The Surprising Effectiveness of Vacation Rental Tax Shelters
Vacation rental owners can actually have the best tax shelters, saving them money in taxes every year.
So, what is a tax shelter? Does your property qualify as one? Let’s explore the specifics of vacation rental tax shelters and how they could be beneficial upon tax time.
What Are ‘Vacation Rental Tax Shelters’?
Tax breaks for rental homes are often referred to as vacation rental tax shelters, and can generate big returns. Taxation of a vacation rental home is contingent on the combination of personal and rental use. If your home is rented often enough to be considered a rental property, you can claim this income as a tax deduction.
Real estate taxation can get complicated, with specific rules differentiating a rental property, vacation home, and residence. The IRS determines which category a given property belongs to based on the frequency it’s used and why. If your property is rented for less than 14 days a year, income made from said property is typically tax-free. However, you’ll pay taxes on property that’s rented out for more than 14 days a year.
Still, you’ll be able to deduct rental expenses from your taxes. This depends on how much you’ve personally used the home and rented it out. Let’s look at an example:
Perhaps you’ve rented out your home for 100 days this year and personally used it for 20 days. You’d divide 100 (the number of days you rented your home) by 120 (the total number of days it was occupied). This will give you 83.3 percent total, which is the amount you can deduct from taxes. Therefore, you’ve earned 83.3 percent of qualifying expenses in this case.
Ways Rental Properties Can Reduce Tax Burdens
Rental income is defined as “any payment you receive for the use or occupation or property.” It must be reported for any and all rental properties.
Looking for tax shelters? Here are some of the expenses you can deduct from your taxes as the owner of a rental property:
- Mortgage interest
- Property tax
- Operating expenses
- Ordinary and generally accepted maintenance expenses
As the owner of a rental property, it can be beneficial to deduct certain expenses from your taxes. However, you won’t be able to deduct home improvements and renovations as tax deductions. If your expenses are for bettering or restoring your property, these aren’t considered tax deductible. Rather, the cost associated with any improvements can be recovered under depreciation—which we’ll dive into next.
If you’re unsure of whether your repairs are eligible for tax deductions, you can check on the IRS website here.
Depreciation is basically the loss of value due to age, overuse, and damage. It’s safe to say that the vast majority of properties depreciate in value over time if their features aren’t maintained.
Luckily, you can harness depreciation as a homeowner to save yourself money in the form of a tax deduction. As depreciation deductions occur over time, you can begin deducting as soon as your property starts being used as a rental. After all, the best tax shelters are those that have a payout over time.
To calculate deductible depreciation, you can use the basis in your property, the determined recovery period, and chosen depreciation method.
Here are some ways to determine whether your rental property is eligible for depreciation:
- You own the rental property.
- The property is used to generate income.
- The useful life of the property can be determined.
- Your property is predicted to last over another year.
About Passive Loss Limitations
Passive activity alludes to taxpayer activity, such as renting a home, without material participation. In contrast, a nonpassive activity would be defined as a business transaction in which the participants work on a regular basis.
According to the IRS, passive losses often result in partners of a business experiencing passive income or losses from their partnership. Equipment leasing, rental real estate, and sole proprietorships are all examples of passive activities which could result in losses. However, certain exemptions allow rental home owners to deduct losses from rentals.
Exception: Active Participant
You could be eligible for a $25,000 deduction if either you or your spouse actively participates in real estate activity. While passive activity loss is generally disallowed, you may qualify to deduct up to $25,000 from nonpassive income sources. However, the total amount you can deduct from taxes is generally reduced if your gross income exceeds a certain level. If your gross income exceeds $150,000, your ability to claim an active participant deduction will be limited.
Exception: Professional in Real Estate
If you or your spouse is a real estate professional, you may be eligible for rental tax deductions.
Qualifying individuals have half of their personal services and over 750 hours in different real estate activities in which material participation is present. This rule allows each real estate activity that you materially participate in to be considered as separate endeavors, if you claim them as such.
In this case, you’ll need to report income or losses from real estate projects you’ve materially participated in as nonpassive income or losses.
Exception: Short-Term Rentals
Short-term rentals are typically defined as a rental which lasts one week or less, such as AirBnB rentals. Some AirBnB hosts take out AirBnB loans to fund their rentals. Due to this, the tax implications of being a short-term rental should be considered.
Many of these types of rentals have property managers which oversee most day-to-day activity and maintenance. If a management company is in place, property owners can fall into the category of passive activity losses with no material participation. However, if you can prove that you’re involved as a daily property manager, you’ll gain the title of active material participant. Then, you’ll become eligible for tax exemptions.
The importance of ‘Material Participation’
The IRS determines whether an individual is a material participant. This is based on whether they’ve participated regularly, on a substantial basis over the duration of a given year. If you participate in a real estate activity for less than 100 hours a year, you likely won’t be considered a material participant.
While any involvement in a real estate endeavor is generally considered participation, having too little activity won’t qualify you for material participation. If you fall outside this realm, you risk not qualifying for valuable tax deductions.
The importance of material participation is that it can be the qualifying factor to save you thousands of dollars in tax deductions. If you’re on the cusp of becoming a material participant, consider how much money you could save during tax season. Those extra hours you put in to pass the 100-hour threshold could be well worth the time investment.
Our final thoughts on tax shelters in vacation home rentals
Vacation home rentals could end up qualifying you for tax deductions for which you didn’t even know you were eligible. If you’re not just seeking a tax shelter but the best tax shelter, check on your rental properties before seeking tax exemptions elsewhere. Often, the payout will be substantial.
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Editorial Note: Any opinions, analyses, reviews or recommendations expressed in this article are those of the author's alone, and have not been reviewed, approved, or otherwise endorsed by any of these entities.