Allocation of Expenses

To figure your vacation-home deductions, you have to allocate expenses to personal or rental use. There are two ways to do this—the IRS method and another approach that has been approved in court cases—and the one that's best for you depends on your circumstances.

According to the IRS, you begin by adding up the total number of days the house was used for personal and rental purposes. Then figure the percentage of time it was used for rental. That's the percentage of total expenses you can deduct against rental income.

Let's say you have a cabin in the mountains that you use for 30 days during the year and rent out for 100 days. The 100 days of rental use equals 77% of the total 130 days the cabin was used during the year. Using the IRS formula, 77% of your expenses— including interest, taxes, insurance, utilities, repairs and depreciation—would be rental expenses.

The IRS is also particular about the order in which you deduct those expenses against your rental income. You deduct interest and taxes first, then expenses other than depreciation, and then depreciation. The sequence is important, and detrimental, because of the rule that limits rental deductions to the amount of rental income when personal use exceeds 14 days or 10% of total use. Remember that mortgage interest and property taxes not assigned to rental use could be claimed as regular itemized deductions instead. But by requiring you to deduct those expenses against rental income—that might otherwise be offset by depreciation you won't get to claim—the law squelches the write-off for taxes and interest as an itemized deduction.

By using a different allocation formula, though, you can limit the interest and tax expenses used to offset rental income and thereby boost the write-off of other rental costs. Courts have allowed taxpayers to allocate taxes and interest over the entire year rather than over just the total number of days a property is used. In the example above, assuming 100 days of rental use, that method would allocate just 27% (100 divided by 365) of the taxes and interest to rental income. That would leave more rental income against which other expenses can be deducted. The extra taxes and interest can be deducted as regular itemized deductions.

Although the court-approved formula can pay off when the 14-day/10% test makes the property a personal residence, the IRS version can be more appealing if the place qualifies as a business property. You

Any passive losses unused when you sell the property can be deducted against the profit on the sale or any other income.

need to look at the specifics of your situation to determine the best method for you and seek the advice of your accountant.

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