The IRS has released much-anticipated temporary and proposed regulations on the capitalization of costs incurred for tangible property. They impact how virtually any business writes off costs that repair, maintain, improve or replace any tangible property used in the business, from office furniture to roof repairs to photocopy maintenance and everything in between. They apply immediately, to tax years beginning on or after January 1, 2012.

These so-called “repair regulations” are broad and comprehensive. They apply not only to repairs, but to the capitalization of amounts paid to acquire, produce or improve tangible property. They are intended to clarify and expand existing regulations, set out some bright-line tests, and provide some safe harbors for deducting payments.

The regulations are an ambitious effort to address capitalization of specific expenses associated with tangible property. The regulations affect manufacturers, wholesalers, distributors, and retailers—everyone who uses tangible property, whether the property is owned or leased. The rules provide a more defined framework for determining capital expenditures.

Most taxpayers will have to make changes to their method of accounting to comply with the temporary regulations and will need to file Form 3115. Taxpayers who filed for a change of accounting method following the issuance of the 2008 proposed regulations will probably have to change their accounting method again.

The IRS has promised to issue two revenue procedures that will provide transition rules for taxpayers changing their method of accounting, including the granting of automatic consent to make the change. The regulations require taxpayers to make a Code Sec. 481(a) adjustment; this means that taxpayers will have to apply the regulations to costs incurred both prior to and after the effective date of the regulations.

The new regulations provide rules for materials and supplies that can be deducted, rather than capitalized. The rules provide several methods of accounting for rotable and temporary spare parts, and allow taxpayers to apply a de minimis rule so that they can deduct materials and supplies when they are purchased, not when they are consumed.

Costs to acquire, produce or improve tangible property must be capitalized. The regulations address moving and reinstallation costs, work performed prior to placing property into service, and transaction costs. Generally, costs of simply removing property can be deducted, but costs of moving and then reinstalling property may have to be capitalized.

To determine whether a cost incurred for property is an improvement, it is necessary to determine the unit of property. Generally, the larger the unit of property, the easier it is to deduct expenses, rather than have to capitalize them. The regulations provide detailed rules for determining the unit of property for buildings and for non-building tangible property. For buildings, the IRS identified eight component systems as separate units of property, requiring more costs to be capitalized. However, the new rules also provide for deducting the costs of property taken out of service, by treating the retirement as a disposition.

The new regulations require virtually every business to review how repairs, maintenance, improvements and replacements are handled for tax purposes, with both mandatory and optional adjustments made to past treatment as appropriate.

Please feel free to call this office for a more targeted explanation of how these new regulations impact your business operations.

The fate of the employee-side payroll tax cut along with a host of tax extenders and other expired provisions could be decided in coming weeks. A conference committee of House and Senate members is negotiating a full-year extension of the payroll tax cut and could add some or all of the tax extenders to a final package. Lawmakers also could extend the payroll tax cut without acting on any tax incentives.

Payroll tax cut

The Temporary Payroll Tax Cut Continuation Act of 2011 extended the employee-side OASDI tax cut through the end of February 2012. The employee-share of OASDI taxes is 4.2 percent for the two-month period, rather than 6.2 percent. The employer-share of OASDI taxes remains at 6.2 percent for the two month period. Self-employed individuals also benefit from a two percentage point reduction in OASDI taxes.

Unless extended, the employee-share of OASDI taxes is scheduled to revert to 6.2 percent after February 29, 2012. The White House and the leaders of the two parties in Congress agree that the payroll tax cut should be extended a full-year. They disagree, however, how to pay for the extension; even if it should be paid for at all.

Congress could extend the two-month payroll tax cut through the end of 2012 without paying for it. The 2011 payroll tax cut was unfunded. Congress appropriated to the Social Security trust funds amounts equal to the reduction in payroll tax revenues. The 2011 payroll tax cut was estimated by the Congressional Budget Office cost approximately $111 billion. Extending it through the end of 2012 is estimated to cost just as much if not more.

House Republicans reportedly have proposed a number of revenue raisers to offset the cost of extending the payroll tax cut through the end of 2012. One GOP proposal would extend the current pay freeze for employees of the federal government. Another GOP proposal would require higher-income individuals to pay increased Medicare premiums.

