Vacation Homes And More

The Tax Cuts and Jobs Act (TCJA) includes two important changes that can negatively affect vacation home owners, but you may be able to help clients limit the damage.

Limit on Property Tax Deductions

Before the TCJA, you could claim itemized deductions for an unlimited amount of personal (nonbusiness) state and local property taxes. For 2018-2025, the TCJA limits itemized deductions for personal state and local property and income taxes to a combined total of only $10,000 ($5,000 for those who use married filing separate status).

Limits on Home Mortgage Interest Deductions

The TCJA also places new limits on the amount of home mortgage debt for which you can claim itemized interest expense deductions.

Prior-Law Rules. Home mortgage interest that you can deduct is called qualified residence interest.  Before the TCJA, you could deduct the interest on up to $1 million of home acquisition debt (meaning debt you incurred to buy or improve a first or second residence) or $500,000 if you used married filing separate status. Before the TCJA, you could deduct the interest on another $100,000 of mortgage debt if the loan proceeds were used to buy or improve a first or second residence, or $50,000 if you used married filing separate status.

So, the debt limit for deductible interest under prior law was really $1.1 million, or $550,000 if you used married filing separate status. Under prior law, you could also deduct interest on up to $100,000 of home equity debt for regular tax purposes, regardless of how you used the loan proceeds. (For AMT purposes, however, you could only deduct the interest if the loan proceeds were used to buy or improve a first or second residence.)

TCJA Change for Home Acquisition Debt. For 2018-2025, the TCJA generally allows you treat interest on up to $750,000 of home acquisition debt (incurred to buy or improve a first or second residence) as deductible qualified residence interest. If you use married filing separate status, the limit is halved to $375,000.  Thanks to a grandfather provision for pre-TCJA mortgages (explained below), this change will mainly affect new buyers who take out large mortgages to buy places in high-cost areas.

TCJA Change for Home Equity Debt. For 2018-2025, the TCJA generally eliminates the prior-law provision that allowed you to treat interest on up to $100,000 of home equity debt, or $50,000 if you use married filing separate status, as deductible qualified residence interest.

TCJA Grandfather Rules for Up to $1 of Home Acquisition Debt. Under one grandfather rule, the TCJA changes do not affect interest deductions on up to $1 million of home acquisition debt that you took out: (1) before 12/16/17, or (2) under a binding contract that was in effect before 12/16/17, as long as your home purchase closed before 4/1/18.

Under a second grandfather rule, the TCJA changes do not affect interest deductions up to $1 million of home acquisition debt that you took out before 12/16/17 and then refinanced later-to the extent the initial principal balance of the new loan does not exceed the principal balance of the old loan at the time of the refinancing.

Prior-Law Rules Scheduled to Come Back in 2026. For 2026 and beyond, the more-generous prior-law rules for qualified residence interest are scheduled to come back into force.

Impact of TCJA on Vacation Properties Not Rented during the Year

If you own a vacation property that you don’t rent during the year, the property is treated as a personal residence for federal income tax purposes. Therefore, the aforementioned TCJA changes can reduce or even eliminate your allowable itemized deductions for vacation home property taxes and mortgage interest.

For instance, if you pay heavy property taxes and have a big mortgage on your principal residence, there may be no room to deduct any property taxes or mortgage interest for your vacation property. However, if you pay a higher interest rate on a vacation home acquisition mortgage, you can choose to deduct the interest on all or part that mortgage instead of deducting interest on an equal amount of your lower-rate principal residence acquisition mortgage (subject to the aforementioned limitations on home acquisition debt).

Vacation Homes Rented for Less Than 15 Days Still Qualify for Special Tax Break

A unique tax break is available if you rent your vacation home for less than 15 days during the year and use it for personal purposes for more than 14 days during the year. In this scenario, you need not declare a penny of the rental income from the vacation home, because the rental activity is completely disregarded for federal income tax purpose.

