Americans are tired of staying home. Very tired. So millions of them went somewhere in the past year, and many rented a house or condo. If any of those rental properties were owned by your clients, they likely saw a solid increase in their rental income.
While leveraging a second home to make extra cash may seem like a financial no-brainer, market fluctuations, tax rules, local law changes, and unexpected costs can produce disappointment or worse, impeding the client's financial plan. This article discusses some of the issues that arise for owners of vacation rentals and how CPA financial planners can assist them.
Ask the right questions upfront
To help clients minimize unpleasant financial surprises that might come from renting out a vacation home, the first step is to determine the client's expectations, risk tolerance, and knowledge with questions like:
- Tell me about the home. Location and size will shape insurance and utility costs as well as rental competitiveness. What are the average rates being charged for nearby listings?
- Why are you considering renting out the home? If a client is thinking of buying a property to rent out, is this a home he or she would purchase anyway regardless of rental income potential?
- Have you talked with people in the community there? Local knowledge can be instrumental in learning about the area and the rental market. Attorney Emily Morris, who owns a property on Maryland's Eastern Shore with her husband, said chatting with locals at shops is "how we get all our information. It's how we find contractors."
- How would any damage or theft affect you? For Morris, the peace of mind of having a year-round tenant to let them know if something was wrong was worth giving up higher, short-term rates. One winter, she recalled, the tenant heard a really loud noise and notified them that one of the HVAC units had frozen over.
Highlight risk protection
CPA financial planners should urge clients who are thinking of renting out a vacation home to carefully consider the issue of risk protection. Renting a home to strangers, even if they are vetted, puts the client at risk.
That risk can take various forms, including lawsuits if a tenant is injured due to a property maintenance issue. Creating a limited liability company can shield property owners from losing personal assets if a tenant sues them for an amount beyond what their liability insurance covers. However, transferring mortgaged property to the LLC can make refinancing difficult, trigger state transfer taxes, and even prompt repayment of the mortgage balance. Morris advises her clients in Washington, D.C., against creating one due to city laws that make evicting a bad tenant close to impossible for an entity like an LLC. You should check local rules.
To protect against personal liability risk, Texas-based CPA Ryan Firth, PFS, recommends purchasing an umbrella policy (a policy that covers claims exceeding the limits of other insurance).
Another risk that vacation rental owners face involves contractual obligations and local laws. Clients planning to rent out a property may want to consult an attorney to avoid noncompliance with the mortgage's terms and any local restrictions on short-term rentals, which can surface at any time. "It's important to understand what your mortgage allows you to do," Morris said. "They could call the note."
Damage to the rental property itself is another risk, of course. Determining the right amount of insurance for property damage and theft is critical. A vacation rental will incur risks that primary homes often do not. Seasonal rentals, for example, will be vacant for periods of time, so unnoticed damage or break-ins are more likely. To lower the insurance rate, burglar alarms and water leak sensors can help.
Based on his own experience, Firth stresses the importance of hiring a good property manager who truly vets prospective renters. Massachusetts CPA Lawrence Carlton concurs. Due to either poor screening or unforeseeable behavior, he has heard from a number of property owners about renters who took things or damaged items.
Discuss how inflation affects expenses
In times of concern about rising prices, CPA financial planners can help vacation property-owning clients to understand the effect that inflation has on expenses, including:
- Property taxes: Thanks to a hot market in many places in recent years, "appraisals have gone up," observed Mike Powers, CPA/PFS, owner of Manuka Financial in Richmond, Va. In developing monthly payment estimates for new property purchases, he cautions that the property tax should be based on the local rate multiplied by the expected purchase price, not the current amount. Lender rates for second homes can also be higher, he said.
- Insurance: Vacation rental owners may wish to purchase landlord insurance or vacation rental insurance because homeowners' insurance often does not cover rental properties. Insurance rates tend to rise when inflation increases the cost of building materials and so forth.
- Utilities and services: The owner of a vacation rental property typically pays for the renters' utilities and all property maintenance. Clients will want to factor current or potential increases in energy prices into their anticipated expenses and the rental rate they charge, particularly if the property is in an area subject to extreme temperatures. For example, New Englanders saw dramatic natural gas price hikes this past winter. Similarly, services such as lawn care can get more expensive if labor shortages drive up these costs.
Explain important tax rules
The Internal Revenue Code provides valuable benefits to vacation rental owners, but tackling your client's assumptions about them is key.
One of the most important questions to ask clients is how many days they plan to use the vacation property for personal purposes, which includes allowing others to stay there at below-market rates. Most likely, it will be more than the greater of 14 days or 10% of the days the home is rented at fair market value. In that case, the client can write off rental expenses only up to the amount of rental income. The client may be surprised that he or she cannot take a loss.
Clients also need to be aware that if they use a vacation property for both rental and personal purposes, in determining their deductible rental expenses, they must divide their expenses for the property based on the number of days used for each purpose. For example, if the property was rented for 150 days and personally used for 40, only 150 ÷ 190 (79%) of the expenses can be deducted as rental expenses.
IRS Publication 527, Residential Rental Property (Including Rental of Vacation Homes), gives an overview of the most common costs and when they can be deducted. Consider reviewing some of these rules with clients, particularly treatment of repairs versus improvements, so they realize that renovations like upgrading a countertop must be capitalized.
If clients plan to offer any kind of substantial services along with the rental, such as regular cleaning, changing linen, or maid service, they may have to pay self-employment tax on their rental income.
Many other tax rules are important for vacation rental property owners to be aware of, including depreciation rules, passive loss restrictions, and much more. Consult IRS Publication 527 for more information.
Ask about lifestyle fit
Renting out a vacation home can be satisfying for some and a stress headache for others. Powers asks clients, "Have you thought this through — is this a good use of your time?" If it's just to make money, he said, "they may be better off developing their career" if they are currently earning sufficient income.
For instance, what Virginia resident Linda Johnson experienced in buying a vacation rental property was not unusual. She spent more time and more money than she planned to get her historic home in a Rhode Island village in shape to be rented out. The "gleaming place" in the listing had broken windows covered with Saran wrap and more hidden problems; repair costs were 30% higher than expected. Fortunately, her location selection and local contacts paid off. Johnson recovered some of her startup expenses through Airbnb bookings. She also found an experienced property manager and caretaker who eliminates much of the stress. "They take care of almost everything," she said.
— Ann Marie Maloney is a freelance writer based in Virginia. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.