Rental Cottages and Limits on Federal Income Tax Deductions
It’s a dilemma that many cottage owners face: you want to earn extra money while away from your cottage but you are worried about the hassles that come with owning a rental property. It is well known that renting out a cottage is not without a few downsides. You must analyze many issues when deciding whether to rent your cottage, including whether you want to open up your personal space to guests, whether your cottage's insurance is affected by renting, and whether your cottage is truly in rentable condition. In addition to these general concerns, you may also be worried that the arrangement will create complicated tax consequences. Fortunately, with careful tax planning and analysis, you should be able to rent your cottage without a tax headache.
One of the most confusing aspects of renting a cottage is determining how the rental deductions are treated for federal income tax purposes. Different tax rules apply depending on the breakdown of personal and rental use of the cottage. Thus, simply put, the amount of time that you spend at your cottage determines the extent to which your cottage expenses are deductible.
Mixed Personal Use and Rental Use of Cottage
1. Mostly Rental Use:
Where a cottage owner uses the cottage for personal purposes for less than the greater of 14 days or 10% of the time that the cottage is rented, then the cottage is treated as a rental property for tax purposes. The cottage will not be treated as a personal residence, and thus, a cottage owner can typically deduct many of the rental expenses associated with the cottage. Common rental expenses include the following:
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As for the limits on the deductibility of these expenses, those rental expenses that are purely attributable to rental activities like advertising costs and expenses are fully deductible.
Alternatively, those expenses that are attributable to general cottage maintenance and ownership, like property taxes, depreciation, and utilities, will be divided into personal expenses and deductible rental expenses in proportion to the rental use of the cottage. Apportionment of these expenses is accomplished based on a fraction of the total, the numerator of which is the number of days the home is rented at fair rental, and the denominator of which is the total number of days the home is used for any purposes. For example, if a cottage owner spends 50 days at his Lake Michigan cottage during the summer but rents out the cottage for a total of 75 days over the course of the rest of the year, then the cottage owner should be able to deduct 60% of the cottage's apportioned rental expenses as trade or business expenses.
Unfortunately, apportionment is not the only step on the road to determining the total amount of deductions to which you are entitled for renting your cottage. Under the so-called "at-risk rules," you can only deduct losses attributable to your cottage rental up to the amount that you have “at risk” - ie: the amount of money that you could actually lose in the cottage rental. If your ability to deduct losses is limited because of the at risk rules, these losses are can be carried forward to future tax years.
Finally, the IRS considers rental activities to be a “passive activity,” meaning that the Internal Revenue Code's passive activity loss limitation rules will apply. In general, rental losses will only be deductible up to the extent that you earn rental or other passive income. Any losses that were not deductible in the current year because of this limitation are carried forward to the next year. There is a limited exception to this rule for certain cottage owners who are more active in the management of their cottage rental activities.
2. Mixed Personal and Rental Use:
Where a cottage owner rents the cottage for more than 14 days each year but also uses it for personal purposes for the greater of at least 15 days each year or 10% of the total time the cottage is rented, then the rental income from the cottage will be taxable income that needs to be reported on the owner’s tax return.
As far as tax deductions are concerned, not only do the previously discussed apportionment rules apply, but a cottage owner is also only allowed to take rental deductions to the extent that he or she actually earns income from renting the cottage. On the plus side, because your cottage qualifies as a personal residence, you can still generally deduct the mortgage interest for the cottage if you treat the cottage as your second home.
3. Mainly Personal Use:
This is one of the few "free passes" in the Tax Code. If a cottage owner uses the cottage as a personal residence and only rents it out for 14 or fewer days each year, then the owner does not need to report any of the rental income earned during those days as taxable income on a tax return. The only downside to this treatment is that expenses incurred in connection with renting the cottage are generally not deductible. This exception is explained in more detail in a previous blog post: Tax Free Income For Up to 14 Days Rental of Personal Residence.
The Alternative Minimum Tax
Rental cottage owners should also consider the effect that cottage ownership will have on their Alternative Minimum Tax (AMT) liability. Generally speaking, the AMT is calculated (1) by computing a person’s regular income tax, (2) by working backwards to increase a person’s regular taxable income by disallowing certain deductions and adding previously excluded items of income, and (3) by applying the AMT tax rates to the newly computed amount of taxable income. If a cottage owner’s tax liability under the AMT system is higher than his or her regular tax liability, the cottage owner must pay the higher amount. Because owning a rental cottage may cause a taxpayer to receive extra federal income tax deductions for real estate taxes, depreciation, and passive activities, the AMT may apply and may eliminate the benefit of these extra deductions.
This information is intended only as a basic introduction to some of the tax issues that cottage owners who rent out their properties face. Because these rules are so complex, and a matter of one day can make a difference on your tax liability, substantial planning opportunities exist. Please feel free to contact Varnum if you would like to determine whether you will be subject to any tax consequences from owning a rental cottage.
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