While many summer vacationers continue to make reservations at traditional resorts and hotels, many others seeking the "comforts of home" or looking to “live like a local” are booking short-term rentals through online marketplaces like VRBO and Airbnb. The trend is making short-term rental properties an increasingly attractive investment.
Owning a short-term rental can be a great way to generate passive income, as well as benefit from the appreciation in value common to many types of real estate investments. However, with the extra income comes the need to consider the potential tax reporting requirements, and the rules governing the taxation of rental income and determination of allowable expenses can be difficult to navigate.
Many vacation-home owners seeking to rent their property use third parties, like the online marketplaces, to manage their listings. Those companies will list your rental on their websites and collect the rental income from your tenants for a percentage of the rent, then pay you the net rental income. Effective January 1, 2022, the IRS requires those U.S. third parties to report gross earnings for U.S. hosts earning more than $600 in a calendar year. If your rental income exceeds the threshold you will receive a Form 1099-K from the listing company showing the income you earned for that year. These forms are useful in reporting income from a rental property to the IRS; still, you should track and maintain detailed records of all rental income earned for the year.
Keeping expense records
In addition to tracking and reporting income, there are many expenses that may qualify for a deduction on your tax return. These expenses, along with your rental income, are generally reported on Schedule E of Form 1040. In general, expenses are allowed to be deducted when they are ordinary and necessary for managing, conserving, or maintaining the property. Ordinary and necessary expenses are those that are common and would be expected when maintaining a rental property. A few examples of items that are listed on Schedule E include cleaning and maintenance, management fees, repairs, and utilities.
You should maintain detailed records, including invoices and receipts, that demonstrate the type of expenses and when they were incurred. Keeping adequate records is important in case your return is audited by the IRS. If you report deductions on your return but do not have records to back them up, those expenses could be disallowed; you also could be subject to penalties and interest.
IRS rules for reporting
Whether your piece of paradise is in the mountains or at the shore, there are special rules for reporting expenses for rental properties, which are based on how the property is used and classified by the IRS. If an owner does not personally use the property, the reporting is fairly straightforward. It is treated as a rental property and all income and expenses are reported on Schedule E. But when there is both personal and rental use, the property will fall into one of the following categories:
- Personal residence: If personal use is more than 14 days or 10 percent of the rental days, whichever is greater, and the property is rented less than 15 days, you generally are not required to report rental income and expenses on your return. You might be able to deduct mortgage interest and real estate taxes as an itemized deduction on Schedule A.
- Rental property with personal use: If personal use is less than 14 days or 10 percent of the rental days, whichever is greater, and the property was rented, or held out for rent, during the year, all rental income is reported on Schedule E, and expenses are prorated between personal and rental use. The personal portion of any real estate taxes can be included on Schedule A as an itemized deduction. Because the property is considered a rental property, mortgage interest allocable to personal use is considered personal interest and is not deductible.
- Dwelling unit used as a home: If personal use is more than 14 days or 10 percent of the rental days, whichever is greater, and the property is rented for more than 15 days, all rental income is reported on Schedule E and expenses are prorated between personal and rental use. However, certain rental deductions are limited to the gross income from the property. The personal portion of mortgage interest and real estate taxes may be deductible on Schedule A as an itemized deduction.
Ordering rules - Dwelling unit used as a home
Not only are expenses for rental property classified as a dwelling unit used as a home limited in terms of being tax deductible, they are also subject to ordering rules. The rental portion of mortgage interest, real estate taxes, and casualty and theft losses—items that would be deductible on Schedule A if the property had not been rented—are deducted first. If these expenses do not offset all of the income, the remaining operating expenses can be deducted up to the amount of income. As well, depreciation can be deducted if income still is in excess of operating expenses. Operating expenses and depreciation cannot produce a loss, but any expenses not allowed in the current year can be carried forward to future years until there is sufficient income to use them as deductions.
These and other IRS rules can make reporting income related to the rental of a vacation home challenging. There are many factors to consider if you are purchasing a vacation home or using an existing vacation home for rental income. The team of professionals at HBK CPAs & Consultants is experienced in planning for these issues and can guide you through the process.
For questions regarding tracking and reporting income and expenses, please contact your HBK representative.