Is Rental Income From a Vacation Home Taxable?

Dear Carrie, 

My husband and I own a small vacation home. Since we only use it now and then and it's so easy to rent through sites like Airbnb or VRBO, we're thinking of doing that to make some extra income. What does this mean for taxes? 

—A Reader

Dear Reader, 

With short-term online rentals now ubiquitous—not only for vacations but also as "work from wherever" locations—more and more people are earning extra income by renting out their property part-time. However, while this can seem like an easy and practical thing to do—and the income can be a real boon—the tax rules can be mind-numbingly complex. 

In this column, I'm going to talk exclusively about renting out a vacation home—but you should be aware that the rules are different if you rent out your primary residence (or even part of it). And while I can give you some basics, I urge you to talk to your tax advisor so you understand exactly how the rules apply to your situation. You might also want to consult IRS Publication 527 for more detail. I don't mean to suggest you shouldn't give it a try. Just be aware of the rules before you start the process so you know what you're getting into. Here are some key points to consider.

Rental income in general is taxable. But the IRS gives you a small break if you rent your vacation home for 14 days or fewer in a year. In this case, your rental income is tax-free. You don't even have to report it on your tax return—no matter how much it is. Of course, this also means you can't deduct any of the expenses from renting the property on your tax return. If you go past the 14-day limit, you have to report your rental income and are subject to paying taxes on it. On the plus side, you can deduct rental expenses. 

But here's where it starts to get complicated because the amount of expenses you can deduct depends on whether the property is considered a personal residence or a business in the eyes of the IRS. And that depends on the proportion of personal use to the amount of time you rent the property. Here's how it works. Your property is considered a personal residence if you use it for more than the greater of 14 days OR 10% of the days it's rented. On the flip side, if you use the home less, it is considered a business property.

To make things a bit more confusing, the definition of personal use includes not only days you use the property but also days your family members use it, days you may have donated the use of the house, or days you rent it out for less than fair market value. So if you give your out-of-town relatives a generous break on the rent or donate two weeks to a local charity auction, that time would be considered personal use.

On the other hand, the days you spend at the house doing maintenance do not count as personal use. If you spend a weekend, a week, or even a month fixing up the property, that time is off the books.

The reason all of this is important goes back to taxes and expenses. If the property is considered a personal residence, you may be able to itemize and deduct things like mortgage interest and property taxes. But when it comes to expenses, you have to apportion eligible deductible expenses (i.e., cleaning, repairs, utilities) according to the amount of personal or rental usage. To determine the percentage of expenses you can deduct, you divide the number of days rented by the total number of days of usage (personal days plus rental days). 

Let's say you spent the month of June (30 days) at your vacation home. You've passed the 14-day limit. Even if you rent it out for 90 days the rest of the year, it's still considered a personal residence. To figure out what percentage of expenses are deductible, you'd divide 90 by 120 to get 75%. Therefore, you could deduct 75% of eligible expenses up to the total amount of the rental income. If your expenses exceed the rental income, you can't take a loss on a personal residence, but you may be able to carry excess expenses forward to the following year.

If you limit your personal use and your rental is considered a business, you may be able to deduct all eligible rental expenses and deduct losses up to $25,000 in the current or future tax years. 

In addition, you can recover the cost of income-producing property by depreciating the part of the property used for rental purposes. Bear in mind, though, that depreciation reduces your basis for figuring gain or loss on a later sale or exchange. In other words, a lower basis will potentially subject you to higher capital gains tax when you sell the property. 

State and local laws vary on sales taxes or hotel taxes even on short-term rentals. So you'll need to look into your own state and local government requirements. Also, it's prudent to check with your local authorities on permitting and HOA rules before renting out your property. Lastly, be sure to check with your homeowner's insurance provider to understand how renting out your home might affect your coverage.

Rental services like Airbnb generally submit a 1099 to the IRS reporting your rental income. So be sure to keep good records of your rental income as well as fees paid to the rental service and all your expenses. If you've rented out your home for more than 14 days, you generally have to file Schedule E with your income tax return.

As I said, the rules can be complicated but don't be discouraged by the details, just be prepared. And do talk to your tax advisor to make sure you have it all under control.

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.