You report any allowable itemized deductions for property taxes and mortgage interest on your Schedule A (subject to the aforementioned limitations for 2018-2025). The only drawback is that you get no deductions for other expenses attributable to the rental period (such as cleaning costs). This beneficial tax-law quirk has survived for many years and is still available in the post-TCJA world.

Impact of TCJA on Mixed-Use Vacation Properties

The 2018-2025 TCJA limitations on itemized deductions for property taxes and mortgage interest can impact the tax results for a mixed-use vacation home (one that you use partly for personal purposes during the year and rent out for part of the year).

To understand how, you must first get up to speed on the complicated federal income tax rules for mixed-use properties.  Then you must figure out how the TCJA changes come into play.

Definition of Section 280A Vacation Home. Mixed-use vacation homes can be classified as either: (1) personal residences falling under the so-called vacation home rules of Internal Revenue Code Section 280A, or (2) rental properties.

The Internal Revenue Code Section 280A vacation home tax rules apply to homes that are:

1. Rented more than 14 days during the year, and
2. Used for personal purposes for more than the greater of 14 days or 10% of the days for which the home is rented at a fair market rate. This definition is found in IRC Sec. 280A(d)(l).

In other words, for your property to fall under the Section 280A vacation home rules for the year, you must rent it out more than 14 days and there must also be substantial personal use (as defined later) during the year. Properties covered by the Section 280A vacation home rules are not subject to the PAL rules [IRC Sec. 469(j)(10)].

To determine if your property is subject to the Section 280A vacation home rules, count only actual days of personal and rental occupancy. Ignore days of vacancy. Also ignore days that you as the owner spend principally on repair and maintenance activities.

Personal use generally means use by the owner, certain family members, and by anyone (family or otherwise) who pays less than fair market rental rates. Note that use by family members (defined as the owner’s brother, sister, spouse, ancestor, or lineal descendent) counts as personal use whether or not fair market rent is paid. The only exception is when the home is used by the family member as his or her principal residence and fair market rent is paid. [See IRC Sec. 280A(d)(3)(A).] This type of use is fairly unusual, but if it occurs, it is considered rental use rather than personal use.

If the home is used by another person under a reciprocal arrangement (“I use your vacation home for two weeks and you use mine for two weeks”), such use is considered personal use. This is the case whether or not fair market rent is paid by the other person and whether or not you pay fair market rent for your use of the other person’s property.

Example 1:  Vacation home tax rules apply.

Pete owns a vacation condo at the beach. During the year, he rents it out for 45 days. Pete and members of his family vacation there for another 30 days. The property is vacant the rest of the year except for three days at the beginning of winter and three days at the beginning of summer, which Pete spends maintaining the property. The condo falls under the Section 280A vacation home rules because it was:

1. Rented for 45 days, which is more than 14 days, and
2. Used for personal reasons for 30 days, which is more than 14 days and more than 70% of the rental days.

Days spent on repairs and maintenance are disregarded.

Variation: If there were only 10 days of personal use by Pete and his family, the condo would be considered a rental property rather than a personal residence subject to the Section 280A vacation home rules. The rules for vacation homes classified as rental properties are covered later.

Allocating Section 280A Vacation Home Expenses between Personal and Rental Use. Since Section 280A vacation homes are treated as personal residences for tax purposes, the TCJA limitations on itemized deductions for property taxes and mortgage interest can come into play for 2018-2025.  The fundamental tax principle for vacation homes is that deductible expenses allocable to the rental activity for the year cannot exceed the gross rental income for the year. In other words, the rental expenses cannot cause a tax loss for the year on Schedule E of your Form 1040. Gross rental income is net of direct expenditures to obtain tenants such as commissions paid to realtors or rental agents and advertising expenses. [See IRC Sec. 280A(c)(5) and Prop. Reg. 1.280A-3(d)(2).]

