A brand new tax law called the Tax Cuts and Jobs Act (“TCJA”) went into effect in 2018. The TCJA affects everyone who pays taxes, including vacation rental hosts, who must pay income tax on the profits they earn. Fortunately, the changes are mostly good for vacation rental hosts. Here are five ways the new law has changed taxes for hosts, starting in 2018.
1. You Can Qualify for a New Passthrough Tax Deduction
The TCJA created a brand new tax deduction for individuals who earn income from businesses owned individually or by pass-through entities like limited liability companies or partnerships, which includes almost all vacation rental hosts. If your short-term rental activity qualifies as a business for tax purposes, you may be eligible to deduct up to 20% of your net vacation rental income from your income taxes. This is in addition to all your other rental-related deductions.
To qualify for this deduction, your rental activity must be considered a business by the IRS, not a mere investment; or, worse yet, a hobby. A vacation rental activity (and any other activity as well) qualifies as a business only if the owner engages in it regularly, continuously, and systematically to make a profit. There is no minimum number of hours a rental host must work to qualify as a business for purposes of the pass-through deduction.
Given the amount of continuous and systematic work required for successful vacation rentals, most vacation rental hosts are in business. However, hosts who make no serious efforts to rent their property or rent it for below market rent to relatives or friends also may fail to the business test and not qualify for the pass-through deduction.
You need not spend any additional money or buy any new property to qualify for this deduction. How much you’ll be able to deduct, however, depends on your taxable income and how much you earn from your rental activity. For higher-income taxpayers, the deduction is limited to 2.5% of the cost of their rental property plus 25% of amounts paid to employees (which for vacation rental hosts is usually zero).
For more information on the pass-through deduction, see this detailed FAQ prepared by the IRS.
2. Writing off Your Expenses Is Easier
When you buy personal property like new furniture or appliances for your rental activity, you get to write-off all or part of the cost as a rental expense. The TCJA makes this easier than ever before. During 2018 through 2022 hosts are able to use 100% bonus depreciation to write off in a single year the full cost of long-term personal property they use for their vacation rental business. Bonus depreciation may now be used for both new and used personal property. It may not be used for real property.
Hosts can also use a provision of the tax code called Section 179 to deduct in one year up to $1 million of personal property purchased for their rental activity. However, Section 179 may be used only for property that is used over 50% of the time for the rental activity, which limits its use by vacation rental hosts who live in their property a majority of the time.
3. New Limits on Property Tax and Mortgage Interest Deductions Don’t Apply to Your Rental Activity
The TCJA limits the personal mortgage interest deduction to interest on $750,000 of acquisition indebtedness, a reduction of $250,000 from prior law which permitted interest to be deducted on up to $1 million. The itemized personal deduction for real property taxes is limited to a maximum of $10,000. Under prior law, there was no limit on this deduction. The limits on the personal itemized deductions for home mortgage interest and property taxes do not apply to vacation rental businesses. Thus, the portion of a vacation rental host’s mortgage interest and property tax allocated to the short-term rental activity don’t come within the limits. These are rental deductions, not personal itemized deductions.
4. No Deductions for Vacation Rentals that Are Hobbies
Operating an activity classified as a hobby for tax purposes has always been a tax disaster; under the TCJA, it is now a tax apocalypse. Under prior law, expenses from a hobby could be deducted as a personal itemized deduction on IRS Schedule A to the extent they exceeded 2% of the taxpayer’s adjusted gross income. However, these deductible hobby expenses could not exceed hobby income. The TCJA completely removes the personal deduction for hobby expenses. This means that while the income from a rental activity classified as a hobby must be reported and tax paid, no expenses may be deducted.
The vast majority of vacation rental activities qualify as businesses or investment activities. However, vacation rentals that are not profit-motivated must be classified as not-for-profit activities or hobbies.
5. Lower Income Taxes Due on Rental Profits
Almost all vacation rental hosts pay income tax on their rental profits at their individual tax rates. The TCJA reduced individual income tax rates for almost all taxpayers. So you’ll pay less tax on your profits in 2018 and later.