Make Your Vacation Home Pay for Itself

Albert Ellentuck, Esq., CPA
King & Nordlinger, LLP

I f you own a second home used purely for your own getaways, the tax
implications, federal and state, are fairly straightforward. You
probably can deduct outlays for mortgage interest and property tax,
just as you can with your primary residence. (Property tax deductions
won't be deductible, though, if you are subject to the alternative
minimum tax.)

Mixing business with pleasu The rules change -- and become
considerably more complex -- if you sometimes receive rental income
from your second home.

Opportunity: Knowing how to mix rental use with personal use can
result in substantial additional tax savings.

14-day rule

If you rent out your vacation home occasionally, you can qualify for a
prime tax break.

Loophole: You can rent out your home for up to 14 days a year and owe
no tax at all on that income.

This can result in thousands of dollars of tax-free income if your
home is near a major sports event, such as the Super Bowl or in a
desirable vacation area.

Caution: It probably won't make sense to rent your home for just over
14 days in a year. If you do, all the income will be taxable, not just
the excess from the fifteenth day on. You might pocket less after
taxes than if you had rented the place out for fewer days.

14-day 10% rule

Once you rent out your home for more than 14 days in a given year,
things become complicated.

Rental vs. residence: If you use your vacation home for personal
purposes* for no more than the greater of (1) 14 days or (2) 10% of
rental days, the home will be considered rental property. In this
case, losses may be deductible.

*You must count as personal use any day that the residence is used for
personal purposes by you or by a relative, even if you used it for
only part of that day.

Example: Jim Smith rents out his beach house for 100 days a year and
uses it personally for 13 days. He can treat his beach house as rental
property. If he uses it for 14 days, however, it is considered a
residence.

Janice Jones has the beach house next to Jim's, which she rents out
for 200 days a year. She can use it up to 19 days (less than 10% of
200 days) and still treat it as rental property.

Why this matters: As explained above, when you rent out a property for
more than 14 days a year, the rental income is taxable. But at the
same time, expenses related to that rental income can be tabulated.
Such expenses might include management fees and marketing costs. You
also can allocate expenses, such as insurance, repairs, and
depreciation to the property's rental use.

Outcome: A portion of your vacation home expenses will become business-
related, and this will reduce the net income you'll report from the
property. You'll owe less tax on your rental income.

In some cases, business-related expenses will exceed rental income.
The resulting loss will fall under the "passive-loss" rules if you can
treat your vacation home as rental property.

How this works: If you have a passive loss, it can offset taxable
income from unrelated passive activities. This could include other
rental property you own or income from a limited partnership.

Even better: In addition, net passive losses may be deductible from
your taxable income (the income you report on your tax return after
deductions).

Required: If your adjusted gross income (AGI) is less than $100,000 on
a single or joint return, you can deduct up to $25,000 worth of net
passive losses.

To deduct passive losses against your taxable income, you also have to
take part in some management decisions, such as approving tenants and
authorizing repairs.

Phaseout: If your AGI is between $100,000 and $150,000, you can deduct
a lower amount of net passive losses.

Example: Your AGI is $145,000 this year, so you are 90% through the
phaseout range. You are entitled to 10% of the maximum passive-loss
deduction, so you can deduct up to $2,500 in net passive losses (10%
of $25,000).

Looking ahead: Net passive losses you can't deduct right away can be
used in the future if your AGI permits a write-off at that time or if
you have passive income from other sources. Otherwise, all of your
deferred passive losses can offset any gains when you sell the
property.

Bottom line: If you think that you'll have a passive loss from renting
out a vacation home and you'll be able to deduct such a loss, keep
personal use down to the level where the home is classed as rental
property.

If you use the vacation home for so many personal days that it is
classed as a residence rather than a rental property, no losses can be
deducted.

seven-day rule

Yet another rule comes into play for vacation home owners.

In some areas, especially resorts, your average rental period for a
vacation home may be less than seven days. If so, you face different
requirements. You divide the number of days you rented by the number
of your paying customers.

If your vacation home rentals average less than seven days, you may be
able to avoid the passive-loss rules and deduct your losses currently,
in the year that you have the loss. To do so, you must "materially
participate" in the venture by either...

Devoting more than 500 hours per year to gaining revenues from the
property or...

Devoting more than 100 hours to this effort, as long as this is more
time than anyone else spends.

Strategy: If your vacation home rentals will average less than seven
days and you expect to have net losses from this activity, consider
not using a management company. By spending more than 100 hours per
year yourself on this business, you will probably be able to deduct
those losses.

What if your vacation home use qualifies you for the seven-day rule,
but you do not materially participate in running the business? You'll
be subject to the passive-loss rules, without the opportunity of
deducting up to $25,000 worth of net losses.

disappearing deduction

As explained, it may make sense to restrict personal use of a vacation
home to qualify it as rental property so that a loss can be deducted.

Trap: A home classified as rental property is no longer a residence.
Mortgage interest payments allocable to your personal use won't be
deductible.

Example: You rent out your vacation home 190 days in a year and use it
for 10 days. Therefore, the home is considered rental property.

However, 5% of the usage (10 days out of a total of 200 days) is
allocable to your personal use. Consequently, 5% of the mortgage
interest you pay is not deductible.

Reasoning: That 5% can't be allocated to your rental activities
because it's attributable to personal use. Yet the home does not
qualify as a residence, so that 5% is not deductible home mortgage
interest, either.

Strategy: Crunch the numbers to see which will produce the best after-
tax result -- a deduction for home mortgage interest or a passive-loss
deduction.

Then adjust your personal use to have your vacation home fall into the
category that works best for you, rental property or residence.

Best: Talk with an accountant experienced in helping clients maximize
the tax benefits of owning a second home.


Tax Hotline interviewed Albert Ellentuck, Esq., CPA, of counsel to the
law firm King & Nordlinger, LLP, 2111 Wilson Blvd., Arlington,
Virginia 22201. Past chairman of the tax division of the American
Institute of Certified Public Accountants (AICPA), he writes a monthly
column for the AICPA publication, The Tax Adviser.