Tax Implications for Vacation Homes Classified as Personal Residences

Do you own a vacation home? If so and you rent it to third parties, you may be confused about the federal income tax rules that apply. Confusion is especially common if you changed your usage pattern during the pandemic. It may have caused your property to be classified as a personal residence — rather than a rental property — for federal income tax purposes.

Here's an overview of the tax implications for vacation homes that fall into the personal residence category.

No Rental Income, No Problem

If you own a vacation property that you don't rent out during the year, it's obviously treated as a personal residence for federal income tax purposes. Unfavorable changes made by the Tax Cuts and Jobs Act (TCJA) can affect your itemized deductions for mortgage interest and property taxes. For instance, if you have a jumbo mortgage on your main residence and pay heavy property taxes on it, there may be no room left to deduct mortgage interest or property taxes on your vacation home.

The TCJA limits itemized deductions for mortgage interest to interest paid on the first $750,000 of home acquisition debt generally starting with loans taken out after December 15, 2017. Preexisting home acquisition debts are grandfathered under the prior law limit of $1 million.

In addition, through 2025, itemized deductions for personal state and local taxes are limited to a combined total of only $10,000 ($5,000 for married filing separately). The limitation applies to state and local 1) income (or sales) taxes and 2) property taxes. Moreover, personal foreign real property taxes can no longer be deducted. So, if you're lucky enough to own a vacation villa in the Bahamas or a beach condo in Cancun, you can't deduct the property taxes.

Properties Rented for Fewer than 15 Days

A special federal income tax break is available if you rent out your vacation home for less than 15 days during the year and use it for personal purposes for more than 14 days. This scenario often happens with vacation homes located near major events, such as professional golf tournaments. Here, you don't need to report any rental income. The rental activity is completely disregarded for federal income tax purposes.

You can report any allowable itemized deductions for mortgage interest and property taxes on your personal tax return. The only drawback is that you can't deduct other expenses attributable to the rental period, such as advertising and cleaning costs.

Personal Residence vs. Rental Property

Assuming your place doesn't qualify for the special break for properties rented for fewer than 15 days, here's what the Internal Revenue Code and IRS regulations say about how to classify "mixed-use" vacation properties that have both personal and rental use during the year.

Your vacation home is classified as a personal residence if:

You rent it out for more than 14 days during the year, and
Personal use during the year exceeds the greater of 14 days or 10% of the days you rent the home out at fair market rates.

Count only actual days of rental and personal occupancy. Disregard days of vacancy and days that you spend mainly on repair and maintenance activities.

Personal use means use by the owner, certain family members and any other party (family member or otherwise) who pays less than fair market rental rates. If your vacation home is used by another person under a reciprocal arrangement ("I use your place and you use mine"), such use is also considered personal use. That's the case regardless of whether you charge the other person fair market rent for your property and whether you pay fair market rent for the other person's property.

Consider this example: During 2021, your family and friends use your beachfront condo for 120 days. You rent the place out to third parties at market rates for 210 days. This condo is classified as a personal residence for the year because your personal use exceeds the greater of 1) 14 days, or 2) 10% of the rental days. See "Reporting Income and Allocating Expenses," below, for how to report the income and expenses related to your personal residence vacation home on your federal income tax return.

Conversely, your vacation home is classified as a rental property if:

You rent it out for more than 14 days during the year, and
Personal use during the year doesn't exceed the greater of 14 days or 10% of the days you rent the home out at fair market rates.

Again, count only actual days of rental and personal use. Also disregard days of vacancy and days spent mainly on repair and maintenance activities.

Here's another example: During 2021, you rent your beachfront condo to third parties at market rates for 300 days. Your family uses the condo for 30 days. This condo is classified as rental property for the year, because personal use doesn't exceed the greater of 1) 14 days, or 2) 10% of the rental days. A different set of tax rules applies to rental properties.

Year-End Planning Considerations

You may be able to manage the number of rental and personal-use days between now and year end. How you decide to use the property for the remainder of the year may have important tax implications. In some cases, your usage may flip the property's tax classification from personal residence status to rental property status (or vice versa).