One possible revenue raiser, increasingly under discussion by Democrats, is a change in the taxation of so-called carried interest. Current law generally taxes carried interest as capital gains and not as ordinary income. Past efforts to change the tax treatment of carried interest have failed to pass Congress.

Extenders

The so-called tax extenders, popular but temporary tax provisions, expired at the end of 2011. Many taxpayers are surprised to learn that their particular tax break, whether it be the state or local sales tax deduction, the teachers’ classroom expense deduction, or the research tax credit, are temporary. The extenders have been routinely revived many times in the past. This year, however, could be different. Faced with record federal budget deficits, lawmakers may decide to extend only some of the expired provisions.

President Obama’s FY 2013 proposals

President Obama is expected to release his fiscal year (FY) 2013 federal budget proposals in early February, which will reignite debate over the Bush-era tax cuts. President Obama is expected to urge Congress to allow the Bush-era tax cuts to expire after 2012 for higher-income taxpayers, which President Obama defines as individuals earning more than $200,000 or families earning more than $250,000. In recent weeks, there has been speculation that President Obama may revisit those definitions in his FY 2013 budget, possibly raising the amounts.

Few Capitol Hill observers expect Congress to take any action on the Bush-era tax cuts before the November elections. Instead, Congress may take up some of President Obama’s other proposals. As in past budgets, President Obama will likely propose to extend some energy tax breaks for individuals and businesses, extend tax incentives for education and provide some targeted-tax breaks to businesses. President Obama has also promised to introduce proposals to encourage U.S. companies to “insource” jobs at home.

On some issues, such as energy and education, lawmakers may find common ground but negotiations are likely to go down to the wire. Our office will keep you posted of developments.

If you have any questions about the payroll tax cut, tax extenders or the various tax proposals under discussion, please contact our office.

The IRS reopened its offshore voluntary disclosure program in early 2012 in response to what the government described as strong interest among taxpayers. The reopened program, the third of its type in recent years, encourages taxpayers with unreported foreign accounts to make full disclosures in exchange for a reduced penalty framework. Like its predecessors, the terms and conditions of the reopened program are very complex. The IRS has promised to provide more details. In the meantime, the prior offshore disclosure programs are guides to how the IRS intends to implement the third, reopened program.

Previous disclosure programs

The IRS launched two previous offshore disclosure initiatives: one in 2009 and another in 2011. Both programs offered reduced penalties in exchange for full disclosure. In early 2012, the IRS reported it received 33,000 voluntary disclosures from the 2009 and 2011 offshore initiatives. The government has collected over $4.4 billion from the 2009 and 2011 programs. The IRS predicted it will collect more revenue as it continues to work cases.

Reopened program

The reopened program operates very similarly to the 2009 and 2011 programs but with some key differences. The previous programs were temporary. The 2011 program ended in mid-September 2011. The reopened program has no set end date. The IRS cautioned, however, that it could close the program at some future date. The decision to end the program is solely at the discretion of the IRS.

The reopened program requires taxpayers to file all original and amended tax returns and include payment for back-taxes and interest for up to eight years as well as pay accuracy-related and/or delinquency penalties. Additionally, taxpayers must pay a penalty of 27.5 percent of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the eight full tax years prior to the disclosure. In comparison, the highest penalty in the 2011 program was 25 percent. IRS officials have said that the penalty was increased because the agency does not want to reward taxpayers who did not participate in the 2009 or 2011 disclosure programs because they anticipated that a future penalty would be lower.

In limited circumstances, taxpayers may qualify for a 12.5 percent penalty or a five percent penalty. Generally, taxpayers whose offshore accounts or assets did not surpass $75,000 in any calendar year may qualify for the 12.5 percent penalty.

The requirements for the five percent penalty are very narrow. The IRS has explained that taxpayers must meet four conditions: (1) The taxpayer did not open or cause the account to be opened; (2) the taxpayer exercised minimal, infrequent contact with the account, for example, to request the account balance, or update account holder information such as a change in address, contact person, or email address; (3) except for a withdrawal closing the account and transferring the funds to an account in the United States, the taxpayer did not withdraw more than $1,000 from the account in any year for which the taxpayer was non-compliant; and (4) the taxpayer can show that all applicable U.S. taxes have been paid on funds deposited to the account (only account earnings have escaped U.S. taxation).

The penalty amounts in the reopened program are not set in stone, the IRS cautioned. It may eventually increase penalties in the program for all or some taxpayers or defined classes of taxpayers.

