Welcome back as we continue discussing deductions.

In this video, we'll examine how to handle deductions related to vacation home rentals.

In general, recall that deductions are not allowed for personal expenditures.

In particular, personal expenses related to the home are also not deductible,

such as buying furniture or paying for maintenance or insurance on your house.

That is, if you use a property for personal purposes,

the only personal types of expenses that are deductible are limited to what's

available on schedule A related to

deducting home mortgage interest and real estate taxes.

Recall also that if you own a property and rented it out,

we would report the income and expenses on schedule E. In this case,

the expenses related to maintaining the property would be deductible.

However, what if you run into the situation where it's a little bit of both?

What if, for example, you own a vacation home on the beach?

Perhaps you use it for two months during the summer,

but also rent it out for two months.

There are, of course,

costs associated with maintaining the beach home.

You might pay for it to be professionally cleaned,

you might pay for lawn maintenance, insurance, and utilities.

How much of these costs are deductible for tax purposes,

and how much of the costs are not deductible?

Well, generally speaking, there are

three possible tax treatments for expenses related to properties.

First is if the property is primarily personal use.

A property is primarily personal use if it's rented out 14 days or less during the year.

Here, any rental income earned from the property is

actually entirely excluded from gross income.

But that also means that no rental expenses are deductible.

Here, the only expenses that are deductible are

the typical schedule A expenses of home mortgage interest and property taxes.

For example, let's say the Olympics comes to your town,

and you rent out your house for 10 days during the Olympics and charge $10,000.

The $10,000 rental income is entirely excluded from your gross income.

But if you incurred any expenses in renting out your home,

such as advertising expenses or you paid a lawyer to drop a rental contract,

those expenses are not deductible.

The only deductible expenses relate to your regular deductible expenses if you itemize.

So on the one side, we have primarily personal property;

at the other extreme, we have primarily rental property.

What does this mean if a property is primarily rental use?

Here it means that the property has been rented out

for more than 14 days during the year,

and it's not used for personal purposes more than the greater

of 14 days or 10 percent of the total days rented.

What happens here is the owner can deduct

all expenses allocated to the rental use of the property,

even if there is a loss.

As an aside, there may be some limits here,

known as passive loss limitations,

but that's beyond the scope of this course.

But generally, the expenses associated with maintaining the property,

including cleaning, maintenance, supplies, utilities, and depreciation,

are deductible against the rental income and may even generate

a net rental loss and be deductible against the property owner's other income.

Now, what if it's a little bit of both?

There's some personal use of the property,

there's also some rental use.

Here, it's considered mixed personal and rental use property.

If the property is rented more than 14 days and personal use

days exceed the greater of 14 days or 10 percent of days rented,

then the property owner has to allocate the rental expenses against

rental income and only deduct rental expenses to the extent of rental income.

This is similar to how hobbies are treated,

as we looked at in a previous video.

Also similar to hobbies,

the expenses are subtracted from gross rental income in the order of the three tiers.

Specifically, all expenses must first be classified into three tiers.

The first tier relates to expenses that would otherwise be deductible,

regardless of whether the activity was rental-related.

This relates to items, for example,

like home mortgage interest or property taxes that are deductible on

Schedule A regardless of

how much the person's property is being used for rental activity.

The second tier relates to expenses incurred for

the rental activity that does not affect basis, that is,

expenses that don't relate to depreciation of the property or equipment in the property,

like refrigerators, washing machines, and the like.

These are kind of like non-capital-based operating expenses.

So any expenses incurred for property insurance, supplies, advertising,

maintenance, cleaning, or real estate broker fees would all fit into tier two expenses.

Finally, we have tier three expenses.

These are expenses that do affect basis, namely depreciation expense.

Such an extent you have property or equipment that's subject to depreciation,

these expenses would be considered last.

This tiered structure is conceptually exactly the same as for hobbies.

However, unlike hobbies, the tiers one, two,

and three expenses related to the rental activity are deductible for AGI.

