If you own a home in a vacation locale – whether it is your primary residence or a vacation home – and are considering renting it out to others, there are complicated tax rules, referred to as the “vacation home rental rules,” that you need to be aware of.
Generally, the tax code breaks a “vacation rental” into three categories, each with a different treatment for income and expenses:
- Rented Less Than 15 Days – If you rent your home for less than 15 days during the tax year, the tax code says that you do not need to report the income and you can still deduct 100% of the property taxes and qualified mortgage interest as an itemized deduction. Yes, you heard me correctly: the government is actually allowing you to ignore the income, regardless of the amount, if you rent the home for less than 15 days during the year. This rule offers some opportunities for substantial tax-free income, especially for more expensive homes. Here are some examples:
- Rental as a film location – typically, film production companies will pay substantial amounts (thousands per day) for the short-term use of homes as movie sets. Individuals with unique properties can register with a local film location company.
- Home in a vacation locale – individuals with homes in a popular tourist or vacation locales can rent their homes out to vacationers in their area while they are on vacation themselves.
- Home in the area of a special event – when a one-time or special event such as a major sports event (think the Super Bowl) or convention comes to town, hotel rooms may be scarce or even fill up. Homeowners in these locations may want to rent their homes short-term during the activity while getting out of town to avoid the crowds.
However, be careful; if the rental goes over 14 days, the income is no longer tax-free. When calculating the number of days, the definition of a day is generally “the 24-hour period” for which a day’s rental would be paid. Thus, a person using a dwelling unit from Saturday afternoon through the following Saturday morning would generally be treated as having used the unit for seven days even though the person was on the premises on eight calendar days.
- Rented 15 Days or More – When the home is rented 15 days or more, the income must be reported. However the tax treatment depends upon how many days you used the home personally:
- Personal Use More Than 10% of the Rental Days – If your personal use of the home totals more than 10% of the rental days, the expenses are allocated according to personal versus rental days. In figuring your rental profit, the expenses must be deducted in the following order: allocated taxes and interest first, then maintenance and other cash expenses, and, finally, depreciation. However, the net result is limited to zero; i.e., a loss cannot be claimed.
- Personal Use 10% or Less of the Rental Days – If your personal use of the home totals 10% or less of the rental days, the expenses are allocated according to personal versus rental days in the same manner as when the personal use exceeds 10% except that a loss is allowed, but the loss cannot include any amount attributed to depreciation.
When figuring the personal use days, include days used by an owner, co-owner, or family member of the owner/co-owner and days used under a reciprocal arrangement. However, you can exclude “fix-up” days, which are days spent repairing and maintaining the property.
With people living longer, many individuals find themselves becoming the care provider for elderly parents, spouses and others who can no longer live independently. When this happens, questions always come up regarding the tax ramifications associated with the cost of nursing homes or in-home care.
Generally, the entire cost of nursing homes, homes for the aged, and assisted living facilities are deductible as a medical expense if the primary reason for the individual being there is for medical care or the individual is incapable of self-care. This would include the entire cost of meals and lodging at the facility. On the other hand, if the individual is in the facility primarily for personal reasons, then only the expenses directly related to medical care would be deductible, and the meals and lodging would not be a deductible medical expense.
As an alternative to nursing homes, many care providers are hiring day help or live-in employees to provide the needed care at home. When this is the case, the services provided by the employees must be allocated between household chores and deductible nursing services. To be deductible, the nursing services need not be provided by a nurse so long as the services are the same services that would normally be provided by a nurse, such as administering medication, bathing, feeding, dressing, etc. If the employee also provides general housekeeping services, then the portion of the employee’s pay attributable to household chores would not be a deductible medical expense.
Household employees, like other employees, are subject to Social Security and Medicare taxes, and it is the responsibility of the employer to withhold the employee’s share of these taxes and to pay the employer’s payroll taxes. Special rules for household employees greatly simplify these payroll withholding and reporting requirements and allow the Federal payroll taxes to be paid annually in conjunction with the employer’s individual 1040 tax return. Federal income tax withholding is not required unless both the employer and the employee agree to withhold income tax, but the employer is still required to issue a W-2 to the employee and file the form with the Federal government. A Federal Employer ID Number and a state ID number must be obtained for reporting purposes, and most states have special provisions for reporting and paying state payroll taxes on an annual basis similar to the Federal reporting requirements. Note: if the caregiver is hired through an agency, generally the agency is considered the employer.
To the extent the payroll taxes are for deductible nursing services, the employer’s portion of those taxes is also deductible as a medical expense.
Correspondence from the IRS has a tendency to escalate a taxpayer’s pulse rate. However, most of the letters received are not of the feared “come on down” type that requests an appearance for a face-to-face audit; they would be more likely to just require a written explanation. Generally, all types of income (wages, interest, dividends, etc.) are reported by the payer to the IRS, which, in turn, matches the reported income to the recipient’s tax return based on Social Security number (SSN). Over the past few years, the IRS has become very proficient in using its matching software to pick up unreported income and other discrepancies on tax returns. Discrepancies will generate an IRS inquiry, so in addition to income, take note of the following items which are frequently monitored by the IRS computer:
- Dependent SSN – The IRS allows only one taxpayer to claim the exemption for a dependent. Frequently, a dependent will claim the exemption himself or herself, or in other cases, separated or divorced individuals will both attempt to claim the dependent. Expect correspondence when the exemption for any SSN has been claimed twice.