Since you use your vacation home for both personal and rental purposes, you can potentially treat some of the interest on the vacation home acquisition debt as deductible qualified residence interest, an itemized deduction claimed on Schedule A, subject to the TCJA limitations for 2018-2025. You can also potentially deduct some of the property taxes as an itemized deduction claimed on Schedule A, subject to the TCJA limitation on state and local taxes for 2018-2025. Allowable expenses allocable to rental use of the property are deducted on Schedule E. You need a procedure to allocate expenses between personal and rental use. The allocation procedure and the related tax return treatment are as follows:

Step 1: Allocate interest from vacation home acquisition debt and real property taxes using days of rental and personal use. Deduct the interest allocable to personal use on Schedule A (subject to the TCJA limitations). If any of the property taxes allocable to personal use can be deducted on Schedule A, put them on the form (subject to the TCJA limitation).

Note:  In many cases, none of the property taxes allocable to personal use will be deductible on Schedule A, because your annual limitation for state and local property and income taxes ($10,000 or $5,000 if you use married filing separate status) will be soaked up by deductions for state and local income taxes and/or state and local property taxes on your principal residence.

Step 2: Reduce the rental income by the rental-use percentage of interest on vacation home acquisition debt and real property taxes that could otherwise be claimed as Schedule A itemized deductions. Report the amounts allocable to rental use on Schedule E along with the gross rental income. However, the amounts you report on Schedule E cannot exceed the gross rental income. If they exceed the gross rental income, you can claim the excess interest and property taxes as itemized deductions on Schedule A (subject to the TCJA limitations).

Step 3: If there is any net rental income left after Step 2, offset the income with allowable deductions for other expenses allocable to periods of rental use (property insurance, utilities, maintenance, depreciation, etc.). Note that other expenses allocable to rental use can include mortgage interest that does not meet the definition of qualified residence interest (for example, interest on a loan that is not secured by your vacation home but the proceeds of which were expended on the vacation home or when the debt limits for qualified residence interest deductions are exceeded). However, all these other expenses allocable to rental use cannot exceed the remaining rental income after the subtraction in Step 2. To the extent these allocable other expenses exceed rental income after the subtraction in Step 2, the excess expenses are disallowed for the current year. Other expenses allocable to rental use that can be deducted in the current year are reported on Schedule E. Other expenses allocable to personal use are nondeductible and do not have any impact on your tax return.

Step 4: Follow the ordering rule to determine which specific other expenses allocable to rental use are disallowed by the rental income limitation.  Under the ordering rule, disallowed expenses consist first of any disallowed depreciation and then a pro-rata portion of any other disallowed expenses.

If depreciation is limited, the basis of the vacation home is reduced only by the allowed amount, if any.

Step 5: Carry over any disallowed other expenses allocable to rental use from Step 4 to your next tax year. In that year, the expenses are again subject to limitation based on that year’s rental income. This future-year limitation applies whether or not your property is subject to the Section 280A vacation home rules for the carryover year [IRC Sec. 280A(c)(5)]. If you sell the property, you can presumably use gain attributable to the rental-use portion of the property to “free up” all or a portion of prior-year disallowed expenses allocable to rental use.

Controversy Regarding Allocation of Interest and Taxes. The IRS position is that you should only use actual days of personal and rental occupancy to allocate all vacation home expenses [Prop. Reg. 1.280A-3(c) and (d)(3)]. As mentioned earlier, days devoted principally to repairs and maintenance are considered days of vacancy and are disregarded.

However, there is a controversy regarding the allocation of mortgage interest and property taxes that can otherwise be claimed as itemized deductions. Two Appeals Court decisions say owners can count actual rental occupancy days as rental days and all other days-including days the property is vacant-as personal days. Before the TCJA, using this method was usually beneficial because: (1) it allocates more mortgage interest and property taxes to Schedule A (where they could usually be currently deducted under prior law), and (2) it allocates less mortgage interest and property taxes to Schedule E, which allowed more of the other expenses allocable to rental usage (property insurance, utilities, etc.) to be currently deducted on Schedule E after applying the rental income limitation. [The two Appeals Court decisions are Dorance Bolton, 51 AFTR 2d 83-305 (9th Cir. 1982) and Edith McKinney, 52 AFTR 2d 83-6281 (10th Cir. 1983}.]

