Americans are tired of staying home. Very tired. So millions of them have moved somewhere in the last year, and many have rented a house or a condo. If any of these rental properties belonged to your clients, they probably saw a big increase in their rental income.
While leveraging a second home to earn some extra money might seem like a financial no-brainer, market fluctuations, tax rules, changes in local laws and unforeseen costs can lead to disappointment or worse, hampering the client’s financial plan. This article discusses some of the issues vacation rental owners face and how CPA financial planners can help them.
Ask the right questions from the start
To help clients minimize any unpleasant financial surprises that could arise from renting a vacation home, the first step is to determine the client’s expectations, risk tolerance and knowledge with questions such as:
- Tell me about the house. Location and size will determine insurance and utility costs as well as competitive rents. What are the average prices charged for nearby listings?
- Why are you considering renting the house? If a client is considering buying a property to rent out, is this a home they would buy anyway, regardless of the rental income potential?
- Have you spoken with people from the community there? Local knowledge can be instrumental in learning more about the area and the rental market. Attorney Emily Morris, who owns property on Maryland’s east coast with her husband, said talking to locals in stores 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 renter to let him know if something was wrong made it worth forgoing higher short-term rates. One winter, she recalls, the tenant heard a very loud noise and informed them that one of the HVAC units had frozen.
Highlight risk protection
CPA financial planners should encourage clients considering renting a vacation home to carefully consider the issue of risk protection. Renting a house to strangers, even if they are vetted, puts the client at risk.
This risk can take various forms, including lawsuits if a tenant is injured due to a property maintenance issue. Setting up a limited liability company can protect landlords from losing personal property if a tenant sues them for more than their liability insurance covers. However, transferring a mortgaged property to the LLC can make refinancing difficult, trigger state transfer taxes, and even prompt repayment of the mortgage balance. Morris advises clients in Washington, D.C. against setting one up because of city laws that make evicting a bad tenant nearly impossible for an entity like an LLC. You should check the local rules.
To protect against the risk of personal liability, Texas-based CPA Ryan Firth, PFS recommends purchasing an umbrella policy (a policy that covers claims that exceed the limits of other insurance).
Another risk vacation rental owners face relates to contractual obligations and local laws. Clients considering renting a property may wish to consult a solicitor to avoid breach of mortgage terms and local restrictions on short-term rentals, which may arise 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 of course another risk. Determining the right amount of insurance for property damage and theft is essential. A vacation rental carries risks that primary residences often do not. Vacation rentals, for example, will be vacant for periods of time, so unnoticed damage or break-ins are more likely. To reduce 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 really vets potential tenants. Massachusetts CPA Lawrence Carlton agrees. Due to poor selection or unpredictable behavior, he has heard a number of landlords report tenants taking things or damaging items.
Discuss the impact of inflation on expenses
In times of concern about rising prices, CPA financial planners can help vacation home-owning clients understand the effect of inflation on expenses, including:
- Property taxes: Thanks to a warm market in many places in recent years, “valuations have gone up,” observed Mike Powers, CPA/PFS, owner of Manuka Financial in Richmond, Va. 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 homeowners insurance or vacation rental insurance, as homeowners insurance often does not cover rental properties. Insurance rates tend to rise when inflation increases the cost of building materials, etc.
- Utilities and services: The owner of a vacation rental property typically pays for tenants’ utilities and all maintenance of the property. Clients will want to factor current or potential increases in energy prices into their projected expenses and the rental rate they charge, particularly if the property is in an area subject to extreme temperatures. For example, New Englanders experienced dramatic increases in the price of natural gas last winter. Likewise, services such as lawn care can become more expensive if labor shortages increase these costs.
Explain important tax rules
The Internal Revenue Code offers valuable benefits to vacation rental owners, but challenging your customer’s assumptions about them is key.
One of the most important questions to ask guests is how many days they plan to use the vacation property for personal use, which includes allowing others to stay there at lower rates to those on the market. 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 this case, the customer can only amortize the rental charges up to the amount of the rental income. The client may be surprised that he cannot sustain a loss.
Customers should also be aware that if they are using a vacation property for both rental and personal purposes, to determine their deductible rental expenses, they should divide their expenses for the property by the number of days used each end. 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), provides an overview of the most common costs and when they can be deducted. Consider reviewing some of these rules with customers, especially the treatment of repairs versus improvements, so they realize that renovations like upgrading a counter should be capitalized.
If clients plan to offer any kind of substantial services in addition to the rental, such as regular cleaning, linen change or maid service, they may have to pay self-employment tax on their rental income.
Many other tax rules are important to vacation rental property owners, including depreciation rules, passive loss restrictions, and more. See IRS Publication 527 for more information.
Learn about lifestyle adjustment
Renting a vacation home can be satisfying for some and a stressful headache for others. Powers asks clients, “Have you thought about that – is it a good use of your time?” If it’s just to make money, he said, “they might be better off developing their careers” if they’re currently earning enough income.
For example, what Virginia resident Linda Johnson experienced while purchasing a vacation rental property was not unusual. She spent more time and more money than she had planned to get her historic home in a Rhode Island village into rentable condition. The “sparkling place” on the list had broken windows covered in Saran film and other hidden issues; repair costs were 30% higher than expected. Fortunately, his location selection and local contacts paid off. Johnson recouped some of his start-up expenses through Airbnb bookings. She has also found an experienced property manager and caretaker which takes a lot of the stress out of it. “They take care of almost everything,” she said.
— Anne-Marie Maloney is a freelance writer based in Virginia. To comment on this article or suggest an idea for another article, contact Dave Strausfeld at [email protected]