If you’ve ever considered renting out your family’s vacation home, or your personal residence, you’re in luck! The IRS has special provisions in the tax code for both vacation home rentals and the short-term rental of your personal residence that could result in you receiving tax-free income.
There is a special section in the Internal Revenue Code known colloquially as the “Augusta Rule”. If you own a vacation property or reside in a highly desirable location, you can choose to rent your residence out for fourteen days or less and collect the rental income tax–free. The only caveat is that the total amount of income received must be deemed reasonable. For example, you cannot rent your home for $1,500 per night when the local market rates are only $500 per night.
For the purposes of this tax section, a residence is defined as any dwelling unit used for personal purposes more than 14 days, or more than 10% of the number of days during the year the unit is rented at a fair rental price. For example: if you rent your home for 14 days, you would have to use it for personal purposes for 1 day to qualify for treatment as a personal residence. If the home qualifies as a residence, and as long as you do not exceed 14 total rental days during the year, you do not have to report the income on your tax return.
Unlike a regular rental business, if you qualify under this exclusion you cannot take any of the home’s expenses as a rental deduction on Schedule E of your personal tax return. The reason for this is this specific rental activity does not qualify as a business for income tax purposes to be reported. Therefore the expenses are considered personal and nondeductible. However, you can still take the mortgage interest and real estate taxes as an itemized deduction on Schedule A to the extent allowed, as well as home office deduction if applicable.
What happens if you exceed 14 rental days?
The rules are a bit more complicated. Step one is you must determine how many days the property is used for personal use. If the property is used for personal use during the year for the greater of 14 days or 10% of the fair rental days, then the property qualifies for “vacation home” treatment and the rental expenses will be limited to the rental income generated. If the property does not meet the “vacation home” criteria, and wasn’t used for enough personal days during the tax year, it would be reported as a regular rental property on Schedule E.
If the property does qualify as a vacation home, step two is to allocate the applicable expenses of the home for the tax year on a pro rata basis between personal and rental use based on the number of days used/rented. After allocating the expenses between rental use and personal use, the rental portion of the deductions is allowed only to the extent rental income was generated. Essentially, if the rental activity generates a profit, it must be reported as income, but if the activity generates a loss, the loss is not deductible. The best you can do is report a zero net profit. The allocable personal portion of the real estate taxes and mortgage interest are still reported as an itemized deduction on Schedule A, to the extent allowable.
Moreover, the IRS has a generous definition of personal use. It is generally defined as:
- property used by a taxpayer or spouse,
- another person with an interest in the unit,
- or any family member of the taxpayer or other person with an interest in the unit
The above definitions all qualify as personal use days under the vacation rental guidelines. Note: this does not apply if the property is rented under a rental arrangement at a fair rental price, and is being used as the tenant’s principal residence, regardless if the tenant is related to the property owner.
What’s the one piece of information to take away?
Go rent your personal residence for 14 days or less and use that money to go on an income tax-free vacation!
Consult your tax advisor for questions about your specific situation.
by: Heather Mallette, CPA