However, with the TCJA’s limitations on itemized deductions for mortgage interest and state and local taxes, this method may be counter-productive.

Example 2:  Allocating vacation home expenses.

Bill is a married joint-filer who owns a beach condo in Florida that is rented three months during 2021 at market rates, used by Bill and his family for two months, and vacant for the remaining seven months because it’s too hot and humid. The property is a Section 280A vacation home because it’s rented more than 14 days and used for personal purposes for more 14 days and more than 10% of the rental days.

Income and expenses for the year are as follow:

Using the five-step procedure explained earlier, the first step is to allocate interest and property taxes.  Using the Bolton/ McKinney method, 25% (3/12) of the interest and property taxes are allocable to rental use and 75% (9/12, which includes the months of vacancy) are allocable to personal use. $9,000 of interest and $1,500 of property taxes can potentially be deducted on Bill’s Schedule A.

The second step is to reduce the gross rental income by the mortgage interest and property taxes allocable to rental use. The $9,500 amount is reduced by $3,000 of interest and $500 of taxes. These amounts appear on Schedule E as rental expenses along with the $9,500 of gross rental income. At this point, the interest and taxes have been fully accounted for and there is $6,000 of gross rental income remaining ($9,500 – $3,000 – $500) to be offset by other expenses allocable to rental use.

In the third step, the $20,000 of other expenses are allocated between rental and personal use based on actual days of rental and personal occupancy.

• 60% (3/5 or $12,000) is allocated to rental and 40% (2/5 or $8,000) to personal. The $8,000 is nondeductible and has no effect on Bill’s tax situation.
• The $12,000 allocated to rental consists of $4,200 of depreciation (60% x $7,000) and $7,800 of other expenses (60% x $13,000) such as property insurance, utilities, maintenance, and so forth. Bill can currently deduct only $6,000 of that amount on Schedule E because of the rental income limitation. The remaining $6,000 of allocable rental expenses are disallowed for 2021.

In the fourth and fifth steps, Bill accounts for the $6,000 of disallowed allocable rental expenses by carrying that amount forward to his 2020 return . The carryover amount consists of $4,200 of depreciation and $1,800 of other expenses.

In this example, Bill’s 2021 Schedule E shows a net of zero: $9,500 of gross rental income – $3,000 of mortgage interest – $500 of property taxes – $6,000 of other expenses (no depreciation is included in the $6,000).

Bottom Line: When all is said and done, $10,500 of Bill’s $34,000 of vacation home expenses went to Schedule A, $9,500 went to Schedule E where they were currently deducted, $6,000 was carried over to 2022 for possible deduction on Schedule E, and $8,000 was permanently nondeductible. At first blush, this seems like a pretty good tax outcome, but the new TCJA limitations on Schedule A deductions for mortgage interest and state and local taxes could translate into a suboptimal outcome. See the following example.

Example 3:  Using IRS-approved method for allocating mortgage interest and property taxes yields better results after the TCJA.

As stated earlier, the IRS wants taxpayers to allocate interest on vacation home acquisition indebtedness and property taxes in the same fashion as other expenses, i.e. by using actual days of rental and personal use occupancy. So what happens if we do that for Bill from the preceding example?

Assume the same basic facts as in Example 2, except this time Bill uses the IRS method to allocate all of his 2021 vacation home expenses, including mortgage interest and property taxes. In addition, assume that Bill cannot claim any itemized deduction for the vacation home mortgage interest because he has an expensive principal residence with a big mortgage that uses up all of his home acquisition debt allowance. Finally, Bill cannot claim an itemized deduction for any of the vacation home property taxes because property taxes on his principal residence use up his entire $10,000 allowance for state and local taxes.

Using the IRS method to allocate all vacation home expenses results in allocating 40% of the interest and taxes ($5,600) to personal use with no resulting Schedule A deductions for the reasons stated above and 60% ($8,400) to Schedule E where the interest and taxes can be currently deducted against rental income.

