Tax Strategy for the Week (June 14th, 2013)

Vacation Homes-Maximizing Deductions

Tax Issue

Any dwelling used for both personal purposes and rented out during the year is subject to special tax rules. The amount of rental expenses allowed as a deduction against rental income is based on an allocation between personal and rental use. The rental expense deduction for mixed use property may be further limited by the amount of rental income received each year, resulting in a potential disallowance and carry forward of excess rental expenses.

Applicable Tax Law

·        When a dwelling unit is used for both personal purposes and rented out during the year, treatment of income and expenses depends on the amount of personal use.

·        A dwelling unit includes a house, apartment, condominium, mobile home, boat, vacation home, or similar property if the property contains basic living accommodations such as sleeping space, toilet, and cooking facilities. A dwelling unit does not include property (or part of the property) used solely as a hotel, motel, inn, or similar establishment.

·        If a dwelling unit that is used by the taxpayer as a residence is rented out for 14 days or less during the year, rental income is not reported and rental expenses are not allowed.

·        If personal use of a dwelling is more than the greater of 14 days, or 10% of the days the unit is rented at fair rental value, the deduction for expenses is limited to rental income. A loss cannot be reported on the tax return. Expenses that are limited by this provision are carried over to future years.

·        Certain expenses are allowed in full for mixed-use property, including rental portion of deductible home mortgage interest, rental portion of real estate taxes, rental portion of deductible casualty and theft losses, and direct rental expenses such as rental agency fees.

·        Use of a dwelling unit by the taxpayer, family member, or any person who has an interest in the property is considered personal use for purposes of allocation expenses. An exception exists if the family member uses the dwelling as their main home and fair rental value is paid. Days spent working substantially full time on repairs or maintenance do not count as personal days.

·        Expenses are allocated between personal and rental based on the number of days during the year the unit is rented out. IRS publications state that the allocation is computed by dividing the number of days the property is rented out by the total number of days the unit is occupied. A more advantageous method has been allowed by the courts.

·        Deductions for mixed-use rental property are taken in the following order: (1) amounts allowed as deductions without regard to the rental use, such as mortgage interest and real estate taxes, (2) rental expenses that do not result in an adjustment to basis of the property, such as the rental portion of utilities and maintenance expense, (3) expenses that result in a basis adjustment, such as depreciation.

Tax Planning Strategies

Rental expenses are limited to rental income for a vacation home that is used personally more than the greater of 14 days or 10% of the days rented. The Tax Court has allowed a method of allocating rental expenses that is more advantageous to the taxpayer. Known as the Bolton method, this method allocates mortgage interest and real estate taxes based on the number of days in the year instead of the number of days the unit is actually used. This method allocates a higher amount of mortgage interest and real estate taxes to Schedule A, allowing a larger amount of other rental expenses to be applied against rental income.

Possible Risks

·        The Bolton method is generally more advantageous in the current year. The disallowed expenses carried forward as a result of using the IRS method may be more beneficial in future years to offset increased rents received or when the taxpayer is in a higher tax bracket.

·        The Ninth and Tenth Circuit Courts of Appeals have upheld the Bolton decision. Taxpayers residing in other districts could have the method challenged by the IRS.

·        When the taxpayer receives a greater deduction using the standard deduction, even after considering the increased Schedule A deductions, the benefit from the increased mortgage interest and real estate taxes allocated to Schedule A is lost. In this situation, using the Bolton method is disadvantageous to the taxpayer.

·        Taxpayers subject to the alternative minimum tax (AMT) may not receive additional benefits from the increased Schedule A deductions. In this situation, the taxpayer receives a greater benefit using the IRS prescribed method for allocating rental expenses and having a larger carry forward of unallowed rental expenses.

·        If the taxpayer is already deducting mortgage interest from two homes on Schedule A, the allocated mortgage interest from this third home is not deductible on Schedule A and would be a lost deduction. The allocated real estate tax is deductible on Schedule A.


Court Case:

The Tax Court allowed a method of allocating expenses for mixed-use property that was more advantageous to the taxpayer than the IRS prescribed method. The Boltons allocated mortgage interest and taxes based on a fraction, using the number of days in the year as the denominator, instead of the number of days the dwelling was occupied. They allocated other operating expenses, including depreciation, according to the IRS method using the number of days occupied. The Bolton method applied a smaller percentage to mortgage interest and taxes against the rental, which allowed a higher amount of other operating expenses to be applied against the income limit. Interest and taxes not deducted against the rental were allowed as itemized deductions. Even though the Bolton method applied a different computation to interest and taxes than it applied to other expenses, the Tax Court allowed the method because interest and taxes accrue evenly throughout the year, but other operating expenses are more closely connected with actual days of occupancy. (Bolton, 77 T.C. No. 104)

Bolton decision: Mixed-use property • Personal use 30 days, rented out 91 days= 121 days occupied • Gross rents $2,700 • Interest and property taxes $3,475 • Operating expenses $2,693