As Americans look to save money on vacations, one of the best alternatives is to book a stay at a vacation home rental. Short-term rentals can save travelers on lodging and food expenses while offering a nice place to relax in-between activities. These factors, combined with the influx of remote workers, have created a popular trend in real estate investing.
Vacation home rentals are properties commonly leased to travelers planning a longer stay. They are fully furnished, typically with a small kitchen stocked with basic cooking essentials to prepare a meal and make a morning cup of coffee. Towels, bedding, and other amenities are also included, depending on the host. Property owners often set daily prices based on the season, or even the day of the week. Savvy owners research the market to set prices and maximize profits.
While the vacation rental marketplace may seem like a great place to invest, there are things to consider before taking the next step. Market fluctuations, tax rules, changes to local laws, and unexpected costs can impede an investor’s financial planning.
Research the market.
Talk to people in the community to learn about the real estate market, especially if investing in a tourist area. Take time to learn about local laws in effect, and those being considered, regarding rental properties.
Evaluate risk assessment.
Renting to strangers brings certain risks as far as injury or property damage. Creating a limited liability company can shield owners’ personal property from lawsuits, particularly those suing for an amount that exceeds that which is covered by liability insurance.
Determine the proper amount of insurance for the property. Accidents happen. Whether caused by a tenant, a break-in during vacancy, or burst water pipe, damage to the property may also result in lost revenue. While it’s important to purchase the optimal coverage, insurance companies can also offer advice on ways to minimize risk for short-term rentals.
Inflation affects expenses.
Property taxes: Lender rates tend to be higher for secondary properties. In addition, appraisals will go up if the property is located in a “hot market.” When estimating payments, the property tax should be based on the local rate multiplied by the expected purchase price, not the current amount.
Insurance: Most homeowner’s insurance plans don’t cover vacation rentals. Property owners should seek to purchase landlord insurance or vacation rental insurance that covers rental properties. When budgeting expenses, keep in mind that insurance rates tend to rise along with inflation.
Utilities and services: Property owners should factor in potential energy increases when evaluating the rental rate charged to tenants. Aside from a rise in utility expenses, landscaping services can also become more expensive due to increased fuel costs and labor shortages.
IRS codes and tax rules.
The 14-day or 10% rule:
If the owner utilizes the property for more than 14 days, or 10% of the number of days the home is rented, whichever is greater, the IRS will consider the property a personal residence and not allow rental loss to be deducted. On the flip side, rental up to the level of rental income, as well with as property taxes and mortgage interest, can still be deducted.
Defining personal use:
- The property owner or any other person who has an interest in the property
- A family member (or of the family of a person who has an interest in it) unless they use the property as their primary residence and pay the fair rental price
- Anyone under an agreement that lets the property owner make use of another residence (trade out)
- Anyone paying less than the fair rental price
It is important to document days used on a personal level. Make additional notes, if staying at the property to perform maintenance, as these days do not count toward the 14-day mark.
Determining deductible rental expenses: If property owners use a vacation property for both rental and personal purposes (more than 14 days, each), they must divide their expenses for the property based on the number of days used for each purpose. For example, if the property was rented for 150 days and personally used for 40, only 150 ÷ 190 (79%) of the expenses can be deducted as rental expenses.
Minimal Rental Use: There is a special and important rule if the property owner uses a dwelling unit as a residence and rents it for fewer than 15 days. In this case, it is not necessary to report any of the rental income or deduct any expenses as rental expenses.
It’s important to create a strategy when looking to purchase a vacation rental property. Owners who understand vacation rental tax deduction rules could save thousands annually. For a more in-depth overview, IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes), gives an overview of the most common costs and when they can be deducted and is an excellent source to review additional rules to know when considering purchasing a vacation rental property.
Note: These guidelines are not an all-inclusive list and are not intended to be used as advice outside of professional consulting.
Author, Dov Neuhaus, CPA
Senior Tax Manager
Any accounting, business or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.