August 16, 2012 : Jenna Bromberg - Past Contributor
How Renting Out Your Extra Bedrooms Affects Your Taxes
With hotel room rates skyrocketing during peak summer travel season, many savvy travelers have been seeking out alternative accommodations when they hit the road. The growing popularity of sites like AirBnB and Craigslist (which connect travelers and potential short and long-term tenants with the extra space in your home) have made the process of securing rentals easy for hosts and guests or tenants – and many home-owning Americans have used these sites to their advantage, turning themselves into mini-entrepreneurs when they figure out that renting out their extra space can generate some serious cash.
The savvy startup landlord or part-time ‘innkeeper’ plans in advance and may even realize that this could affect the tax return. Some sites matching travelers with hosts will make tax time a bit easier on you: AirBnB, for example, asks hosts to fill out tax information (e.g. W-9 form for property owners and lease holders in the U.S. or W-8 for specific international situations). At the end of the tax year, they’ll mail you the appropriate corresponding Form 1099 or Form 1042-S. But there’s more to consider.
If you’re thinking about renting space in your home, you probably have some questions about exactly how to handle that extra income come tax time. We turned to Lynn Wilson of The Tax Institute at H&R Block for some answers.
Block Talk: If I were to host paying guests in my extra bedroom through AirBnB or Craigslist, do I have to report the income I make to the IRS?
TTI: Possibly. Rental income is usually taxable under the Federal tax laws. But there is an exception if you rent out a home that you use as a home and the home is rented less than 15 days during the year. The exception is that rental income and rental expenses are not reported on your return at all. This allows a person to rent out his or her home for a short period of time with no tax consequences.
Expenses that you are otherwise allowed to be deducted as itemized deductions (such as qualified mortgage interest, real estate taxes, and casualty losses) and are still deducted on Schedule A under the normal rules if you itemize.
BT: How many days do I have to use the home to fall under this exception?
TTI: In addition to renting the home 14 or fewer days during the year, you must use the home for personal purposes more than the greater of 14 days or 10% of the total days it is rented to others at a fair rental price. This is no problem if you are temporarily renting out one spare room in a home that you live in. But for second homes or vacation homes, you need to keep track of your days. For example, if you use your beach home for 13 days and rent the home for 13 days, this special exception will not apply because you did not use the home for 14 days. So if you don’t want the hassle of reporting rental income and expenses on your vacation home, make sure you extend your vacation at least past 15 days.
BT: Oops! I couldn’t stop renting out my home and passed up the 15-day benchmark. Now what?
TTI: Now you start keeping track of rental income and expenses for tax time. If the home is rented for 15 days or more and is also used for personal purposes (but is not used as a home), then rental income and expenses must be reported. All the home expenses must be divided between personal and rental use. The rental portion of the expenses are all reported on Schedule E, but if there is a loss, the loss may be limited under the passive activity loss rules.
Many expenses apply to the entire home the entire year, such as homeowner’s association fees and insurance. For example, you can probably figure out how much mortgage interest and real estate taxes you paid for the year, but how much of that is personal and how much is rental? This depends on what you are renting. If you are renting out a spare room in a home that you live in, you will apply a fraction based on square footage. For example, imagine you found a roommate on Craigslist for an entire year. She is renting 1,500 square feet while your living quarters and common areas total 3,000 square feet. The fraction of the mortgage interest, utilities, or real estate taxes that is due to your roommate is one-third (1,500 sq ft / 4,500 sq ft). The expenses allocated to rental use are deductible as rental expenses on Schedule E. The expenses that are personal are deductible on Schedule A if they are otherwise deductible (such as qualified mortgage interest, real estate taxes, and casualty losses) if you itemize.
However, one catch is that if the property is used as a home (defined above), then deductible expenses are limited to rental income. This means you cannot have a rental loss that lowers the tax owed on your other income, even if the rental activity turns out to be more expensive than you originally thought.
BT: What if the property is not my primary residence, but a vacation home?
TTI: You will still allocate your expenses between rental and personal and report your rental income. Since we are renting the whole house, we cannot base the fraction on square footage. Again, we count days. But allocating expenses between rental and personal becomes a bit trickier if there are also days that are not rented or used for personal use. Now we have three categories of days: days rented, days used personally, and vacant days.
There are two methods for allocating rental expenses on residential real property used for both rental and personal use: the “IRS” method and the “Tax Court” method. The difference between these two methods is whether the vacant days are figured in the denominator.
- Under the IRS method, expenses are prorated using the ratio of the number of days rented at fair rental over the total of rental-use and personal-use days (total days used).
- Under the Tax Court method, the allocation ratio for mortgage interest, real estate taxes, and casualty losses as the days rented at fair rental value to the total number of days owned during the year (not just the days of use).
Believe it or not, the method picked for figuring the allocation of deductions between rental and personal can actually make a big difference on your return. The last thing not to forget is that rental expenses are again limited to the amount of rental income you receive if you use the home as a home.
BT: Do timeshares fall under a different set of rules?
TTI: Yes- timeshare owners generally must always report the rental income and expenses. When figuring whether or not you qualify for the exception that allows you to forget about reporting rental income or expenses, remember that you cannot rent the home out for more than 15 days. But the days rented actually are counted for the entire year, even if you only own a week or two. This means any days any other owners of your timeshare unit rent out their week are also counted. How do you know what the other owners are doing? That’s the problem. It is almost impossible to prove that the timeshare unit that you own a week or two is not rented less than 15 days for the entire year.
Even if you can overcome that problem, there is another problem. Remember that the exception to reporting rental income and expenses had two requirements. The second is that you must also use the home as a home to qualify for the exception. This means you have to use the timeshare at least two weeks in addition to being able to prove that the timeshare was rented less than 15 days.
BT: Got it. If I decide to rent, how much should I charge?
TTI: If you are reporting rental income on your tax return, you definitely want to charge “fair rental value” to prove you have a profit-seeking motive.
Fair rental value for a home can be learned by checking out the rent for other homes that are of the same size, location, and condition. If research reveals you are charging rent comparable to the other homes, you know this home is rented at fair rental value and you probably have a profit motive. Keep the research materials used, such as newspaper or online ads, with your other tax records.
If you are not charging fair rental value, the IRS can come back and say you are not renting the home with the intention of making a profit. This means rental expenses could be even further limited under the hobby loss rules.