Tax Planning for Second Homes and Vacation Rentals

Overview

Owning a second home or operating a vacation rental creates both tax opportunities and traps. With careful planning you can often deduct operating costs, use depreciation to reduce taxable rental income, and position a property for more favorable treatment at sale. But you must follow IRS rules about personal use, rental reporting, and depreciation recapture to avoid audits and unexpected taxes (see IRS Publication 527) (https://www.irs.gov/pub/irs-pdf/p527.pdf).

In my practice working with homeowners and short-term rental operators, the biggest wins come from: clear documentation of days used and rented, timely elections (for depreciation and entity structure), and choosing the right balance between personal enjoyment and business treatment.

Key tax rules that affect second homes and vacation rentals

• Personal use threshold: If you rent a dwelling unit for fewer than 15 days in the year and use it personally the rest of the time, you generally do not report the rental income (IRS Pub 527). Conversely, if you rent it more and provide personal use, you must allocate expenses between personal and rental use.
• Vacation home classification test: A property is treated as a residence for tax purposes if you use it personally for the greater of 14 days or 10% of the days rented at fair rental value. When it’s a residence, deductible rental expenses are limited and prioritized by rules in IRS Publication 527.
• Reporting forms: Rental income and expenses are usually reported on Schedule E (Form 1040). If you provide substantial services (hotel‑like activities), the IRS may treat the activity as a trade or business and you could report on Schedule C, which carries self‑employment tax risks and different deduction rules.
• Depreciation: Buildings used for rental are depreciated using the Modified Accelerated Cost Recovery System (MACRS) over 27.5 years for residential rental property. Land is not depreciable. Use Form 4562 to start depreciation (https://www.irs.gov/forms-pubs/about-form-4562).
• Depreciation recapture and sale: When you sell, accumulated depreciation can increase taxable gain and may be subject to depreciation recapture taxed at up to 25% (IRC Section 1250 rules) and any remaining gain is taxed at capital gains rates. Converting a rental to your primary home before sale can allow partial exclusion of gain if you meet the ownership and use tests (see IRS guidance on the sale of your home).

How to decide whether a property is personal, rental, or a mixed-use business

1. Count days carefully. Track: (a) days rented at fair rental value, (b) personal days, and (c) days for repairs/maintenance (not personal). A simple spreadsheet or calendar with receipts is usually sufficient evidence.
2. Apply the IRS tests: fewer than 15 rental days = no income reporting; greater of 14 days or 10% rule determines residence classification. If rental activity rises to a business level (services, regular advertising, and continuous operations), consult a tax pro about Schedule C treatment and QBI possibilities (IRS Rev. Proc. 2019-38 guidance on qualifying rental real estate for trade or business classification).
3. Consider state lodging taxes and local regulations for short‑term rentals; compliance is separate from federal tax rules.

Depreciation and accelerated methods (practical example)

Residential rental property is depreciated over 27.5 years. Depreciation applies only to the building and improvements, not to land.

Example calculation:

• Purchase price: $500,000
• Land value (non-depreciable): $100,000
• Basis for building: $400,000
• Annual straight-line MACRS depreciation: $400,000 ÷ 27.5 ≈ $14,545 per year.

If property is used 50% personal and 50% rental, allowable depreciation is halved to ~$7,273.

Bonus depreciation and Section 179: Historically, 100% bonus depreciation was available for qualifying assets placed in service through 2022. As of 2025, bonus depreciation is phased down (80% for 2023, 60% for 2024, 40% for 2025, 20% for 2026) and generally does not apply to residential buildings but may apply to qualifying personal property or certain components after a cost segregation study. Always confirm current bonus depreciation percentages before applying them.

Practical tip: a cost segregation study can reclassify building components (carpets, appliances, certain finishes) into shorter recovery classes to accelerate depreciation. For larger vacation rental portfolios this often produces meaningful near‑term tax benefits.

