The passage of the new tax law, the Tax Cut and Jobs Act (TCJA), ushered in a bevy of changes that tax professionals and the IRS are still working to interpret. While the bill was being debated in congress, there was substantial discourse regarding the negative effects the bill might have on three key constituencies: 1) Individuals living in areas with high state and local taxes (SALT), 2) Homeowners with home loans over $750k, and 3) Taxpayers owning multiple homes. Hilton Head homeowners often fit into more than one of these categories. Furthermore, because South Carolina has state income tax, many South Carolinians will now easily exceed the new $10,000 SALT deduction limit.

It appears that some of the negative effects of the bill on these types of taxpayers can be mitigated by using a property as a rental property for a portion of the year. This has the potential to help out many Hilton Head Island residents who own two homes. Here’s how it works:

1. If you pay over $10,000 in SALT

The TCJA caps SALT deductions at $10,000. But, there may be a way around this if you rent out the home for more than 15 days per year according to legal writer Stephen Fishman. Let’s say have a vacation home in the low country. The property taxes on this home are $15,000 per year. Under the new law you could only take the maximum deduction ($10,000) from your federal taxable income. However, if you rent out the home in question for 6 months (50% of the year), you could claim 50% of the property taxes as a Schedule E (Supplemental Income and Loss) taxes expense and the remaining 50% ($7500) in property taxes could be claimed as a Schedule A itemized deduction. Keep in mind that the $10,000 SALT deduction cap applies to your aggregate state and local taxes between all states where you pay tax throughout the year.

Kathryn Vasel from CNN Money has written a great article on SALT deductions here.

Mr. Fishman’s book “Every Landlord’s Tax Deduction Guide” was released on August 30^th 2018 with updated information pertaining to the Tax Cut and Jobs Act. Previous editions of the book have been favorably received and the new version is available here.

 2. If you wish to take a deduction for personal property 

Another big benefit for owners of Hilton Head rental property is immediate expensing of personal property used by renters. Previously, these types of purchases had to be depreciated over a 5 or 7-year period. This deduction can be applied to anything from furniture to a television used in the rental home and it applies to the homeowners full cost basis in the property. The cost basis that can be taken as a deduction is equal to the purchase price times the percentage of the year the property is rented.

3. If you have a mortgage balance over $750k

While the SALT deduction cap made most of the headlines, the TCJA also included a reduction in the mortgage interest deduction for first and second homes. Previously, the interest on the first $1 million in loans on first and second homes combined could be deducted from taxable income. The TCJA reduced this cap to $750k. Thankfully, this lower limit only applies to new mortgages originated after 12/15/2017. Mortgages taken out prior to this are grandfathered at the higher limitation. If you recently purchased a home and have over $750k in debt, renting a residence for more than 15 days per year may provide homeowners with a workaround for this limit.

Let’s say you have a $1 million mortgage on your South Carolina home that you purchased in 2018 and pay $40,000 per year in interest. Under the new law with the $750,000 cap, you would only be able to deduct ¾ ($750k/$1 million) of the interest you paid from your taxable income. However, if you were to rent out the property for one quarter of the year, you would be able to claim $10,000 ($40,000 * ¼) as a Schedule E mortgage interest expense and claim the remaining $30,000 as a Schedule A home mortgage interest deduction.

Michael Kitces has written extensively on this subject and more information from him can be found here.

A major benefit of renting a home for 15 days or more per year is that there are a wide variety of expenses that can be taken as a deduction from your rental income. The IRS lists all of the following as the most common types of rental expenses. The rules can get quite complicated with these expenses especially when it comes to mortgage interest, points, and the like. We always recommend speaking with a CPA prior to deciding to rent a property. The IRS has extensive guides for owners of rental properties available here and here.

Are there any pitfalls I need to watch out for?

Yes, the IRS rules involving rental properties used as both a home and a rental property can get quite complex. You will most likely need professional accounting advice to navigate these rules. This is especially true when you use the home for personal use for more than 10% of the rental period or more than 14 days (whichever is greater). For example, if you rent the home for 180 days per year, and use the home for personal use for more than 18 days per year (10%), special rules apply regarding the deduction of rental expenses. In general, you would only be able to deduct the portion of the expenses attributable to the period when the home was actually rented (days the home is vacant do not count). The rules can get even more complicated if you had a net loss from renting the dwelling for the year and can result in a limitation on the deduction for certain rental expenses.

What if I rent my home for 14 days or less?

Renting your home for 14 days or less is a double-edged sword. On one hand, the rental income you receive will be entirely tax-free! That’s right- you do not need to report income from renting your home for 14 days or less. For example, you might only rent it out the week of the RBC Heritage to golf fans traveling to Hilton Head for the annual event. On the other hand, you will not be able to deduct any of your rental expenses. This means that you must rent your home for 15 days or more to take advantage of any of these strategies to work around these new TCJA rules.

As you can see, many of the issues for higher wealth individuals created by the TCJA can be overcome by renting properties that aren’t in use for a portion of the year. In many cases, owners of multiple homes can receive a tax benefit from renting in addition to the extra rental income they will receive. However, as the homeowner you will have weigh these potential tax benefits against the costs. Will you manage the property yourself or pay a property management company? Will you have to hire a cleaning company? Will your insurance costs change? How will you advertise the property? Do you want to use the rental property for more than 10% of the rental days? Will potential tax savings offset the costs associated with the accounting required? These are all things to consider when making this decision.

Please keep in mind there are many aspects of the new tax law for which the IRS is still writing regulations and this article should not be used as a substitute to guidance from the IRS. There are a lot of different factors to consider when making the decision to rent a home and we recommend speaking to a Certified Financial Planner™ and a CPA before making that decision.