About a Vacation from the Complexity of Vacation Home Rules?
APRIL 2007 -
IRC section 280A, “Disallowance of Expenses Relating to the
Use of a Home with a Business,” does not allow individual
taxpayers to deduct expenses that would otherwise be allowed for
a dwelling unit used by the taxpayer as a residence. Exceptions
include qualified interest, taxes, casualty losses, and certain
business uses. Restrictions on deductions and losses also specifically
apply to vacation home rentals.
Complexity arises from
several IRC sections, including 280A, which defines whether a
vacation home is a residence and provides guidelines to categorize
the property as personal, rental, or some combination of the two.
If property is considered to be a vacation home, section 280A
applies to limit losses; if property is considered to be strictly
rental, passive activity loss rules of IRC section 469 apply to
the activity. The dwelling could also be held as an investment
or used as part personal and part business, such as a home office
(both of which are beyond the scope of this article). As with
any endeavor, if the activity is strictly personal in nature and
not pursued with the intent to make a profit, the hobby loss provisions
of IRC section 183 will disallow the deduction of any net losses.
and Rental Days
summarizes the key factors to consider when determining the classification
of a dwelling and consequent tax implications. It shows how critical
it is to properly categorize and count personal and rental days.
It can be difficult, however, to determine which days to count
as personal and which to count as rental. For example, IRC section
280A(d)(2) considers personal-use days to include any day the
property is used as follows:
- For personal
purposes by the taxpayer, the taxpayer’s family, or a
co-owner. Family is defined to include a taxpayer’s spouse,
brothers, sisters, ancestors, and lineal descendants. Fair market
rental paid by a family member does not remove the usage from
personal unless the property is the family member’s main
- By any
individual under a reciprocal-use arrangement.
- By any
individual who does not pay a fair rental for the use of the
to the personal-use day exists for each day the taxpayer spends
substantially full-time on repairs and maintenance [IRC section
the above definitions of attributed personal use found in the
IRC, hidden traps are still unaddressed by the IRC. For example,
how should a taxpayer count days under IRC section 280A(d) that
the taxpayer “donates” to a charity to be auctioned
to a high bidder who pays a fair rental to the charity? Assuming
that the days are being used neither by the taxpayer nor by the
taxpayer’s family and a fair rental is being paid to the
charity, are these personal-use days or rental days? While the
IRC does not address the issue, Revenue Ruling 89-51, 1989-1 C.B.
89 holds that the donated days are counted as personal-use days
because the property owner does not receive a fair market rent
for use of the property.
must also know how to deduct expenses related to rental income.
The IRS interprets IRC section 280A(c)(5)(B) as requiring interest
and property taxes to be allocated to the rental activity based
upon the ratio of rental days to total days occupied. The tax
court held in Bolton v. Comm’r (77 TC 104), however,
that interest and property taxes accrue over the entire year,
so the proper denominator is 365, not the total days occupied.
Interest and property taxes accrue regardless of whether the property
is occupied, which can make a considerable difference in expense
deductions. In the Bolton case, the property was occupied
for 121 days and rented for 91 days. The IRS contended that proper
allocation of interest and property taxes should be 91/121, or
75%, while the taxpayer contended that proper allocation of interest
and property taxes should be 91/365, or 25%. The percentage difference
is significant because of the required three-tiered allocation
of expenses: Tier 1 is qualified interest and property taxes;
tier 2 is operating expenses; tier 3 is depreciation.
the expenses of a dwelling classified as a residence may be deducted
only up to the rental income. Allocating less tier 1 expenses
(qualified interest and property taxes), per Bolton,
to the rental property on Schedule E allows more interest and
property taxes to be deducted as itemized deductions on Schedule
A. This increases total deductible expenses for the taxpayer.
After deducting tier 1 expenses from rental income, tier 2 expenses
(operating expenses such as utilities, supplies, and repairs and
maintenance) are deducted. Finally, tier 3 expenses (depreciation)
are deducted if any net income remains after deducting tier 1
and tier 2 expenses. None of the tier 2 and tier 3 expenses exceeding
rental income and not deducted on Schedule E, however, are deductible
on Schedule A, further showing the benefit for taxpayers of Bolton.
taxpayers whose vacation property is considered a rental-only
property due to personal-use days that are below the threshold,
another complexity exists related to IRC section 469 that may
further thwart the taxpayer’s ability to deduct losses from
section 469(i), a taxpayer may be able to deduct up to $25,000
of rental real estate losses from other income. The following
are requirements to qualify for this deduction:
- The taxpayer’s
modified adjusted gross income (MAGI) is less than $150,000.