Common deductions and limits

Allowable expenses for the rental portion can include:

• Mortgage interest (subject to the residential mortgage interest rules and the $750,000 acquisition debt cap for loans after 2017),
• Real estate taxes (subject to the SALT $10,000 limit for individual returns),
• Insurance, utilities, property management fees,
• Repairs (routine maintenance) vs. improvements (capitalized and depreciated),
• Advertising, supplies, and travel related to rental management.

Keep settled records that show the split between personal and rental use. If the property qualifies as a rental, you can deduct expenses up to the amount of rental income; passive activity loss rules then determine whether excess losses can offset other income or are suspended.

Passive activity rules and material participation

Most rental activities are passive (subject to passive activity loss rules) and losses can usually only offset other passive income. Exceptions include the active participation exception for certain taxpayers (limited offset up to $25,000 of rental loss for eligible owners with modified adjusted gross income up to $100,000, phased out above that) and the real estate professional election for materially participating taxpayers which can treat rental losses as non‑passive but has strict tests.

Sale planning and capital gains strategies

• Capital gains: Sale of a second home or rental is generally a taxable event. The primary residence exclusion ($250k/$500k) typically doesn’t apply to second homes unless you convert the property to your primary residence and meet the two‑of‑five‑year rule (partial exclusions may apply).
• Depreciation recapture: Any depreciation claimed while the property was rented is subject to recapture at up to 25% when sold.
• Timing: Consider the impact of tax rates, potential 1031 like-kind exchanges (limited now to real property) and state income taxes when selling. See our deeper guide on Tax Consequences of Selling a Second Home: Reporting, Exclusions, and Calculations.

When a short-term rental becomes a business (and why it matters)

If you operate a vacation rental with substantial services (daily cleaning, concierge service, meals) you may be running a business. This affects:

• Self-employment tax exposure (if reported on Schedule C for services),
• Availability of the qualified business income (QBI) deduction (if the activity qualifies as a trade or business),
• How losses are treated for passive vs. non‑passive rules.

If you run multiple short-term rentals, consider aggregating them under one rental enterprise for elections and for meeting recordkeeping thresholds under IRS safe harbor guidance (IRS Rev. Proc. 2019-38).

Practical 6-step checklist before tax season

1. Reconcile a calendar of days: rental, personal, repairs. Keep digital backups of listings and booking confirmations.
2. Separate bank accounts and credit cards for the property to simplify bookkeeping.
3. Determine classification: residence, rental, or business (consult a CPA if you provide services).
4. Run depreciation calculations and file Form 4562 the first year you claim depreciation.
5. Review major expenditures: repairs vs. improvements — capitalizable items must be depreciated.
6. Talk to a tax advisor about cost segregation, entity structuring (LLC vs. individual ownership), and state lodging tax compliance.

Common mistakes to avoid

• Failing to document personal use days and rental days accurately.
• Forgetting to depreciate the building after first year of rental (missed Form 4562 can be remedied, but timely filing is simpler).
• Treating repairs as deductible when they should be capitalized.
• Ignoring local lodging or transient occupancy taxes and regulatory rules for short‑term rentals.

Where to learn more (authoritative resources)

• IRS Publication 527, Residential Rental Property (including vacation homes): https://www.irs.gov/pub/irs-pdf/p527.pdf
• IRS Form 4562 — Depreciation and Amortization: https://www.irs.gov/forms-pubs/about-form-4562
• CFPB guidance on housing and consumer protections: https://www.consumerfinance.gov/

For practical, site-specific guidance on adjacent topics see these FinHelp articles:

• Tax Consequences of Selling a Second Home: Reporting, Exclusions, and Calculations
• Depreciation
• Form 4562 — Depreciation and Amortization

Final recommendations and disclaimer

Every property and taxpayer situation is different. In my experience, investing a modest amount in a CPA or tax advisor skilled with rental real estate pays for itself quickly by capturing depreciation, advising on entity selection, and steering clear of costly reporting mistakes. This article is educational and does not replace personalized tax advice — consult a qualified tax professional for decisions about your specific properties.

(Information in this article is current through 2025. Tax law changes can affect deductions, bonus depreciation phase‑outs, and reporting rules.)