How About a Vacation from the Complexity of Vacation Home Rules?

By August A. Saibeni

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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.

Personal and Rental Days

The Exhibit 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 residence.
• By any individual under a reciprocal-use arrangement.
• By any individual who does not pay a fair rental for the use of the property.

An exception to the personal-use day exists for each day the taxpayer spends substantially full-time on repairs and maintenance [IRC section 280A(d)(2)(C)].

Even with 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.

A taxpayer 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.

For example, 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.

Rental-only Property

For those 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 the activity.

Under IRC 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 activities.

Any rental 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.

The temporary 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 activity.

Material Participation

Material 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 following tests:

• 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.
• Based on all of the facts and circumstances, the individual participates in the activity on a regular, continuous, and substantial basis during the tax year.

An additional 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 participation.

Significant Complexities

As previously mentioned, a significant number of complexities are related to properly counting personal and rental days and classifying dwellings, such as the following:

• Entirely personal
• Entirely rental
• A mix of personal and rental
• Subject to passive loss rules
• Subject to hobby loss rules.

One must 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.

The panoply 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 home rentals.

August A. Saibeni, MS, CPA, is an adjunct professor of accounting, auditing and taxation at Cosumnes River College, Sacramento, Calif.

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