The personal portion of tier one expenses that do not pertain to the rental activity are

still deductible but as from AGI deductions if the taxpayer itemizes.

Importantly, unlike hobbies, the tiers two and three expenses are

not potentially disallowed if they do not exceed two percent of the taxpayer's AGI.

Here, the rental-related expenses are deductible for AGI against rental income.

Note that you can only deduct expenses for AGI that

are related to the rental portion of the property's activity.

So the big question now is,

how does the taxpayer allocate the cost between rental and personal days?

Here, for tier one expenses only, that is,

think mortgage interest and property taxes,

two methods are allowed.

The first is the IRS's method,

where expenses are allocated on the basis of total days used.

So here, the taxpayer has to take the number of days

rented divided by the number of days used for

either rental or personal use to figure out the percentage

of tier one expenses that are deductible for AGI.

The second method was approved by the Court in Bolton v. Commissioner in

1982 by the Ninth Circuit Court of Appeals

after the case was heard and decided in the Tax Court.

This is referred to as the Bolton method.

Here, the tier one expenses are allocated over the number of days in

the year rather than the number of days used.

So here the taxpayer would take the number of days

rented divided by the number of days in the year,

or 365, to figure out the percentage of tier one expenses that are deductible for AGI.

For tiers two and three expenses,

the taxpayer can only allocate the cost using the IRS method, again,

number of days rented divided by the number of days the property

is used for both rental and personal use.

In terms of process, the rationale follows just like for hobbies.

When a taxpayer goes through this calculation,

the taxpayer will start with gross income from the rental activity,

then the taxpayer will subtract tier one expenses.

If the net rental income amount remains positive,

then the taxpayer can go on and subtracted tier two expenses.

If the net rental income amount remains

positive after having subtracted tier two expenses,

then the taxpayer can go on and subtract tier three expenses.

If at any point the expenses exceed the remaining income,

the most in expenses that can be used in

the current year is how much net rental income is left.

Therefore, rental expenses cannot create

net rental losses for mixed personal and rental use properties.

Any losses in excess of rental income are disallowed.

That is, they cannot be claimed against other income of the taxpayer.

This is like a hobby.

However, unlike a hobby,

the net rental losses can be carried forward indefinitely to offset future rental income.

Let's turn back and look at this Bolton method a little bit more closely.

What usually happens when a taxpayer chooses

the Bolton method over the IRS method is that the share of

tier one expenses deductible for AGI will be

smaller under the Bolton method than under the IRS method.

Yes, smaller deductions for AGI.

So, a smaller deduction is allocated to rental income

from tier one expenses under the Bolton than IRS method.

So why would a taxpayer want to do that,

to choose to minimize their for AGI deductions for tier one expenses?

Well, if a taxpayer knows that he or she will be itemizing expenses,

then in effect the taxpayer might be indifferent whether

the tier one expenses are allocated for or from AGI.

The deduction will reduce gross income one way or another.

Where this does matter is that if the net rental income that is left

over after having deducted tier one expenses is now relatively higher,

because the Bolton method did not allocate very many expenses to tier one,

then there's more net rental income against which to

claim tiers two and three expenses against.

So here, tiers two and three expenses can only be allocated using the IRS method.

And recall if these expenses are greater,

then the net rental income after having subtracted out tier one expenses,

then they're disallowed for the current year,

although they are carried forward indefinitely to offset future rental income.

So in the end, what can happen is that under the Bolton method,

there will be more deductions claimed in total in the current year, that is,

expenses in all three tiers plus the larger

personal from AGI deductions using the Bolton method,

compared to the total deductions claimed using the IRS method for

all three tiers plus the lower personal from AGI deductions.

To recap, in this video,

we looked at how to differentiate rental activity between primarily personal,

primarily rental, and mixed personal and rental use,

and how rental expenses and losses are treated and allocated for tax purposes.

Vacation Home Rental Deductions

Federal Taxation I: Individuals, Employees, and Sole Proprietors

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