Phase-out begins at $100,000 of MAGI per IRC section 469(i)(3).
- The taxpayer
and spouse own at least a 10% interest in the property.
- The taxpayer
“actively participates” in the rental real estate
activity by making bona fide and significant management decisions.
These include approving new tenants, deciding upon rental terms,
reviewing fair market rental fees, and approving capital or
repair expenditures. Delegating all management decisions to
a rental agent would most likely not qualify as active participation.
The active participation standard is much less stringent than
the material participation standard applicable to other passive
loss over $25,000 can be carried forward and applied against ordinary
income in subsequent years under IRC section 469(i)(1) and Treasury
Regulations section 1.469-9(h)(3)(j), subject to the same limitations.
regulations pursuant to IRC section 469 indicate, however, that
if the average period of customer use of the property is seven
days or less, or 30 days or less with significant personal services
provided, the activity will not be considered a rental activity
for purposes of the passive loss rules [Temporary Regulations
section 1.469-1T(e)(3)(ii)]. Instead, the activity is more in
the nature of the hotel business and, therefore, the special rental
real estate loss allowance of section 469(i) is not available.
To deduct losses from such an activity, a taxpayer must meet the
more difficult test of “material participation” required
of nonrental real estate activities. Many second-home rental properties
fail the seven-day or 30-day service test; therefore, even if
the owners restrict their personal use of the property to avoid
the distinction of “vacation home,” they may still
be denied losses due to a lack of material participation in the
participation is defined by Temporary Regulations section 1.469-5T,
which treats individuals as materially participating in a nonrental
activity for the taxable year if the individual meets any of the
- The individual
participates in the activity for more than 500 hours during
such a year.
- The individual’s
participation in the activity constitutes substantially all
of the participation in such an activity of all individuals
for such a year.
- The individual
participates in the activity for more than 100 hours during
the year and such participation is not less than the participation
of any other individual for the year.
- The activity
is a significant participation activity for the taxable year,
and the individual’s aggregate participation in all significant
participation activities during such a year exceeds 500 hours.
- The individual
materially participated in the activity for any five taxable
years (whether or not consecutive) during the 10 taxable years
that immediately preceded the taxable year.
- The activity
is a personal service activity and the individual materially
participated in the activity for any three taxable years (consecutive
or not) preceding the taxable year.
on all of the facts and circumstances, the individual participates
in the activity on a regular, continuous, and substantial basis
during the tax year.
owner category is a taxpayer whose primary business is real estate.
This taxpayer (the full details of the classification are beyond
the scope of this article) avoids passive loss rules but is not
a casual vacation-home renter. To be considered as being involved
in the real estate rental business, the taxpayer must materially
participate in the activity. Material participation requires that
more than 50% of the individual’s personal service during
the year be performed in real property trades or businesses, and
the individual must perform more than 750 hours of work during
the year in the real
property trade or business in which the taxpayer claims material
mentioned, a significant number of complexities are related to
properly counting personal and rental days and classifying dwellings,
such as the following:
- A mix
of personal and rental
to passive loss rules
to hobby loss rules.
also consider whether the taxpayer qualifies for either active
participation in rental activities (for taxpayers with MAGI below
$150,000) or material participation in rental or business activities.
of IRC sections, Treasury Regulations, Revenue Rulings, general
rules, and exceptions to general rules significantly lessens the
likelihood that average vacation home owners can prepare their
own income tax returns. Even experienced tax professionals should
pay careful attention when tackling the complex area of vacation
A. Saibeni, MS, CPA, is an adjunct professor of accounting,
auditing and taxation at Cosumnes River College, Sacramento, Calif.