali- fies as a residence (see discussion at the beginning of the chapter) and on the number of days the taxpayer rents out the home. The home is categorized in one of three ways:
1. Residence with minimal rental use (rented for 14 or fewer days).
2. Residence with significant rental use (rented for 15 or more days).
3. Nonresidence.
Recall that, as we discussed earlier in the chapter, a property is considered a “resi- dence” for tax purposes if the taxpayer uses the home for personal purposes for more than the greater of 14 days or 10 percent of the number of rental days during the year. For ex- ample, if a taxpayer rents her home for 200 days and uses it for personal purposes for 21 days or more, the home is considered to be a residence for tax purposes. If the same tax- payer used the home for personal purposes for 20 days, the home would be considered a nonresidence for tax purposes.
Residence with Minimal Rental Use
The law is simple for taxpayers who rent out a residence for a minimal amount of time during the year (i.e., they live in it for at least 15 days and they rent it for 14 or fewer days). These taxpayers are not required to include the gross receipts in rental income and they are not allowed to deduct any expenses related to the rental.18 They are, however, allowed to claim as itemized deductions any home mortgage interest and real property taxes on the second home (subject to limits discussed above).
LO 14-5
THE KEY FACTS Rental Use of the Home
• Tax treatment depends on amount of personal and rental use. The three cat- egories are:
(1) Residence with mini- mal rental use (per- sonal residence) (2) Residence with sig-
nificant rental use (vacation home) (3) Nonresidence
(rental property)
THE KEY FACTS Rental Use of the Home
• Residence with minimal rental use.
• Taxpayer lives in the home at least 15 days and rents it 14 days or fewer.
• Exclude all rental income.
• Don’t deduct rental expenses (other than mortgage interest and real property taxes).
Example 14-11
The Jeffersons purchased a vacation home in a golf community in Scottsdale, Arizona, in January. They spent 10 days vacationing in the home in early March and another 15 days vacationing in the home in mid-December. In early February, they rented the home for 14 days to a group of golfers who were in town to attend a PGA Tour golf tournament and play golf. The Jeffersons received $6,000 in rent from the group, and the Jeffersons incurred $1,000 of expenses relating to the rental home (other than mort- gage interest and real property taxes). The Jeffersons did not rent out the property again for the rest of the year. How much will the $5,000 net income from the rental increase their taxable income?
Answer: Zero! Because the Jeffersons lived in the home for at least 15 days and rented out the home for 14 or fewer days during the year, they do not report the rental income to the IRS, and they do not deduct expenses associated with the rental. The Jeffersons saved $1,600 in taxes by excluding the
$5,000 of net rental income ($5,000 net income × 32 percent marginal tax rate). Note that they can also claim the home the mortgage interest and real property taxes (subject to the $10,000 itemized deduction limit for taxes) on the property for the full year as itemized deductions.
18§280A(g).
A taxpayer with a strategically located second (or even first) home can take advan- tage of this favorable tax rule by renting the property to those in town to attend high- profile events such as the Olympics, the Masters golf tournament, the Super Bowl, and Mardi Gras—and excluding potentially large rental payments from taxable income.
Residence with Significant Rental Use (Vacation Home)
When a home qualifies as a residence and the taxpayer rents out the home for 15 days or more, the rental revenue is included in gross income, expenses to obtain tenants (advertis- ing and realtor commissions) are fully deductible as direct rental expenses, and expenses relating to the home are allocated between personal and rental use. The expenses allo- cated to personal use are not deductible except under nonrental tax provisions as itemized deductions. (These deductions include mortgage interest, real property taxes, and certain casualty losses on the home.)
When the gross rental revenue exceeds the sum of the direct rental expenses and the expenses allocated to the rental use of the home, the taxpayer is allowed to deduct the expenses in full. However, when these expenses exceed the rental revenue, the deduct- ibility of the expenses is limited. In these situations, taxpayers divide each of the rental expenses into one of three categories or “tiers.” The tier 1, 2, and 3 expenses for rental property are described in Exhibit 14-3.
