Capital Gains Tax on a Vacation Rental

Section 280A decides whether the IRS sees a rental with some personal use or a home with some rental

Section 280A(d)(1) treats a dwelling unit as a residence for the year if your personal use exceeds 'the greater of 14 days, or 10 percent of the number of days during such year for which such unit is rented at a fair rental'. Section 280A(d)(2) counts as personal use any day the unit is used by you, by a family member, by anyone under a reciprocal arrangement, or by anyone paying less than fair rental. Publication 527 adds that days spent mainly on repairs and maintenance do not count.

The classification changes what you can deduct while you own the property, and it fixes the pattern that matters later. A unit that is a residence under the test has its rental deductions capped at rental income under section 280A(c)(5), with the excess carried forward. A unit rented fewer than 15 days in the year is outside the system entirely under section 280A(g): the rent is not reported and nothing is deducted.

If you never rent at all, or rent under 15 days, the property is a second home with a single personal-use gain, no depreciation and no exchange. Whether a second home or former residence can go into a 1031 covers that case.

Every mixed-use year is allocated, and only the rental share is depreciated

Section 280A(e) limits rental deductions to the fraction that 'the number of days during each year that the unit is rented at a fair rental bears to the total number of days during such year that the unit is used'. Publication 527 applies the same fraction to depreciation, so a unit rented 200 days and used personally 40 days has five-sixths of its depreciation claimed each year and one-sixth never claimed.

That ratio is what comes back at sale. The depreciation allowed or allowable on the rental share is unrecaptured section 1250 gain, taxed at your ordinary rates with the 25% ceiling of section 1(h)(1)(E). The personal share has no depreciation, so it has no recapture layer. The recapture rate and how it stacks is on its own page.

Keep a day log. The allocation at sale depends on the pattern of use over the whole ownership period, and the exchange safe harbor depends on the two years before the exchange, so the calendar is evidence in both directions.

At sale you compute two gains, and only one of them can produce a deductible loss

Publication 544 requires separate computations for the rental part and the personal-use part. The sale price, selling costs and basis are each split by the use ratio, the rental share's basis is reduced by depreciation, and the two results are reported separately: the rental part on Form 4797 and the personal part on Schedule D.

On the rental share, a gain is long-term capital gain (through section 1231) at 0%, 15% or 20% above the depreciation layer, and a loss is deductible. On the personal share, a gain is a capital gain at the same rates, but a loss is a personal loss that section 165(c) does not allow an individual to deduct. A property that fell in value can therefore produce a deductible loss on one part and a non-deductible loss on the other.

The home-sale exclusion does not rescue the personal share. Section 121(a) requires the property to have been 'owned and used by the taxpayer as the taxpayer's principal residence for periods aggregating 2 years or more' in the five years before the sale, and section 121(d)(6) excludes depreciation-related gain even when it applies. Comparing section 121 with a 1031 for a former home covers owners who move in before selling. Both gains are net investment income for the 3.8% surtax once modified adjusted gross income passes $250,000 joint or $200,000 single.

A hypothetical 240-day year: 200 days rented, 40 days personal

Hypothetical: the unit is rented at fair rental for 200 days a year and used by the family for 40 days, so it is a residence under section 280A because 40 exceeds both 14 and 10% of 200. The rental fraction is 200/240, five-sixths. The owners bought for $420,000, claimed $60,000 of depreciation on the rental share over the years, and sell for $720,000. Ignore selling costs.

• Rental share: amount realized $600,000; basis $350,000 less $60,000 of depreciation, $290,000; gain $310,000, of which $60,000 is unrecaptured section 1250 gain at up to 25% and $250,000 is long-term gain at 0%, 15% or 20%.
• Personal share: amount realized $120,000; basis $70,000; gain $50,000 of long-term capital gain. Had the market fallen and this share shown a loss, it would not be deductible.
• For a joint filer with $200,000 of other taxable income, the depreciation layer is taxed at about 24%, the $300,000 of appreciation sits inside the 15% band, and the surtax applies to the whole $360,000, so federal tax on the sale is roughly $73,000. Run your own numbers with your CPA.

The Rev. Proc. 2008-16 safe harbor fixes the use pattern that lets the rental share exchange

Section 1031 applies to property held for investment or business use, and a house the family uses is the classic case the IRS questions. Rev. Proc. 2008-16 gives a safe harbor: the IRS will not challenge a dwelling unit as relinquished or replacement property if it is held for a 'qualifying use period of at least 24 months' immediately before or after the exchange, and in each of the two 12-month periods the taxpayer 'rents the dwelling unit to another person at a fair rental for 14 days or more' and personal use 'does not exceed the greater of 14 days or 10 percent of the number of days the unit is rented at a fair rental'. Personal use takes its meaning from section 280A(d)(2).

The safe harbor is about the property's status, not the allocation. A unit that meets it can be exchanged in full; one that fails it is judged on facts and circumstances, where heavy family use is hard to explain away. Many owners cut personal use to the safe-harbor level for the two years before a planned sale. Managing personal use before a 1031 of a vacation home or short-term rental sets out that plan, and what exchanging a vacation rental looks like covers replacement options.

The replacement must meet the same test for 24 months after the exchange, which rules out moving into it. A Delaware Statutory Trust interest avoids the question, because it has no personal use at all. Traditional DST solutions describe the structure.