Will 2022 be the year of the vacation home?

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With some COVID-19 restrictions relaxing and others already lifted, the smell of tourism is in the air. Demand for leisure travel is skyrocketing, and the booking pace for travel in the northern hemisphere spring is 49% higher than this time last year, and 26% higher than pre-pandemic 2019 (according to AirDNA).

Meanwhile, more people are investing in vacation homes or second properties, especially as companies permanently transition to hybrid or fully-remote environments where employees can work from any place, in any season. No matter how you slice it, 2022 is going to be the summer of travel and consequently, the summer of booked-up rentals.

Pros and cons

Is it time to rent out your seasonal property? While the opportunity to generate additional income is tempting, letting strangers enter your personal space can be difficult, even as we anticipate endemic stages of COVID-19. What if your renters don’t respect the space like you do?

There’s a lot to consider, but you don’t have to go it alone. Many people hire a property manager, management company or real estate agent to help screen renters and protect the property. They can shoulder responsibility for everything from advertising and scheduling to maintenance and cleaning—especially if your vacation home is far away.

For the right guest, your home is a chance to make memories of their own by exploring a place that’s truly special. Here are some other tips to help you fully enjoy the perks of sharing your space.

Turning a profit & tax implications

Your rental property must bring in enough income to cover expenses and make a profit, and this might seem easy when the U.S. average daily rate (ADR) is expected to increase by 23% during Q2 (peaking at $295 in June), according to Lodgify data.

Just make sure you look before you leap, since the tax implications of renting can have a significant impact on your ROI.

If your second home is for personal use only and you never rent it, you can deduct mortgage interest the same way you do on your primary home. But when you rent it, you’ll feel the effects in your income and property taxes.

The deciding factor is how much time you spend at your second home, compared to the number of days that you rent it out. This determines whether the IRS considers it a rental property or a residence, which makes all the difference.

Defining your destination

So what IS your second home, as far as taxes are concerned? Here’s how the IRS defines some key terms:

A residence is a vacation home you either:

• Do not rent
• Rent for 14 days or less or
• Rent for more than 14 days and use for personal use more than 14 days or 10% of the rental days.

A rental is a second home that you rent for more than 14 days and your personal use is not more than 14 days or 10% of rental days.

Personal use is use by:

• You or anyone who has an interest in the home
• A family member, unless they rent it as their main home for fair market value
• Anyone who “swaps” a property with you
• Anyone who rents it for less than fair market value

Note that work days do not count as personal-use days. So, if you’re mowing the lawn and hammering shingles on the roof, it’s not considered a day of personal use, even if your spouse and kids are out on the boat doing the opposite of work.

Passive loss: Financial loss in a business where you do not “materially participate,” like owning a rental property.

Non-passive loss: Financial loss in a business where you participate in “a regular, continuous and substantial basis,” such as being on-site at your second home every day as the caretaker and property manager.

For all the details and definitions, visit irs.gov/taxtopics/tc415. But when in doubt, remember: 14 days or 10% of rental days are the magic “personal use” numbers that tip the scales. Don’t worry—next, we’ll explain what that means for you.

Rent for 14 days or less: Easy living

When you rent your property for 14 days or less, then you don’t have to report your rental income to the IRS. In that case, you’re made in the shade. Just keep in mind that in this scenario, you can’t deduct rental expenses; however, you can deduct property taxes and mortgage interest on Schedule A (see below for limits).

Rent for more than 14 days and use it even less: Mixed bag

Let’s say you rent out the family cottage for more than 14 days, but life gets busy and you only spend about a week there this year. In that case, the IRS considers your second home a rental property, which has its pros and cons. You have to report your rental income, but you may be able to deduct a prorated portion of your rental expenses based on the percentage of days you rent it out, and perhaps even report a rental loss on your tax return.

Here’s how you can figure out the percentage of days rented out:

(number of days rented out) + (number of days of personal use) = (total number of days the property was used)

Then:

(number of days rented out) divided by (total number of days used) = (percentage of days rented out)

For example, if you rented the house 80 days and used it 7 days, that’s 87 days that the property was used in total. Then, 80 divided by 87 is 92%. So, when you file your taxes, you can deduct 92% of the expenses—like repairs, management and cleaning fees, depreciation, taxes and utilities—against the rental income.

And depending on your adjusted gross income, you may be able to deduct passive rental losses or carry rental expenses over to the next year.

Rent for 14+ days and personally use even more: Win-win

Now imagine you’re able to spend a week at the cottage, and then another week, and even a few weekends in between. But there’s so much going on at home this year, you might as well rent the cottage out for the rest of the time.

In this best-case scenario, the IRS considers your second home a residence. That means you must report all rental income and can deduct a portion of rental expenses based on the percentage of days you rented the cottage as outlined above. Unlike with a rental property, you cannot report a loss on your tax return, though you can use the expenses to reduce your rental income to zero.

Be aware of property tax and mortgage interest caveats

Under current tax laws, you can only deduct $10,000 of property, state and local income taxes, which could reduce or eliminate the property tax deduction on your second home. In this case, consider renting for just long enough to make up what you lost, especially if you can earn that money back by renting your space for 14 days or less, and therefore avoid having to report the rental income.

Just remember, if you purchased your second home on or after December 15, 2017, you can only deduct the mortgage interest you pay on a home loan of up to $750,000 (combined mortgages of your primary and second home). But if you purchased your vacation home before then, you’re grandfathered into the $1 million threshold.

Do as the locals do

Be sure to brush up on local and state guidelines before listing your property. You may need to get a business license or register your vacation property depending on where it’s located. Some municipalities even collect taxes from vacation rentals as if they were hotels. And of course, second homes in a different state require you to file in that state and pay that state’s income tax based on their guidelines.

Keep track, sit back, and let the experts do the rest

If you’ve made the decision to rent, you’ll want to take advantage of every legal opportunity to reduce your tax liability to make it worth your while. Keep track and document every rental day, personal-use day and work day, and consult with a tax specialist to help you strategize the best way to rent out your vacation home—and enjoy it.

Anthony R. Scinto, CPA, is a Tax Partner and Chair of the Tax Department at Mengel Metzger Barr & Co.