Quiet disclosures

One goal of the three programs is to caution taxpayers against so-called “quiet disclosures.” A quiet disclosure occurs when a taxpayer files an amended return and pays any tax delinquency without making a formal voluntary disclosure. The IRS warned taxpayers making quiet disclosures that they risked being sanctioned to the fullest extent allowed by law.

Critics

The offshore disclosure programs were not without their critics. The National Taxpayer Advocate recently told Congress that the IRS should streamline what is a very complicated process. The National Taxpayer Advocate also reported that IRS examiners were assuming that all violations were willful unless a taxpayer presented evidence to the contrary. It is possible that the IRS may revisit some of the terms and conditions of the reopened program in light of the National Taxpayer Advocate’s report.

If you have any questions about the reopened offshore voluntary disclosure program, please contact our office.

Taxpayers with children should be aware of the numerous tax breaks for which they may qualify. Among them are: the dependency exemption, child tax credit, child care credit, and adoption credit. As they get older, education tax credits for higher education may be available; as is a new tax code requirement for employer-sponsored health care to cover young adults up to age 26. Employers of parents with young children may also qualify for the child care assistance credit.

Dependency Exemption

In addition to the personal exemption an individual taxpayer may take for him or herself to reduce taxable income (Line 42 on Form 1040), that taxpayer may also take an exemption for each qualifying dependent who has lived with the taxpayer for more than half of the tax year. A dependent may be a natural child, step-child, step-sibling, half-sibling, adopted child, eligible foster child, or grandchild, and generally must be under age 19, a full-time student under age 24, or have special needs. The amount of the exemption is the same as the taxpayer’s personal exemption, $3,700 for the 2011 tax year and $3,800 for the 2012 tax year.

Child Tax Credit

Parents of children who are under age 17 at the end of the tax year may qualify for a refundable $1,000 tax credit. The credit is a dollar-for-dollar reduction of tax liability, and may be listed on Line 51 of Form 1040. For every $1,000 of adjusted gross income above the threshold limit ($110,000 for married joint filers; $75,000 for single filers), the amount of the credit decreases by $50.

Child and Dependent Care Credit

If a taxpayer must pay for childcare for a child under age 13 in order to pursue or maintain gainful employment, he or she may claim up to $3,000 of his or her eligible expenses for dependent care. If one parent stays home full-time, however, no child care costs are eligible for the credit.

Adoption Credit

Taxpayers who have incurred qualified adoption expenses in 2011 may claim either a $13,360 credit against tax owed or a $13,360 income exclusion if the taxpayer has received payments or reimbursements from his or her employer for adoption expenses. For 2012, the amount of the credit will decrease to $12,650, and in 2013 to $5,000.

Higher Education Credits

There are two education-related credits available for 2012: the American Opportunity credit and the lifetime learning credit. The American Opportunity credit amount is the sum of 100 percent of the first $2,000 of qualified tuition and related expenses plus 25 percent of the next $2,000 of qualified tuition and related expenses, for a total maximum credit of $2,500 per eligible student per year. The credit is available for the first four years of a student's post-secondary education. The credit amount phases out ratably for taxpayers with modified AGI between $80,000 and $90,000 ($160,000 and $180,000 for joint filers). The lifetime learning credit is equal to 20 percent of the amount of qualified tuition expenses paid on the first $10,000 of tuition per family. The phaseout for 2012 ranges from $52,000 to $62,000 ($104,000 to $124,000 for joint filers). Parents also find tax relief in saving for college though Coverdell accounts, section 529 plans and specified U.S.. savings bonds.

Extended Health Care Coverage

Effective since September 23, 2010, the new health care law requires plans to provide coverage for children until they attain age 26. Further, effective on or after March 30, 2010, children under the age of 27 are considered dependents of a taxpayer for purposes of the general exclusion from income for reimbursements for medical care expenses of an employee, spouse, and dependents under an employer-provided accident or health plan. Therefore, a plan must provide coverage to a child who is still a dependent up to age 26; but can do so up to age 27 without income tax consequences. A child includes a son, daughter, stepson, or stepdaughter of the taxpayer; a foster child placed with the taxpayer by an authorized placement agency or by judgment, decree, or other order of any court of competent jurisdiction; and a legally adopted child of the taxpayer or a child who has been lawfully placed with the taxpayer for legal adoption.