The taxpayer first deducts tier 1 expenses (expenses to obtain tenants and the mort- gage interest and real property taxes that are allocated to rental use19) in full. This is true even when tier 1 expenses exceed the gross rental revenue.20 Second, the taxpayer deducts tier 2 expenses.21 However, the tier 2 expense deductions are limited to the gross rental revenue in excess of tier 1 expenses. Any tier 2 expenses not deducted in the current year due to the income limitation are suspended and carried forward to the next year.
Finally, the taxpayer deducts tier 3 expense (depreciation calculated using the straight-line method over 27.5 years). The tier 3 expense deduction is limited to the gross rental revenue in excess of tier 1 and tier 2 expenses. Any tier 3 expenses not deductible because of the income limitation are suspended and carried forward to the subsequent year. The nondeductible tier 3 expense does not reduce the basis in the home. The three
ETHICS
Carey and Pat were good friends and neighbors in an upscale neighborhood near several highly rated golf courses in Arizona. During the winter, both Carey and Pat decided to rent their homes (at a premium) to groups of golfers from the New York area who wanted to get out of the snow and enjoy sunshine and golf for a couple of weeks during the winter. While their homes were rented, Carey and Pat vacationed together in Cancun. In January 2018, Carey rented his home for 14 days and received $14,000 in rent. Pat also rented his home for the same 14 days and re- ceived $16,000 in rent. Near the end of the 14- day rental period, Pat got a call from the renters,
who wanted to extend their stay for one day. Pat agreed to the extension and charged the group
$2,000 for the extra day. When preparing his 2018 tax return, Pat discovered that taxpayers who rent their home for more than 14 days are required to report all their rental income on their tax returns. Pat didn’t think it was fair that he had to pay taxes on the rental income while Carey did not just because Pat rented his home for one more day than Carey in 2018. Consequently, Pat decided that he had rented his property for 14 days and given the renters the last day for free.
What do you think about Pat’s approach to solv- ing his tax problem?
THE KEY FACTS Rental Use of the Home
• Residence with significant rental use.
• Rental use is 15 days or more and personal use exceeds the greater of (1) 14 days or (2) 10 per- cent of rental days.
• Deduct direct rental expenses such as advertising and realtor commissions.
• Allocate home-related expenses between rental use and personal use.
• Interest and taxes allo- cated to personal use are deducted as itemized deductions; all other expenses allocated to personal use are not deductible.
• IRS method allocates in- terest and taxes to rental use based on rental use to total use for the year.
• Tax Court method allo- cates interest and taxes to rental use based on rental use to total days in entire year.
• Rental deductions other than tier 1 expenses are limited to gross rental revenue. When limited, deduct tier 1 (interest and taxes) first, then tier 2 (all expenses except interest, taxes, and depreciation), and then tier 3 (depreciation).
19Technically, expenses to obtain tenants (advertising and realtor commissions) are a reduction in gross rental income for tax purposes. However, we classify them as tier 1 expenses to simplify the discussion.
20The rental activity associated with a home that falls into the residence-with-significant-rental-use category is not considered to be a passive activity, so income or loss generated from the activity is not considered to be passive income or passive loss [§469(j)]. See discussion of passive loss rules below.
21§280A(c)(5). Also see IRS Publication 527, “Residential Rental Property (Including Rental of Vacation Homes).”
tier deduction sequence is designed to maximize taxpayer deductions for expenses that would be deductible even without any rental use of the home (most commonly, mortgage interest and real property taxes) and to minimize the allowable depreciation deductions for the home. This sequence is more favorable for taxpayers who do not itemize deduc- tions or whose potential mortgage interest and/or real property tax deductions are limited (e.g., limit on itemized deduction for taxes) and it is less favorable to other taxpayers.
As we mentioned above, expenses associated with the rental use of the home must be allocated between rental use and personal use of the home. These expenses are generally allocated to rental use based on the ratio of the number of days of rental use to the total number of days the property was used for rental and personal purposes (see Exhibit 14-4).
All expenses not allocated to rental use are allocated to personal use.
The only potential exception to the general allocation rule is the allocation of mortgage interest expense and real property taxes (both tier 1 expenses). The IRS and the Tax Court disagree on how to allocate these particular expenses. The IRS allocates these expenses the same way as all other expenses. However, the Tax Court allocates interest and taxes to rental use based on the ratio of days the property was rented over the number of days in the year, rather than the number of days the property was used for any purpose during the year.22 The IRS and Tax Court allocation methods are described in Exhibit 14-4.