- Gross Proceeds of Sale – All brokerage firms are required to report security sales to the IRS as “gross proceeds of sale” on Form 1099-B. The 1099-B copy provided to the account owner is generally combined with interest and dividend reporting requirements and included in a consolidated 1099 statement. These statements can be confusing, and the “gross proceeds of sale” line is frequently buried in the multi-page statements. If a taxpayer fails to report these security sales, the IRS will treat the gross proceeds as all profit, recompute the tax owed and send a bill.
- Stock Basis – For stocks purchased beginning in 2011, the IRS requires the brokerage houses to track the cost of the stock and report that information on Form 1099-B when the stock is ultimately sold, so the IRS can then verify profit or loss.
- Pension and IRA Rollovers – Unless it is a direct (trustee-to-trustee) rollover, the plan administrator is required to issue a Form 1099-R whenever a taxpayer withdraws funds from an IRA or other type of qualified plan. If the 1099-R income is not properly accounted for on the tax return, the IRS may treat it as unreported, taxable pension income and issue a revised tax bill. Even if it is directly rolled over, ALWAYS bring rollovers to our attention.
- Alimony – The person paying alimony must include the recipient’s name and Social Security Number with the deduction claimed for alimony payments. The IRS will match the payments to income reported by the recipient. If the two amounts are not the same, the IRS will initiate correspondence to both parties.
- Home Sales – Technically, escrow companies are not required to issue 1099-S forms to taxpayers who sell their primary residence for less than the home sale gain exclusion amount and certify that they meet the exclusion qualifications ($250,000 for a single taxpayer and $500,000 for married taxpayers). Despite this, many escrow companies choose to issue them, making it necessary to report the home sale on the seller’s tax return to avoid IRS correspondence.
- Home Mortgage Interest – Since all lenders who are in the business of lending money are required to report home mortgage interest, the IRS can verify the amount claimed as deductible mortgage interest on Schedule A of a tax return, and any significant discrepancy can lead to IRS correspondence. If a private party holds the loan (not in the course of business), Form 1098 is not required to be filed, but the taxpayer claiming the mortgage interest as a deduction is required to include that party’s name, contact information and SSN on Schedule A. The IRS can then match the claimed interest deduction to the amount reported by the private party as interest income. However, if a third party lent money to the taxpayer to purchase the home, the third party’s information is not required.
- Education Benefits – Colleges and universities are required to report the tuition payments that may qualify for the American Opportunity or Lifetime Learning tax credits on Form 1098-T. Educational lenders report the amount of student loan interest paid on Form 1098-E. Both are used to match against claimed deductions and credits on the tax return
Bay Area Tax Attorneys – Self-employed taxpayers should consider their options carefully when it comes to applying tax benefits for their own education tuition and expenses.
Tax law provides multiple ways to benefit from the educational expenses and one may provide more benefit to you than another based on your particular set of circumstances. In addition, your tuition may qualify for one tax benefit while other education expenses qualify for another.
• As a Business Expense – Generally, if the education qualifies, it is better to take the cost as a business expense since as a business expense it will offset both income taxes and self-employment tax. The expenses can include tuition, books, supplies, and allowable travel for the education. To qualify as a business expense, the education must either be to maintain or improve your skills or be required in your business. You may, however, not wish to use the education’s costs as a business expense when doing so limits your net profit and consequently limits your retirement plan contribution. Another situation when you may not want to claim the education costs as a business expense is when your Schedule C only has a very small profit or shows a loss for the year.
• As an Adjustment to Income – If the education expense is tuition at an institution of higher education and you are under the AGI phase-out limit for this deduction, you have the option to deduct up to $4,000 as an adjustment to overall income for the year. You can take this above-the-line education deductionwhether or not the education maintains or improves your skills required in your business. Other expenses related to this education such as books, supplies, and travel can still be deducted on your Schedule C as long as the education maintains or improves your skills required in your business. The deduction is a maximum of $4,000 if AGI does not exceed $65,000 ($130,000 for married couples filing jointly) or a maximum of $2,000 if AGI doesn’t exceed $80,000 ($160,000 for married joint filers). This provision is scheduled to expire at the end of 2013, unless extended by Congress.
• As a Tax Credit – As with the adjustment to income above, if the education expense is tuition at an institution of higher education, you might qualify for the lifetime learning credit. It may be more beneficial than the business expense or AGI adjustment for the tuition portion of the expenses, especially if you are in a lower tax bracket or the business profits are low. The lifetime learning credit allows you a credit of 20% of the cost of your tuition (up to $10,000 of costs annually) as a tax credit. It, too, has an AGI phase-out limitation. For 2013, the credit for single taxpayers phases out between $53,000 and $63,000 and $107,000 to $127,000 for joint filers. The phase-out ranges are inflation adjusted each year. Please call this office for the phase-out ranges for years other than 2013. If you meet the full-time student requirement, you may qualify for the more beneficial American Opportunity credits.