The $20,000 of other vacation home expenses are also allocated 60/40 between rental and personal used based on actual days of rental and personal occupancy.

• 60% of the other vacation home expenses ($12,000) is allocated to rental and 40% ($8,000) to personal. The $8,000 allocated to personal is nondeductible and has no effect on Bill’s tax situation.
• The $12,000 of other expenses allocated to rental use consists of $4,200 of depreciation (60% x $7,000) and $7,800 of other expenses (60% x $13,000) such as property insurance, utilities, maintenance, and so forth. Bill can currently deduct only $1,100 of the $12,000 on Schedule E because of the rental income limitation ($9,500 rental income – $8,400 of allocable mortgage interest and property taxes). The remaining $10,900 ($12,000 – $1,100) of other expenses allocable to rental use is disallowed for 2021.

Bill accounts for the $10,900 of disallowed allocable rental expenses by carrying them forward to his 2022 return for possible deduction on Schedule E. The carryover amount consists of $4,200 of depreciation and $6,700 of other expenses.

Bottom Line: When all is said and done after using the IRS-approved allocation method for Bill’s $34,000 of vacation home expenses, $9,500 went to Schedule E and was currently deducted, $10,900 was carried over to the following year for possible deduction on Schedule E, $5,600 was nondeductible because of the TCJA limitations on itemized deductions for home mortgage interest and state and local taxes, and $8,000 of other expenses allocable to personal use were permanently nondeductible.

If Bill uses the Bolton/McKinney method explained in Example 2 to allocate mortgage interest and property taxes, $10,500 of those expenses would be nondeductible due to the TCJA limitations on itemized deductions for home mortgage interest and state and local taxes. Bill could currently deduct $9,500 of allocable rental expenses (including $3,500 of allocable mortgage interest and property taxes) against rental income on Schedule E; $6,000 of disallowed other allocable rental expenses would be carried over to the following year for possible deduction on Schedule E; and $8,000 of other expenses allocable to personal use would permanently nondeductible. Using the Bolton/McKinney allocation method would result in $18,500 of permanently nondeductible expenses ($10,500 + $8,000) while using the IRS-approved allocation method would result in only $13,600 of permanently nondeductible expenses ($5,600 + $8,000). The game has changed!

Impact of TCJA Increases to Standard Deduction Amounts on Section 280A Vacation Homes. Using the IRS-approved method to allocate more vacation home mortgage interest and taxes to Schedule  E might also be beneficial if your increased standard deduction amount ($24,800 for married joint-filing couples in 2020; $18,650 for heads of households; $12,400 for singles) would make using the alternative Bolton/McKinney method counterproductive. The Bo/ton/McKinney method shifts more interest and taxes to Schedule A, but if you still don’t have enough itemizable expenses to exceed your standard deduction, the amounts shifted to Schedule A will never deliver any tax benefit. Using the IRS method to shift more interest and taxes to Schedule Eat least preserves the possibility of a future tax benefit if the shifted expenses are not currently deductible due to the rental income limitation.

Conclusions on Section 280A Vacation Homes. The tax rules for mixed-use vacation homes were already complicated before the TCJA.

• The TCJA makes things even more complicated.
• Under the TCJA, your client might benefit from using the IRS-approved method for allocating mortgage interest and property taxes between personal and rental use. Run the numbers to find out.

Unchanged Tax Rules for Vacation Homes Classified as Rental Properties

This classification covers vacation homes that are rented for more than 14 days and for which personal use does not exceed the greater of 14 days or 10% of the rental days during the year. For tax purposes, such homes are considered rental properties-as opposed to Section 280A vacation homes.

For vacation homes that are classified as rental properties, mortgage interest, property taxes, and other expenses must all be allocated between rental and personal use based on actual days of rental and personal occupancy [IRC Sec. 280A(e)].

Example 4:  Determining when vacation home is classified as a rental property.