For instance, you and family members may be anxious to spend more time at your vacation home and less time in the big city. That could place your vacation home firmly into the personal residence category. If so, adding more personal-use days may increase current itemized deductions for qualified residence interest expense and property taxes.

However, if you're affected by the TCJA limitations on interest expense and property taxes, adding more personal-use days may just result in bigger personal-use allocations of interest expense and property taxes that you can't currently write off as itemized deductions because of the TCJA limitations. The tax results will depend on your exact situation.

Alternatively, the current rental demand for your vacation home may be so high that you can't resist the opportunity to collect more rental income. That could put your place into the rental property category.

What's Right for Your Property?

As you can see, the federal income tax rules for vacation homes can be complicated. Consult your tax professional for advice on how to get the best tax results in your particular situation.

Reporting Income and Allocating Expenses

The fundamental federal income tax principle for a mixed-use vacation home that's classified as a personal residence is that deductible expenses allocable to rental usage can't exceed the gross rental income. In other words, rental expenses can't cause a tax loss.

Gross rental income is defined as rental income after subtracting direct expenditures to obtain tenants, such as commissions paid to rental agents and advertising expenses. Deduct allowable expenses allocable to rental use on Schedule E of your personal return. You can also claim itemized deductions for allowable mortgage interest expense and allowable property taxes allocable to personal use.

How do you allocate vacation home expenses between personal and rental use? For a vacation home that's classified as a personal residence, apply the following seven steps to report the rental income and allocate expenses:

Determine your personal and rental-use ratios. For example, in 2020, Ann used her beachfront condo 120 days for personal purposes, and she rented it out 210 days. So, the condo is classified as a personal residence for federal income tax purposes. For the 2020 tax year, Ann must allocate expenses between personal and rental usage using 120/330 as the personal-use fraction and 210/330 as the rental-use fraction.
Allocate qualified residence interest expense from a mortgage taken out to buy or improve your vacation home and property taxes using actual days of rental and personal use. Subject to the limitations under the Tax Cuts and Jobs Act (TCJA), write off the interest expense and property taxes allocable to personal use as itemized deductions.
For some owners, none of the property taxes allocable to personal use will be deductible, because their annual limitation for itemized state and local property taxes and income (or sales) taxes will be absorbed by deductions for state and local property taxes on your main residence and/or deductions for state and local income (or sales) taxes.
Report on Schedule E 100% of the gross rental income from your vacation home.
Report on Schedule E the rental-use percentage of mortgage interest that could otherwise be claimed as an itemized deduction for qualified residence interest. Do the same for the rental-use percentage of property taxes that could otherwise be claimed as an itemized deduction. However, these rental-use expenses can't exceed the gross rental income from the property. If they exceed gross rental income, claim the excess interest and property taxes as itemized deductions, subject to the TCJA limitations.
If there's any net rental income left on Schedule E, offset the income with allowable deductions for other expenses allocable to periods of rental use, such as property insurance, utilities, maintenance and depreciation. Other expenses allocable to rental use can't exceed the remaining rental income. To the extent allocable other expenses exceed rental income after this step, the excess expenses are disallowed for the current year. Other expenses allocable to personal use are nondeductible and have no impact on your tax return.
Other expenses allocable to rental use can include mortgage interest that doesn't meet the definition of qualified residence interest. For example, you may include interest on a loan that isn't secured by your vacation home but the proceeds of which were expended on the vacation home or when the debt limits for itemized qualified residence interest expense deductions are exceeded.
Follow the ordering rule to determine which specific other expenses allocable to rental use are disallowed in the previous step. Under the ordering rule, disallowed expenses consist first of any disallowed depreciation and then a pro-rata portion of any other disallowed expenses. If depreciation is limited, the tax basis of your vacation home is reduced only by the allowed amount, if any.
Carry over any disallowed other expenses allocable to rental use from the previous step to your next tax year. In that year, expenses are again subject to limitation based on that year's rental income. Presumably, if you sell the property, you can use any tax gain attributable to the rental-use portion of the property to "free up" prior-year disallowed expenses allocable to rental use.