Vacation Rental Income Tax

Let us first begin by the disclaimer that I am not a tax professional and my personal opinions may not be correct and does not constitute tax advice

Having my vacation rentals at Pelican Beach Resort, Destin since 2016; I have been learning and learning about income return requirements

What is debt to income (DTI) ratio?

Your debt-to-income ratio is all your monthly debt payments divided by your gross monthly income. While some people are trying to save tax, I was some years trying to pay more so that my gross income can raise in order to be able to get a new loan (capitalism, right !). On the side note, if your monthly payments to gross income ratio is higher than 43% including the projected payments of the new property, it is unlikely that you would qualify for a conventional mortgage. Annual debt also includes HoA payments you make for every condo plus the prospect. Getting a 30 year term loan would decrease your payment, and increase your ability to get the loan.

How to get a vacation condo mortgage?

Getting mortgage for a condominium can be challenging. The big banks we know wants to see new, approved condominium projects to fund. Therefore, you may be likely denied. However, local banks know the market and risk, hence easily approve these mortgages. In Destin, you can use Trustmark Mortgage or Bankcorp South. You may also shop using mortage brokers, who are middlemen but it may be a more expensive loan

Tax Deductable Costs for Vacation Rentals

When January comes, it is time to open the excel to sum up the revenues collected and expenses. I usually categorize the expenses in a column as Advertising, Travel (excl mileage), Cleaning, Maintenance, Commissions, Insurance, Professional Fees, Management Fees, Repairs, Supplies, Real Estate Taxes, Other Taxes, Utilities and HOA Assessments. This helps me to build a pivot table from excel and enter these in Turbotax.

If you spent less than $2500 to buy an appliance, it is deductible as expense. If you spent more than $2500 for an A/C unit, it is an improvement and will be depreciated according to schedule of the improvement but will not be a direct expense for that year. The $2,500 limit refers to individually invoiced items and includes any sales tax. For example, if you buy furniture and the receipt said, “Furniture – table and chairs – $3,000” you would have to depreciate this under the normal rules of depreciation

Also try NOT to claim home office expenses as it may trigger suspicion.

What closing costs are deductable?

Again, you are a vacation rental owner, and make profit from your vacation rental. If you purchased your property recently, you can deduct the origination fees and points from your income without limit. Needless to say, the prorated portion of property tax and HOA for that year is also deductible as business expense

Following closing costs are not tax deductible but added to the property basis, hence depreciated with the property however most of the time they are small compared to the property itself.

  • Attorney fees in connection with obtaining property
  • Commissions
  • State stamp taxes and transfer taxes
  • Tax service fees
  • Title policy fees or title insurance
  • Miscellaneous abstracts of title, surveys, recording of deed

All of us know that there are 2 important milestones, April 15th which is due date for returns; and Jan 31st which is the last mailing date for 1099 forms. In order to avoid underpayment penalty, you should be paying at least 90% of your projected taxes or the amount of taxes you paid previous year, whichever is lower. In order to keep this safe zone, you must be making quarterly payments on rough calculations and the last quarterly payment you can make is due Jan 15th before you file your income tax return.

Tax forms from Airbnb, VRBO/Homeaway, Flipkey/Tripadvisor and Payment Processors

End of January, you should be getting 1099-K forms from vacation rental sites. Airbnb and VRBO send Form 1099K if you earn over $20,000 and have at least 200 or more reservations in the previous year. If you used payment processors such as Square, Stripe, Paypal and had $20,000 and at least 200 transactions, they will also send you 1099-K forms. Tripadvisor/Flipkey sent me 1099-MISC form. It is important that you report your income correctly, hence the income should be equal to or more than the sum of these forms as they also file them to IRS. Even if you do not get any forms, you must be reporting your correct income to IRS. Only exception is if you rented for less than 14 days in the year.

You may see more $ on these forms than you were paid. Some OTAs include the gross payment they collected from the guests, but they keep some of them for them. In such case, you should document and report that difference as expense.

