Did you know there’s a way to rent out your vacation home tax-free? There’s a loophole in the tax code that allows property owners to temporarily use their residences as short-term rentals. And right now, the short-term rental industry is on the rise with an estimated 1.3 million vacation rentals in the US. Within the next two years, experts project a global market value of $8.9 billion.
Vacation homes make fantastic seasonal rentals, and the IRS even offers tax breaks to property owners who meet certain requirements. Let’s talk about seasonal rentals, the pros and cons of short-term rentals, and the tax implications that come from renting out your vacation home.
What Are Seasonal Rentals?
Many people think of seasonal rentals as short-term rental properties at vacation destinations, with rental terms of six months or less.
Of course, you can also rent out seasonal spaces other than vacation homes. Perhaps you have a stunning patio that would work for bridal or baby showers. A larger space like a pavilion or lovely garden may work well for weddings or parties. In the spring and summer, you could rent out space in your yard for others to garden. In the winter, you can lease a parking space in your garage to protect a vehicle from snow and ice. These are all forms of house hacking, which comes with its own tax considerations.
For this discussion, we’re focusing on vacation homes that double as short-term seasonal rentals.
Advantages of Seasonal Rentals
Many benefits come with operating a seasonal rental. These are our top four:
- Offset your costs: Maintaining a vacation property takes money. According to Doorloop, almost 50 percent of short-term rental owners report that their units help cover expenses. Using your second home for short-term rentals, even for a few weeks, is a smart way to offset costs.
- Account for seasonality: The location of your property and time of year affect occupancy rates. But with shorter rental periods, you can adjust your rates to reflect demand. Charge a premium during the peak season, then reduce the rate during the offseason.
- Use dynamic pricing: Pricing for demand extends beyond seasons. With dynamic pricing, you can adjust rent rates each day. Weekend bookings may call for a higher rate, but you can charge less for midweek or longer stays to keep your unit occupied. By combining dynamic pricing with your peak-season rates, you can optimize your revenue and you’ll be able to better manage your cash flow.
- Maximize your income: If you’re already renting out your vacation home, consider offering additional services to tenants during their stays. Extra amenities are a source of additional revenue. Just remember that providing substantial services can subject you to self-employment taxes, so check with your CPA before you expand your offerings.
Disadvantages of Seasonal Rentals
Renting out your vacation home comes with a few drawbacks. If you’re considering renting your property to short-term tenants, keep these risks in mind.
- Property damage: Short-term stays come with a higher risk of property damage, both to the dwelling and its contents.
- Increased costs: If you plan to rent out your vacation home regularly on a short-term basis, be prepared for higher outlays related to cleaning fees, restocking toiletries, and maintenance.
- Irregular income: Peak season comes with high demand, but be prepared for bookings and revenue to fluctuate from month to month. Remember, your property’s location helps determine your occupancy rate.
- More regulations: Many state and local authorities have restrictions in place regarding short-term rentals. Check with your homeowners’ association, condo board, or zoning regulations to see if they permit rentals in your area.
- Insurance liability: Renting out your vacation home may affect your insurance coverage. Ask your provider if you need to adjust your coverage before you lease your property.
Renting Your Vacation Home
About 20 percent of the global vacation rental market is in the US, so it’s a great time to join the seasonal rental industry. The IRS even offers tax breaks if you rent out your vacation home. The tax breaks come with conditions, and the IRS has three different tiers related to vacation home rentals.
Tier 1: Rent up to 14 Nights
For the first tier, you may rent out your property for up to two weeks each year without having to report the rental income. The property is still your personal residence, and you can deduct mortgage interest and property taxes on your Schedule A if you choose to itemize deductions. However, any costs associated with renting the property, like advertising or cleaning fees, are not deductible.
You’re free to rent the property out at any point during the year, and nonconsecutive rental days are fine. Keep records detailing when you rent the property and when you use it personally. Set a reasonable rent rate, based on the location and date, staying within going rates. You should also keep records of the market rent rates as proof that your rents are reasonable.
We call this section of the tax code the Augusta rule or the Masters exemption. Each year, the Masters golf tournament takes place in Augusta, Georgia. In the 1970s, residents lobbied for a tax provision allowing them to rent their homes to tournament goers without tax complications. When the IRS granted the provision, it wasn’t limited to Augusta residents—it’s nationwide. This is an excellent example of monetizing your property during a peak-demand period.
Tier 2: Rent More Than 15 Days with Less Than 14 days of Personal Use
In the second tier, you rent out the property more than you use it personally. With 15 or more rental days and less than 14 personal-use days, your vacation home becomes a rental property instead of your personal residence. This means your rental activities can count as a business and you must report all rental income.
Plus, you’re now able to deduct certain expenses, like insurance premiums, property management fees, utilities, and depreciation. The outlays aren’t 100 percent deductible, though. Your deductible amount is based on the property’s percentage of rental days. Use this formula to calculate your deductible percentage:
Number of days the property was rented ÷ Total number of days the property was used = Deductible percentage
When you’re determining the total number of days the property was used, remember to include both rental days and personal-use days.
Another benefit of this second tier is that you may also deduct up to $25,000 each year in losses, depending on your adjusted gross income. Check with your tax preparer to see if you qualify.
Tier 3: More Than 14 days or 10 Percent of Personal Use
With the third category, your personal use of the property is over 14 days or 10 percent of the total rental days, whichever is more. The IRS counts the property as a personal residence in this case, and your rental losses are not deductible.
However, your rental costs are still deductible, up to the level of your rental income, along with mortgage interest and property taxes on your Schedule A if you choose to itemize deductions.
What Counts as Personal Use?
So if your tax breaks are contingent on the number of rental days versus personal-use days, what does the IRS consider personal use?
Great question.
Personal use has a broader range than you might think. Of course, if you stay at your property for vacation, that’s personal use. But it’s also personal use if you donate a few days or weeks of rental time as an item for a charity auction. And it’s still personal use if you let friends or family rent the property at a significantly reduced rate—or for free.
But days that you spend on the property to do maintenance don’t count as personal-use days. When you’re on the property, it’s worth keeping a log of when you perform maintenance. Even a few personal-use days can end up affecting your tax deductions.
Takeaways
The short-term rental market is booming, both in the US and globally. If you have a vacation home, consider putting your property to work for you. Seasonal rentals are a great way to monetize your vacation home. With a little planning, you can maximize your profits and offset your costs. If you’re new to short-term rentals, use the Augusta rule as a trial period and enjoy two weeks’ worth of tax-free rental income. Just remember that using your vacation home as a seasonal rental comes with tax implications, so documentation is important.
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