In 2021, Loretta rents her vacation home at the beach for 240 days and uses the property herself for 22 days. Since her personal use does not exceed the greater of 14 days or 10% of the rental days, the home is considered a rental property for the year.

Variation: If Loretta uses the home for 25 days, it would fall back under the Section 280A vacation home rules explained earlier.

Unlike a Section 280A vacation home, a vacation home that is treated as a rental property can generate a tax loss on Schedule E when allocable rental expenses exceed rental income. However, the loss may be subject to deferral under the IRC Section 469 passive activity loss (PAL) rules. As you know, taxpayers can generally deduct passive losses only to the extent of passive income from other sources (such as rental properties that produce positive taxable income). Disallowed passive losses from a property are carried forward to future tax years and can be deducted when there is sufficient rental income or when the property is sold.

A favorable exception allows current annual deductions for up to $25,000 of passive rental real estate losses incurred by taxpayers who “actively participate” and have AGI under $100,000. The $25,000 exception is phased out between AGI of $100,000 and $150,000.

Note: The IRS says the $25,000 exception doesn’t apply when the average rental period for a property is seven days or less, because the rental is then considered a “business” rather than a rental real estate activity [see Temp. Reg. 1.469-1T(e)(3)(ii)(A) and TAM 9505002]. In this scenario, the “business” losses are deferred under the PAL rules unless:

1. The owner has passive income from other sources, or
2. The owner materially participates in the “business” of renting the vacation property.

In some resort areas, the average rental period is seven days or less, and the $25,000 exception to the PAL rules is therefore unavailable. Then the taxpayer’s only hope for a current deduction may be to pass one of the material participation tests with respect to the vacation home rental activity.

Another problem: mortgage interest allocable to personal use of a residence treated as a rental property does not meet the definition of qualified residence interest for itemized deduction purposes. The qualified residence interest deduction is only allowed for mortgage interest on homes meeting the IRC Section 280A(d)(l) definition of a personal residence. To meet this requirement, personal use must be more than the greater of 14 days or 10% of rental days [IRC Sec. 163(h)(4)(A)(i)(II)]. Residences treated as rental properties fail this test by definition. As a result, the interest allocable to personal use is nondeductible personal interest pursuant to IRC Sec. 163(h).

Example 5:  Impact of classification as rental property.

As in Example 4, assume Loretta rents her beach home for 240 days and uses the property herself for only 22 days. Since her personal use does not exceed the greater of 14 days or 10% of the rental days, the home is considered a rental property. Therefore, Loretta must allocate all her vacation property expenses between personal and rental use using 240/262 as the rental-use fraction and 22/262 as the personal-use fraction. Accordingly, 22/262 of the mortgage interest from the beach house is nondeductible. The same is true for 22/262 of the other operating expenses (insurance, utilities, maintenance, depreciation, etc.). However, the personal-use portion of Loretta’s real property taxes can be deducted on Schedule A subject to the TCJA limitation on deductions for state and local taxes.

Loretta subtracts 240/262 of her total vacation home expenses (mortgage interest, property taxes, and other expenses) from rental income to determine if there is overall positive income or a loss. If there is a loss, Loretta must determine if it is limited by the PAL rules.

Loretta will be ineligible for the $25,000 PAL exception for rental real estate exception if the average rental period for her property is seven days or less or if her AGI is too high. Assume she strikes out on both counts and is unable to currently deduct her loss. In this circumstance, Loretta may be well-advised to squeeze in some extra vacation days. In fact, just three additional days of personal use would cause the property to slip back into the Section 280A vacation home category (she would have 25 personal use days which would exceed 10% of the rental days). This might allow Loretta to deduct all of her vacation home mortgage interest (part on Schedule E and part on Schedule A) and at least some of her vacation home property taxes (part on Schedule E and maybe some on Schedule A) while offsetting all of her rental income with expenses allocable to rental use. Client advice in that case: spend some more personal days at the beach house between now and yearend.