Child Care Assistance Credit (for businesses)

Employers may take up to $150,000 of the eligible costs of providing employees with child care assistance as tax credit. These costs may include a portion of the costs of acquiring, constructing, improving, and operating a child care facility.

If you have any questions about these provisions and how they may benefit you, please contact our office.

The Treasury Department is authorized to offset a taxpayer’s tax refund to satisfy certain debts. A spouse who believes that his or her portion of the refund should not be used to offset the debt that the other spouse owes may request a refund from the IRS.

Offset

If an individual owes money to the federal government because of a delinquent debt, the Treasury Department’s Financial Management Service (FMS) can offset that individual's tax refund (and certain other federal payments) to satisfy the debt. The debtor will be notified in advance of the offset.

A taxpayer’s refund may be reduced by FMS and offset to pay:

• Past-due child support
• Federal agency non-tax debts
• State income tax obligations, or
• Certain unemployment compensation debts owed a state.

FMS advises taxpayers by written notice of an offset. FMS has explained that the notice will reflect the original refund amount, the taxpayer’s offset amount, the agency receiving the payment, and the address and telephone number of the agency. FMS will notify the IRS of the amount taken from your refund.

Form 8379

If a taxpayer filed a joint return and is not responsible for the debt of his or her spouse, the taxpayer may request his or her portion of the refund by filing Form 8379, Injured Spouse Allocation, with the IRS. Form 8379 may be filed with the original return or by itself after the taxpayer is aware of the offset.

The IRS has instructed taxpayers filing Form 8379 by itself to attach a copy of all Forms W-2 and W-2G for both spouses, and any Forms 1099 showing federal income tax withholding to Form 8379. Failure to attach these items may result in a delay in processing by the IRS.

The IRS has reported on its website that it generally processes Forms 8379 that are filed after a joint return has been filed in approximately eight weeks. The timeframe for processing a Form 8379 that is attached to a joint return is approximately 11 weeks (14 weeks if the joint return is filed on paper).

As an individual or business, it is your responsibility to be aware of and to meet your tax filing/reporting deadlines. This calendar summarizes important tax reporting and filing data for individuals, businesses and other taxpayers for the month of February 2012.

February 1

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates January 25–27.

February 3

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates January 28–31.

February 8

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 1–3.

February 10

Employees who work for tips. Employees who received $20 or more in tips during November must report them to their employer using Form 4070.

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 4–7.

February 15

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 8–10.

Monthly depositors. Monthly depositors must deposit employment taxes for payments in January.

February 17

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 11–14.

February 23

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 15–17.

February 24

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 18–21.

February 29

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 22–24.

March 2

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 25–28.

March 7

Employers. Semi-weekly depositors must deposit employment taxes for payroll dates February 29–March 2.

If you use your car for business purposes, you may have learned that keeping track and properly logging the variety of expenses you incur for tax purposes is not always easy. Practically speaking, how often and how you choose to track expenses associated with the business use of your car depends on your personality; whether you are a meticulous note-taker or you simply abhor recordkeeping. However, by taking a few minutes each day in your car to log your expenses, you may be able to write-off a larger percentage of your business-related automobile costs.

Regardless of the type of record keeper you consider yourself to be, there are numerous ways to simplify the burden of logging your automobile expenses for tax purposes. This article explains the types of expenses you need to track and the methods you can use to properly and accurately track your car expenses, thereby maximizing your deduction and saving taxes.

Expense methods

The two general methods allowed by the IRS to calculate expenses associated with the business use of a car include the standard mileage rate method or the actual expense method. The standard mileage rate for 2007 is 48.5 cents per mile. In addition, you can deduct parking expenses and tolls paid for business. Personal property taxes are also deductible, either as a personal or a business expense. While you are not required to substantiate expense amounts under the standard mileage rate method, you must still substantiate the amount, time, place and business purpose of the travel.

The actual expense method requires the tracking of all your vehicle-related expenses. Actual car expenses that may be deducted under this method include: oil, gas, depreciation, principal lease payments (but not interest), tolls, parking fees, garage rent, registration fees, licenses, insurance, maintenance and repairs, supplies and equipment, and tires. These are the operating costs that the IRS permits you to write-off. In general, the actual expense method usually results in a greater deduction amount than the standard mileage rate. However, this must be balanced against the increased substantiation burden associated with tracking actual expenses. If you qualify for both methods, estimate your deductions under each to determine which method provides you with a larger deduction.

