How Renting Out Your Extra Bedrooms Affects Your Taxes

How Renting Out Your Extra Bedrooms Affects Your Taxes

With housing costs on the rise and the sharing economy booming, more and more homeowners are looking to earn extra income by renting out their spare bedrooms or vacation properties. Sites like Airbnb, VRBO, and Craigslist have made it easier than ever to find temporary tenants and short-term guests. However, along with this new income stream comes some important tax considerations.

If you plan on renting out space in your home, it's crucial to understand how the IRS views this rental income and what expenses you can deduct. Failing to properly report the income or claim allowable deductions could lead to unpleasant surprises come tax season. Let's dive into the key tax rules around renting out part of your residence.

The 14-Day Rule: The Tax-Free Window

In some situations, you may not have to report rental income from your home at all. The IRS provides an exception for homeowners who rent out their residence that they also use as a home for 14 days or less during the year. Under this rule, any income earned from renting in those 14 days is non-taxable, and you don't have to report it on your tax return.

However, there are a couple of additional requirements. First, you must use the home for personal purposes more than the greater of 14 days or 10% of the days it is rented out at fair market value. Secondly, any deductible expenses you normally claim for the home, such as mortgage interest and property taxes, are still deductible if you itemize, regardless of the rental days.

For example, let's say you rent out a spare bedroom in your house for 10 days over the summer to out-of-town guests. As long as you live in the home for more than 14 days (which you likely do as your primary residence), the income from those 10 rental days is tax-free, and you can still deduct your standard homeownership expenses.

Crossing the 15-Day Threshold

Once you exceed 14 days of renting out your home that you also live in, things change from a tax perspective. Now, you must report all of your rental income to the IRS on Schedule E of your personal tax return. Additionally, you'll need to allocate any associated rental expenses based on the portion of the home's square footage that was rented out.

Let's look at an example. You rent out a 500 square foot basement apartment in your 2,500 square foot home all year. The apartment represents 20% of your home's total area. In this case, 20% of expenses like utilities, homeowner's insurance, and mortgage interest are deductible rental expenses. However, these rental expenses cannot exceed the total rental income earned or else you'll have a non-deductible rental loss.

For a second home or vacation property that you both rent out and use personally, expense allocation gets a bit trickier as you'll need to divide expenses based on the number of rental days vs personal use days. The IRS has specific formulas for how to calculate this. In general, you'll fare better from a tax perspective the more personal use days you have vs rental days.

Dwellers Beware of the Tax Court Method

Speaking of allocating expenses, one crucial aspect is deciding whether to use the IRS method or the "Tax Court" method. The IRS method is based on rental days vs. total personal and rental use days, excluding vacant days from the equation.

The Tax Court method has you allocate mortgage interest, property taxes, and casualty losses based on the total days you own the property, not just the days it was actually rented or personally used. For most taxpayers, the Tax Court method is less favorable as it reduces their deductible percentage.

For example, say you personally used your beach house for 30 days last year and rented it for 90 days. The remaining 245 days it was vacant. Using the IRS method, you'd allocate 75% of expenses to rentals (90 rental days / 120 total use days). With the Tax Court method, only 23% would be allocated as rental expenses (90 rental days / 365 total days owned). While the percentages may seem small, over a mortgage and other large expenses, the difference is significant.

A note for timeshare owners - you'll generally always have to report rental income. Since you only control use for a week or two, it's nearly impossible to prove your unit wasn't rented more than 14 days total by other owners.

How Much to Charge for Rental?

To maximize your deductions, it's wise to charge a fair market rental rate. The IRS could question whether you had a legitimate profit motive if you persistently undercharge for the rental space. Do some research on comparable rental rates for properties like yours in the same area to determine a fair price.

Have a Tax Plan

As you can see, there are many nuances when it comes to taxes and renting out part of your home. The IRS rules aim to distinguish between true rental businesses and personal-use situations. Work with a qualified tax professional to have a tax plan, properly track all income and expenses, and determine the best way to treat your rental activity.

While renting out extra space can be a great way to earn supplemental income, be sure you understand the tax obligations. The last thing you want is an unexpected bill from the IRS because you didn't properly report rental income or miscalculated allowable deductions. With some advanced preparation and record-keeping, you can maximize the benefits of your new rental business while remaining compliant.