Variation: On the other hand, Loretta may have plenty of passive income from other sources.  Or she may have AGI below $100,000 and no problem with the seven-day rule. These circumstances should allow Loretta to currently deduct the full amount of her passive loss from the vacation property. If the amount of nondeductible personal interest expense will be nominal, the planning suggestion in this variation is for Loretta to minimize her vacation days in order to maximize the rental loss by maximizing the rental use percentage. Stay away from that beach house!

Tax Planning for Vacation Homes Classified as Rental Properties

As explained earlier, vacation homes treated as rental properties don’t qualify for the $25,000 rental real estate exception to the PAL rules if the average rental period is seven days or less. In this situation, the general PAL rule applies, which often means no current deduction for the vacation home rental loss.   However, there are two potential solutions to problems caused by the seven-day rule.

First, the property owner can try to take action to extend the average rental period beyond seven days. If successful, eligibility for the $25,000 PAL exception is restored. However, extending the average rental period is not possible in all markets. If not, the owner can attempt to materially participate in the “business” of renting the vacation property. If the material participation standard is met, the rental activity is a non passive activity for PAL purposes, and the homeowner can deduct his or her losses against taxable income from any and all sources.

Meeting the Material Participation Standard. Under Temp. Reg . 1.469-5T, the three most likely ways to meet the material participation standard for a vacation home rental activity that is treated as a “business” are when:

1. The owner does substantially all the work related to the property [Temp. Reg. l.469-5T(a)(2)].
2. The owner spends more than 100 hours dealing with the property and no other person spends more time than he or she does [Temp. Reg. l.469-5T(a)(3)].
3. The owner spends more than 500 hours dealing with the property [Temp. Reg. l.469-5T(a)(1)].

In attempting to clear these hurdles, the owner’s time and that spent by his or her spouse can be combined. Realistically, however, an owner who uses a property management firm to handle the details for the vacation home will be very unlikely to qualify.

Possible Negative NIIT Side Effect. While meeting the material participation standard for a vacation home with an average rental period of seven days or less will allow the homeowner to deduct the rental loss for regular federal income tax purposes (because the loss is transformed into a nonpassive loss}, it may have the unintended side effect of increasing the homeowner’s exposure to the 3.8% net investment income tax (NIIT) under IRC Sec. 1411. That is because a passive vacation home rental loss can be used to offset passive income that is subject to the NIIT while a nonpassive vacation home rental loss cannot.

In other words, nonpassive losses are almost always good for regular federal income tax purposes, but they may be counterproductive for NIIT purposes. That said, the homeowner will usually come out well ahead by meeting the material participation standard because the now-nonpassive vacation home rental loss will offset income that would otherwise be taxed under the regular tax rules at a rate that is far higher than the 3.8% NIIT rate.

Example 6:  Meeting the material participation standard.

Jane cannot take advantage of the $25,000 passive loss exception for rental real estate because her AGI is too high. She also has zero passive income. As a result, she has been piling up suspended passive losses from her vacation home rental property in Santa Fe, New Mexico.

However, Jane may be able to transform the rental activity into a “business” by reducing the average rental period to seven days or less. Then as long as meets one of the material participation standards, Jane can completely avoid the PAL rules and deduct the losses from the vacation home against her other income without limitation. (However, watch out for the potential NIIT side effect.)

Variation: Assume Jane’s property already has an average rental period of seven days or less. Therefore, it is ineligible for the $25,000 exception because the rental activity is a “business.”

Again, the solution for Jane is to meet one of the material participation standards. This would allow her to currently deduct her rental losses. (However, watch out for the potential NIIT side effect.)

Planning Personal and Rental Days for Vacation Homes with Significant Rental Use. Depending on the time of year when the vacation homeowner considers the tax issues explained in this analysis, the number of personal and rental days may still be up for grabs. When a vacation home is classified as a rental property, more rental days can lead to better or worse tax results, depending on the homeowner’s specific circumstances as illustrated in the preceding examples.