Substantiation requirements

Taxpayers who deduct automobile expenses associated with the business use of their car should keep an account book, diary, statement of expenses, or similar record. This is not only recommended by the IRS, but essential to accurate expense tracking. Moreover, if you use your car for both business and personal errands, allocations must be made between the personal and business use of the automobile. In general, adequate substantiation for deduction purposes requires that you record the following:

• The amount of the expense;
• The amount of use (i.e. the number of miles driven for business purposes);
• The date of the expenditure or use; and
• The business purpose of the expenditure or use.

Suggested recordkeeping: Actual expense method

An expense log is a necessity for taxpayers who choose to use the actual expense method for deducting their car expenses. First and foremost, always keep your receipts, copies of cancelled checks and bills paid. Maintaining receipts, bills paid and copies of cancelled checks is imperative (even receipts from toll booths). These receipts and documents show the date and amount of the purchase and can support your expenditures if the IRS comes knocking. Moreover, if you fail to log these expenses on the day you incurred them, you can look back at the receipt for all the essentials (i.e. time, date, and amount of the expense).

Types of Logs. Where you decide to record your expenses depends in large part on your personal preferences. While an expense log is a necessity, there are a variety of options available to track your car expenditures - from a simple notebook, expense log or diary for those less technologically inclined (and which can be easily stored in your glove compartment) - to the use of a handheld device, palm pilot or software. Software programs specifically designed to help track your car expenses can be easily downloaded onto your blackberry or palm pilot.

Timeliness. Although maintaining a daily log of your expenses is ideal - since it cuts down on the time you may later have to spend sorting through your receipts and organizing your expenses - this may not always be the case for many taxpayers. According to the IRS, however, you do not need to record your expenses on the very day they are incurred. If you maintain a log on a weekly basis and it accounts for your use of the automobile and expenses during the week, the log is considered a timely-kept record. Moreover, the IRS also allows taxpayers to maintain records of expenses for only a portion of the tax year, and then use those records to substantiate expenses for the entire year if he or she can show that the records are representative of the entire year. This is referred to as the sampling method of substantiation. For example, if you keep a record of your expenses over a 90-day period, this is considered an adequate representation of the entire year.

Suggested Recordkeeping: Standard mileage rate method

If you loathe recordkeeping and cannot see yourself adequately maintaining records and tracking your expenses (even on a weekly basis), strongly consider using the standard mileage rate method. To claim the standard mileage rate, appropriate records would include a daily log showing miles traveled, destination and business purpose. If you incur mileage on one day that includes both personal and business, allocate the miles between the two uses. A mileage record log, whether recorded in a notebook, log or handheld device, is a necessity if you choose to use the standard mileage rate.

If you have any questions about how to properly track your automobile expenses for tax purposes, please call our office. We would be happy to explain your responsibilities and the tax consequences and benefits of adequately logging your car expenses.

Under the so-called "kiddie tax," a minor under the age of 19 (or a student under the age of 24) who has certain unearned income exceeding a threshold amount will have the excess taxed at his or her parents' highest marginal tax rate. The "kiddie tax" is intended to prevent parents from sheltering income through their children.

A child with earned income (wages and other compensation) in excess of the filing threshold is a separate taxpayer who is generally taxed as a single taxpayer. If a child in one of the following categories has unearned income (i.e., investment income) in excess of the "threshold amount" ($950 in 2009) that unearned income is taxed at the parent's marginal tax rate, as if the parent received that additional income.

• A child under the age of 19;
• A child up to age 18 who provides less than half of his or her support with earned income; or
• A19 to 23 year-old student who provides less than half of his or her support with earned income.

If the child's unearned income is less than an inflation-adjusted ceiling amount ($9,500 in 2009), the parent may be able to include the income on the parent's return rather than file a separate return for the child (and which the tax based on the parent's marginal rate bracket is computed on Form 8615).

Any distribution to a child who is a beneficiary of a qualified disability trust is treated as the child's earned income for the tax year the distribution was received.

