If you are thinking about renting out your vacation home, you need to be aware of the tax consequences. To find out what they are, we'll follow husband and wife Max and Erica as they meet with their financial adviser.

Three scenarios

Max and Erica's adviser said that whichever of three scenarios applies will determine the tax consequences of renting out their vacation property:

1. They use the home for 14 days or less or for less than 10 percent of the days during which the property is rented. The home will be considered a rental property. They'll have to report the rental income, but they may be allowed to deduct rental expenses, including depreciation, subject to the passive activity loss rules. They won't be able to deduct their personal portion of expenses against the rental income, although they may be able to take an itemized deduction for certain personal expenses.

2. They use the home for more than 14 days or for 10 percent or more of the days during which it's rented and rent it for 15 days or more. The property will be considered a personal residence. The couple will have to report the rental income, although they could still take itemized deductions for their personal portion of mortgage interest and property taxes, and, perhaps, other expenses.

They may also still deduct the rental portion of their expenses up to the amount of their rental income. If rental expenses exceed their rental income, however, they cannot deduct the loss against other income. They can, however, carry forward the excess rental expenses.

3. They rent out the home for less than 15 days. They won't have to report any rental income. But they won't be able to deduct any rental expenses, either.

Strict distinction

Their adviser warned that the IRS draws strict distinctions between personal use and rental use.

Any time spent by Max and Erica, their children, other relatives, home exchange partners or anyone who doesn't pay fair-market rent will count as personal use. There is an exception for full days spent on repairs and maintenance. Even if family members pay fair-market rent, the IRS will likely deem it personal use.

Meticulous planning

This is not intended as specific advice to anyone. Each situation is different. Always discuss important financial decisions with a qualified adviser before taking any actions.

Norm Grill is a certified public accountant and managing partner of Grill & Partners LLC, accountants and consultants to closely held companies and high net-worth individuals, with offices in Fairfield and Greenwich. He can be reached at n.grill@GRILL1.com.