EXHIBIT 14-3 Rental Expenses by Tier and Deduction Sequence
Tier 1
Expenses for obtaining tenants (such as advertising expense and realtor commissions) and expenses allocated to the rental use of the home that would be
deductible as itemized deductions even if the home were not rented (mortgage interest expense and real property taxes)
Tier 2
All other expenses allocated to the rental activity except depreciation expense, including payments for utilities, maintenance, and other direct expenses
Tier 3 Depreciation expense
EXHIBIT 14-4 Tax Court versus IRS Method of Allocating Expenses
Rental Allocation IRS Method Tax Court Method Mortgage interest and property
taxes (tier 1 expenses) All other expenses
Expense×Total rental days
Total days used Expense×Total rental days Days in year Expense×Total rental days
Total days used Expense×Total rental days Total days used
22The Tax Court method of allocating these expenses is also referred to as the Bolton method after the taxpayer in the court case in which the Tax Court approved this method of allocating deductions. While the court case initially was tried in the Tax Court, the decision in favor of the taxpayer was appealed to the Ninth Circuit Court that also ruled in favor of the taxpayer and sanctioned the use of the Tax Court or Bolton method of allocating interest expense. Bolton v. Commissioner, 82-2 USTC par. 9699 (CA 9), Affirming Tax Court, 77 TC 104.
The Tax Court justifies its approach by pointing out that interest expense and prop- erty taxes accrue over the entire year regardless of the level of personal or rental use.
Taxpayers generally choose the approach most beneficial to them. Determining which method is more favorable for a particular taxpayer was made more complicated by recent tax law changes that increased the standard deduction and limited the itemized deduction for taxes. When the gross income limitation does not apply, the IRS method is generally more favorable because it allocates more mortgage interest and real property taxes to rental use where they are deductible as for AGI deductions. Under the Tax Court method more mortgage interest and real property taxes would be allocated to personal use where they may or may not provide tax benefit depending on whether the taxpayer itemizes de- ductions and whether the taxpayer has reached the $10,000 limit for deducting taxes.
When the gross income limitation applies, the Tax Court method is likely more favorable for taxpayers who receive tax benefit from additional mortgage interest and real property tax itemized deductions because it maximizes their total current year deductions ( for AGI plus itemized deductions) from the property relative to the IRS method. On the other hand, when the gross income limitation applies, the IRS method likely favors taxpayers who do not itemize deductions or who do not receive full tax benefit from the additional itemized deductions that would be provided by the Tax Court method (they are already capped on the itemized deduction for taxes or the full amount of mortgage interest and real property taxes are not above the standard deduction amount when combined with other itemized deductions). For these taxpayers, the trade-off is they have more excess tier 2 and tier 3 deductions that they carry over and deduct in a subsequent year instead of having more itemized deductions that provide little to no tax benefit. In any event, use of the Tax Court method likely involves more risk of IRS scrutiny than the IRS method.
Example 14-12
At the beginning of the year, the Jeffersons purchased a vacation home in Scottsdale, Arizona, for
$500,000 ($400,000 for the building and $100,000 for the land). They paid $200,000 down and financed the remaining $300,000 with a 6 percent mortgage secured by the home. During the year, the Jeffersons used the home for personal purposes for 30 days and rented it out for 200 days. Thus, the home falls in the residence-with-significant-rental-use category. They received $37,500 of rental revenue and incurred $500 of rental advertising expenses. How are their expenses allocated to the rental use under the IRS and Tax Court methods?
Answer: See the following summary of allocation of expenses associated with the home:
Allocation Method to Rental Use
Tax Court Method IRS Method (200/365 Tier 1 Expense Amount Tier (200/230) 200/230 other)
Advertising* $ 500 1 $ 500 $ 500
Interest 18,000 1 15,652 9,863
Real estate taxes 5,000 1 4,348 2,740
Total tier 1 expenses $23,500 1 $20,500 $13,103
Utilities 4,500 2 3,913 3,913
Repairs 1,800 2 1,565 1,565
Insurance 3,500 2 3,043 3,043
Maintenance 3,200 2 2,783 2,783
Total tier 2 expenses $13,000 2 $11,304 $11,304 Tier 3: Depreciation $13,939 3 $12,121 $12,121 Total expenses $ 50,439
*Advertising is a direct expense of the rental so it is fully deductible against rental revenue.