How to file 1099-MISC for your Vacation Rental?

Next step is to send 1099-MISC forms to whoever you paid more than $600 in the subject year. You may have received an invoice, but if the entity is a simple LLC (not S corp), you would still need to give them 1099-MISC by January 31st.

In order to file 1099-MISC, you should get from them a W-9 form stating their personal information and SSN/EIN, as well as a signature saying that they are subject to withholding tax. If you do not get this form when you pay them, good luck getting it later.

1099-MISC is an overwhelming form, it has carbon copies which you would need to distribute around. So better way to handle this is either a Turbotax Desktop version or using (as I do), to file these forms and share it with the recipients. They charge a few dollars for every form and if the recipient does not confirm receipt by email, you can also pay a little more to have them mailed. For housekeepers, you will need to put the amount you paid in Box 1.

As most homeowners aren’t, I am also not a real estate professional

To qualify as a ‘Professional’ for tax purposes, a taxpayer, or their spouse, must meet a two-part test: (1) the taxpayer must spend the majority of his or her time in real property businesses, and (2) the taxpayer must spend 750 hours or more in the real property business and rentals in which he or she materially participates.

So we will report the income as passive income in Schedule E. In such case, if you incurred losses, you cannot deduct it from your overall income but carry it over to next year to offset your profits. Schedule E is a pretty simple form, and Turbox will handle that for you when you answer the questions.

What is Depreciation?

One of your expenses will be depreciation. For real estate, the property is depreciated in 27.5 years. You need to know the purchase price less the land value, and divide it by 27.5 to write depreciation as an expense. Depreciation helps you today but also decreases the base cost of your property. If you bought the property for $275,000 and depreciated every year $10,000 for 10 years, that means every year you had a fictive cost of $10,000 reducing your income, hence tax. However, if you now sell the property for $400,000; while the taxable capital gain is $125,000, you would still pay regular income tax on the depreciated amount of $100,000 (depreciation recapture).

Capital Gain Taxes of Rental Property

When you sell a property you’ve owned for more than one year, the profit (the difference between the net sales proceeds and the tax basis of the property after subtracting depreciation deductions) is generally treated as a long-term capital gain. As such, it will be taxed at a federal rate of no more than 20% (or 23.8% if you owe the 3.8% Medicare surtax). However, part of the gain—an amount equal to the cumulative depreciation deductions claimed for the property—is subject to a 25% maximum federal rate (28.8% if you owe the 3.8% Medicare surtax). The rest of your gain will be taxed at a maximum federal rate of no more than 20% (or 23.8%).

Qualified Business Income (QBI) for Vacation Rentals

We lined up our income and expenses, and have a net income in Schedule E for each investment we have. With the new tax code, there is a significant pass-through benefit which is called QBI. The QBI deduction is potentially available to eligible non-corporate owners of pass-through business entities for tax years beginning in 2018 and extending through 2025. The deduction is scheduled to disappear after 2025, unless Congress extends it. It doesn’t reduce an individual’s adjusted gross income (AGI), but decreases your income. QBI is not reported on Schedule E but on 1040 form (main return).

Qualified Business Income (QBI) Limit for Vacation Rentals

If you pass the Safe Harbor Test (you can find on page 5 of this IRS publication), (in simple terms you and/or your contractors can document with contemporaneous records that you have spend 250 hours for your vacation rental), you can deduct some of your income from Schedule E. The deduction is 20% of your net income, however it is capped.

Above specified income levels, the QBI deduction for income from an eligible business can’t exceed the greater of:

  • 50% of W-2 wages paid by the business, or
  • 25% of W-2 wages plus 2.5% of the unadjusted basis immediately after acquisition of qualified depreciable property used in the business.

It is likely that you will not have W-2 employees, hence the deduction will be the lower of 2.5% of the price you paid for your property and 20% of your net income.

Tax Disclaimer

The information contained herein is general in nature and based on authorities that are subject to change. Author guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Author assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein. This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations.