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The Tax Prophet Newsletter   Issue # 11 May, 2004

In This Issue:
Introduction
Taxation on Sale
Vacation Home Defined
Interest and Tax Deductions
Renting Out a Vacation Home
Tax Planning Opportunities
Conclusion

Taxation of Vacation Homes


Introduction So you want to buy a vacation home to escape the rat race – at least for the weekend? An emotional purchase, maybe, but leaving aside the investment considerations in purchasing a vacation home, what are the tax implications of ownership and eventual sale?


Taxation on Sale

Unfortunately, while a major exclusion for principal residence sales exists, this break does not apply to a vacation home. In addition, a vacation home is considered personal use property and not an “investment” under the tax code, so the IRC Sec 1031 tax-free exchange rules do not apply. More bad news: although your profit from the sale of a vacation home is taxed as a capital gain, a loss is considered personal and therefore not deductible. (See Tax Planning below.)

Vacation Home Defined

A vacation home is referred to as a “second residence” under the tax code. It must have sleeping, cooking, and toilet facilities to be eligible for the mortgage interest deduction. Any type of home can be designated a vacation home that contains these amenities – a single-family residence, a condominium, cooperative unit, houseboat, mobile home, or house trailer.


Interest and Tax Deductions

For taxpayers who itemize their deductions, taxes incurred with respect to real estate (including a vacation home) are fully deductible under the regular tax system, but not under the alternative minimum tax (AMT)

There are special rules regarding deducting mortgage interest. The homeowner designates a second residence in addition to their main home. Interest is deductible on the second residence to the same extent as that allowed for the main residence; that is, interest on up to $1 million of indebtedness, in total, to buy, construct or improve a principal or second residence, or both.

In addition, interest incurred on a home equity debt secured by either a principal or second residence, and not exceeding $100,000, is also deductible under the regular tax system, but not under the AMT. If you rent your vacation home for 14 days a year or less, the income received is not taxable. This is good news for those who rent their vacation homes for a short period during major festivals or sporting events.

Note: Evidently Hollywood is abusing this loophole by characterizing prize money as rents and tenant improvements. See the accompanying story. Expect Congress to eliminate the 14-day loophole once it discovers Hollywood's tax-dodging shenanigans.

Because of the limitations on itemized deductions and the rules regarding the AMT, it could be advantageous to rent out your property to shift a portion of your mortgage interest and property tax deductions to the real estate rental schedule (Form 1040, Schedule “E” ), as discussed below.

Renting Out a Vacation Home

Once you rent your vacation home for more than 14 days or 10% of the number of days the property is rented (the 14 day/10% rule), whichever is greater, the rules change.

There are complex regulations covering this subject, but in most cases you do the following: First, you include all rental income, but deductions are limited by a fraction, the numerator of which is the number of days the unit is rented out and the denominator is usually 365. Assume the unit is rented out 100 days, then the fraction for determining your allocable rental expense is 100/365. You then multiply all rental-related expenses, including advertising, commissions, maintenance, depreciation, utilities, taxes and mortgage interest by the fraction to determine the deduction against rental income. The 14 day/10% rule is applied each calendar year.

For example, if you incurred $10,000 in rental-related expenses, your deduction would be $2,740 [ (100/365) x 10,000 = $2,740]. If you received $5,000 in rental income, you would report a gain. However, if your rental-related expenses exceeded $5,000 you would have a loss, but could not offset the loss against other income. You carry the loss forward to future years until you have enough rental income to offset it.
Note: Mortgage interest and real property taxes allocable to your personal use are still deductible as an itemized deduction. In the example above the personal use days were 265, so the fraction for determining personal use is 265/365 or 72.6%.


Tax Planning Opportunities

There are two strategies available to save on taxes when selling your vacation home:

a. Move into the vacation home and convert it into your principal residence. You must live there as your principal residence for at least 24 of the 50-month period prior to sale. By converting your vacation home into a principal residence, single filers may exclude up to $250,000 in gain (married couples filing jointly may exclude up to $500,000).

Example: Married taxpayers own their principal residence and vacation home (assume they never rented it out) for more than 2 years. The couple sells their principal residence for a gain of $500,000 and excludes it. Then, they move into their vacation home and convert it into their principal residence. Two years later, they sell their converted residence for a $500,000 gain and, once again, exclude all the gain.

The result, $1 million of gain has been excluded under the principal residence rules. If they sold their vacation home while living in their residence, the vacation home would be subject to tax on $500,000 of capital gains.

b. Convert the vacation home into a rental property at the beginning of the year and diligently avoid the 14 day/10% rule. Then use the tax-free exchange provisions to exchange the property for like kind property, which must be used as investment property.

Note: There is no formula for the amount of time the acquired property must be used as investment property, although most tax advisors recommend that you rent out the property for at least 12 full months and do not violate the 14 day/10% rule.
.



Conclusion

The key decision is whether to rent your vacation home for 2 weeks or less, or limit your personal use to below the 14 day/10% threshold. In any event, unless you convert the vacation home into your principal residence and meet the residency exclusion rules, or convert it to rental property in the year of sale to take advantage of the tax-free exchange rules, be prepared to pay full capital gains taxes on the sale.



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All contents copyright © 1995-2004 Robert L. Sommers, attorney-at-law. All rights reserved. This newsletter provides information of a general nature for educational purposes only and is not intended to be legal or tax advice. This information has not been updated to reflect subsequent changes in the law, if any. Your particular facts and circumstances, and changes in the law, must be considered when applying U.S. tax law. You should always consult with a competent tax professional licensed in your state with respect to your particular situation. The Tax Prophet® is a registered trademark of Robert L. Sommers.