Example:  Greta is a 16-year-old whose father is alive. In 2009, she has $3,000 in unearned income, no earned income, and no itemized deductions. Her basic standard deduction is $950, which is applied against her unearned income, reducing it to $2,050. The next $950 of unearned income is taxed at Greta's individual tax rate. The remaining $1,100 of her unearned income is taxed at her parent's allocable tax rate. Assuming her father's tax rate bracket is 25 percent, her tax on the $1,100 is $275.

If you own a vacation home, you may be considering whether renting the property for some of the time could come with big tax breaks. More and more vacation homeowners are renting their property. But while renting your vacation home can help defray costs and provide certain tax benefits, it also may raise some complex tax issues.

Determining whether to use your vacation home as a rental property, maintain it for your own personal use, or both means different tax consequences. How often will you rent your home? How often will you and your family use it? How long will it sit empty? Depending on your situation, renting your vacation home may not be the most lucrative approach for you.

Generally, the tax benefits of renting your vacation home depend on how often you and your family use the home and how often you rent it. Essentially, there are three vacation home ownership situations for tax purposes. We will go over each, and their tax implications.

Tax-free rental income

If you rent your vacation home for fewer than 15 days during the year, the rental income you receive is tax-free; you don't even have to report it on your income tax return. You can also claim basic deductions for property taxes and mortgage interest just as you would with your primary residence.

You won't, however, be able to deduct any rental-related expenses (such as property management or maintenance fees). And, if your rental-related expenses exceed the income you receive from renting your vacation home for that brief time, you can't take a loss. Nevertheless, this is an incredibly lucrative tax break, especially if your vacation home is located in a popular destination spot or near a major event and you don't want, or need, to rent it out for a longer period. If you fit in this category of vacation homeowners and would like more information on this significant tax benefit, call our office.

Pure rental property

Do you plan on renting your vacation home for more than 14 days a year? If so, the tax rules can become complicated. If you and your family don't use the property for more than 14 days a year, or 10% of the total number of days it is rented (whichever is greater), your vacation home will qualify as rental property, not as a personal residence.

If you rent your vacation home for more than 14 days, you must report all rental income you receive. However, now you can deduct certain rental-related expenses, including depreciation, condominium association fees, property management fees, utilities, repairs, and portions of your homeowner's insurance. How much you can deduct will depend on how often you and your family use the property. But, as the owner of investment property, you can take a loss on the ultimate sale of your rental homes, which second-homeowners can't do.

Income and deductions generated by rental property are treated as passive in nature and subject to passive activity loss rules. As passive activity losses, rental property losses can't be used to offset income or gains from non-passive activities (such as wages, salaries, interest, dividends, and gains from the sale of stocks and bonds). They can only be used to offset income or gains from other passive type activities. Passive activity losses that you can't use one year, however, can be carried forward to future years.

However, an owner of rental property who "actively participates" in managing the rental activities of his or her vacation home, and has an adjusted gross income that doesn't exceed $100,000, can deduct up to $25,000 in rental losses against other non-passive income, such as wages, salaries, and dividends. It's not all that difficult to meet the "active participation" test if you try.

Personal use for more than 14 days

If you plan on using your vacation home a lot, as well as renting it often, your vacation home will be treated as a personal residence. Specifically, if you rent your home for more than 14 days a year, but you and your family also use the home for more than 14 days, or 10% of the rental days (whichever is greater), your vacation home will qualify as a personal residence, not a rental property, and complex tax issues arise.

All expenses must be apportioned between rental and personal use, based on the total number of days the home is used. For example, you must allocate interest and property taxes between rental and personal use so that a portion of your mortgage interest payments and property taxes will be reported as itemized deductions on Schedule A (the standard form for itemized deductions) and a portion as deductions against rental income on Schedule E (the form for rental income and expenses.) You will only be able to deduct your rental expense up to the total amount of rental income.  Excess losses can be carried forward to future years though.

Proper planning

With proper planning and professional advice, you can maximize tax benefits of your vacation home. Please call our office if you have, or are planning to buy, a vacation home and would like to discuss the tax consequences of renting your property.

The benefits of owning a vacation home can go beyond rest and relaxation. Understanding the special rules related to the tax treatment of vacation homes can not only help you with your tax planning, but may also help you plan your vacation.

The benefits of owning a vacation home can go beyond rest and relaxation. Understanding the special rules related to the tax treatment of vacation homes cannot only help you with your tax planning, but may also help you plan your vacation.

