Introduction
So you want to buy a vacation home to escape the rat race - at least for the weekend. After all, the brightest spot in an otherwise tough economy is real estate. The National Association of Realtors informs us that 2004 is expected to be the second best year for housing in the U.S., only slightly behind the blockbuster year of 2003. The reasons are apparent - mortgage rates are low, unemployment is coming down, and the aging baby boomer population is looking forward to retirement.
All these factors point to the high probability that homeowners will be looking to buy a second home. 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?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.
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.
Personal use is important in determining whether a vacation home is personal, an investment, or a mixture of both. Personal use includes all days you used the home, other than those days spent making repairs or preparing the property for rental. It also includes time spent in the home by family members or friends, or where a reciprocal arrangement has been made with another - for example to exchange properties. Any time one stays in the property and pays less than the fair rental amount counts as personal use times as well. Personal use also includes time when the owner donates use of the house for a charitable fundraising event.
When two separate owners share equity in the vacation home, use of the home by a co-owner is treated as personal use. For what it is worth, use of the home by a co-owner is not treated as personal use only where each co-owner has maintained an undivided ownership interest in the home for more than 50 years and the co-owner pays a fair rental value.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. 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.
Those fortunate individuals who own more than two homes must decide on one to be treated as the second residence (vacation home) for purposes of the mortgage interest deduction. For tax purposes, they will want to designate as their second home the residence with the largest total deductions for mortgage interest and real estate taxes. The decision is not final, however; one residence can be elected one year, and a different one the next year.
Mortgage interest on a third home may be deductible, but only as investment or business interest where proceeds from the loan are used for investment or business purposes.
Points paid on a mortgage loan to buy, build, or improve a primary residence are deductible in full for the year in which they are paid. Although points are not deductible on a vacation home, they may be amortized over the term of the loan, as with any other purchase of investment real estate.
A casualty loss, not covered by insurance on a vacation property, may be deductible as an itemized deduction - to the extent that total casualty losses exceed 10% of adjusted gross income. As with other personal casualties, each loss must be reduced by $100. Again, there is no limit on the number of vacation homes one may own to which this deduction may apply.
Once you personally use your vacation home for more than 14 days or 10% of the total number of days the property is rented (the 14 day/10% rule), whichever is greater, the rules change. The order for calculating deductions is as follows:
Example: 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%. Note: Evidently, Hollywood is abusing this loophole by characterizing game-show prizes as rent payments and tenant improvements. See the accompanying story. Expect Congress to eliminate the 14-day loophole once it discovers Hollywood's tax-dodging shenanigans.
Passive activity loss rules apply to rental real estate activities unless the owner is a real estate professional. A loss deduction up to $25,000 in excess of passive activity income does exist provided you actively participate in the activity and meet an income limitation. Active participation means active participation in the decision making concerning the property, such as setting rents. To meet the income limit restriction, an owner's adjusted gross income must not exceed $100,000. The $25,000 deduction phases out as income rises to $150,000; no loss is allowed with AGI equal to $150,000. Losses can be carried forward and become fully deductible when the vacation home is sold or otherwise relinquished.
Gain on this type of investment rental is taxed at up to 15%, where the home is held more than one year, and depreciation claimed is recaptured at the rate of 25%. The more improvements that are added to the owner's basis in the home, the more likely it is that gains will be minimized or avoided. A loss on sale of this type rental is allowed. A home held more than one year is a long-term capital loss.
There are two main 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.
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.
© 1995-2004 Robert L. Sommers, attorney-at-law, all rights reserved. This article and internet site 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.