Taxpayers report their rental activities on Schedule E of Form 1040. The deductible tier 1, tier 2, and tier 3 expenses are for AGI deductions. Exhibit 14-5 displays the com- pleted Schedule E for the Jeffersons’ Scottsdale vacation home using the Tax Court method. Note that net rental income is considered to be investment income for purposes of determining the 3.8 percent net investment income tax (discussed in the Individual
Income Tax Computation and Tax Credits chapter). THE KEY FACTS
Rental Use of the Home
• Nonresidence
• Rental use is at least 1 day and personal use is no more than the greater of (1) 14 days or (2) 10 percent of rental days.
• Allocate expenses to rental and personal use.
• Rental deductions in excess of rental income are deductible subject to passive loss limitation rules.
• Interest expense allocated to personal use is not deductible.
Net Income from Rental IRS Method Tax Court Method
Rental receipts $ 37,500 $ 37,500
Less tier 1 expenses (20,500) (13,103)
Income after tier 1 expenses 17,000 24,397
Less tier 2 expenses (11,304) (11,304)
Income after tier 2 expenses 5,696 13,093
Less tier 3 expenses (5,696) (12,121)
Taxable rental income $ 0 $ 972
Interest itemized deduction $ 2,348 $ 8,137
(Real property tax itemized deduction) 652 2,260
Deductible rental expenses 37,500 36,528
(sum of tier 1, 2, and 3 expenses)
Total itemized and rental expenses $40,500 $46,925
At first glance, it appears that the Tax Court method is more favorable for the Jeffersons. After all, the Jeffersons are able to claim $6,425 more total deductions under the Tax Court method compared to the IRS method ($46,925 − $40,500). While the IRS method allows the Jefferson to deduct $972 more for AGI (rental) deductions than the Tax Court method ($37,500 − $36,528), the Tax Court method al- lows the Jeffersons to potentially deduct $5,789 more in mortgage interest expense ($8,137 − $2,348) and $1,608 more in real property taxes ($2,260 − $652) as itemized deductions. However, on closer inspection, it is not clear whether the Tax Court or the IRS method is more favorable for two reasons.
First, the Jeffersons are allowed to carry forward to next year the $6,425 of depreciation expense that they did not deduct this year under the IRS method. That is, they were not able to deduct the $6,425 this year but they will be able to deduct it in a subsequent year if they generate enough income. Sec- ond, the Jeffersons report $1,608 more in real property taxes under the Tax Court method than under the IRS method. However, as indicated in Example 14-10, the Jeffersons exceed the $10,000 limit on the itemized deduction for taxes so the additional $1,608 of real property taxes does not increase their itemized deductions and it provides no tax benefit. The Tax Court gives the Jeffersons more deductions in the current year but the IRS method gives them more deductions in the current plus future years (as- suming they generate enough income).
TAXES IN THE REAL WORLD Airbnb Anyone?
Online home rental communities such as Airbnb, HomeAway, and VRBO provide a marketplace that connects travelers looking for lodging with taxpay- ers seeking rental income from renting all (or part) of their homes. Online rental communities con- tinue to grow as travelers increasingly seek lodg- ing bargains. For example, reportedly, Airbnb recognized $1.7 billion in revenue in 2016 and is projecting revenue of $2.8 billion in 2017 and as much as $8.5 billion in revenue in 2020 (see http://fortune.com/2017/02/15/airbnb-profits/).
Taxpayers renting entire homes or even just a bedroom on Airbnb must deal with the tax conse- quences discussed in the Rental Use of the Home section of this chapter. See https://www.forbes.
com/sites/anthonynitti/2015/11/09/renting- your-home-on-airbnb-be-aware-of-the-tax- consequences/#31e78cbfc518 for a discussion of the tax consequences of those renting their homes (consistent with the discussion in this chap- ter) and the tax consequences of renting out part of the home (beyond the scope of this chapter).