For tax purposes, vacation homes are treated as either rental properties or personal residences. How your vacation home is treated depends on many factors, such as how often you use the home yourself, how often you rent it out and how long it sits vacant. Here are some general guidelines related to the tax treatment of vacation homes.

Treated as Rental Property

Your home will fall under the tax rules for rental properties rather than for personal residences if you rent it out for more than 14 days a year, and if your personal use doesn't exceed (1) 14 days or (2) 10% of the rental days, whichever is greater.

Example - You rent your beach cottage for 240 days and vacation 23 days. Your home will be treated as a rental property. If you had vacationed for 1 more day (for a total of 24 days), though, your home would be back under the personal residence rules.

Income: Generally, rental income should be fully included in gross income. However, there is an exception. If the property qualifies as a residence and is rented for fewer than 15 days during the year, the rental income does not need to be included in your gross income.

Expenses: Interest, property taxes and operating expenses should all be allocated based on the total number of days the house was used. The taxes and interest allocated to personal use are not deductible as a direct offset against rental income. In the example above, the total number of days used is 263, so the split would be 23/263 for personal use and 240/263 for rental.

Any net loss generated will be subject to the passive activity loss rules. In general, passive losses are deductible only to the extent of passive income from other sources (such as rental properties that produce income) but if your modified adjusted gross income falls below a certain amount, you may write off up to $25,000 of passive-rental real estate losses if you "actively participate". "Active participation" can be achieved by simply making the day-to-day property management decisions. Unused passive losses may be carried over to future years

Planning Note: If your personal use does exceed the greater of (1) 14 days, or (2) 10% of rental days, the special vacation home rules apply. This means you drop back into the personal residence treatment, which allows you to deduct the interest and taxes and usually wipe out your rental income with deductible operating expenses. This is explained in greater detail below.

Treated as Personal Residence

If you use your vacation home for both rental and a significant amount of personal purposes, you generally must divide your total expenses between the rental use and the personal use based on the number of days used for each purpose. Remember that personal use includes use by family members and others paying less than market rental rates. Days you spend working substantially full time repairing and maintaining your property are not counted as personal use days, even if family members use the property for recreational purposes on those days.

Rented 15 days or more. If you rent out your home more than 14 days a year and have personal use of more than (1) 14 days or (2) 10% of the rental days, whichever is greater, your home will be treated as a personal residence.

Income: You must include all of your rental receipts in your gross income. Again, however, if the property qualifies as a residence and is rented for fewer than 15 days, the rental income does not need to be included in your gross income.

Expenses:

Interest and Taxes: Mortgage interest and property taxes must be allocated between rental and personal use. Personal use for this allocation includes days the home was left vacant.

Example: You rent your mountain cabin for 4 months, have personal use for 3 months, and it sits empty for 5 months. The amount of interest and taxes allocated to rental use would be 33% (4 months/12 months) and since vacant time is considered personal use, you would allocate 67% (8 months/12 months) to personal use. The rental portion of interest and taxes would be included on Schedule E and the personal part would be claimed as itemized deductions on Schedule A.

Operating Expenses: Rental income should first be reduced by the interest and tax expenses allocated to the rental portion (33% in our example above). After that allocation is made, you can deduct a percentage of operating expenses (maintenance, utilities, association fees, insurance and depreciation) to the extent of any rental income remaining. When calculating the allocation percentage for operating expenses, vacancy days are not included. Any disallowed rental expenses are carried forward to future years.

Planning Note: It would be wise to try to balance rental and personal use so that rental income is "zeroed" out since, even though losses may be carried forward, they still risk going used. Mortgage interest should be fully deductible on Schedule A as a second residence. If more than two homes are owned, choose the vacation home with the biggest loan as the second residence. Property taxes are always deductible no matter how many homes are owned.

Rented fewer than 15 days. If you have the opportunity to rent your home out for a short period of time (< 15 days), you will not have to worry about the tax consequences. This rental period is "ignored" for tax purposes and the house would be treated purely like a personal residence with no tricky allocation methods required.

Income: You do not include any of the rental income in gross income.

Expenses: Interest and taxes are claimed on Schedule A. You can not write off any operating expenses (maintenance, utilities, etc...) attributable to the rental period.

Planning Note: Take advantage of this "tax-free" income if you get the chance. Short-term rentals during major events (such as the Olympics) can be a windfall.

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