Taxpayers are entitled to claim deductions for their principal residence and one vacation or second home. Except for unusual situations, the ownership tax breaks for a primary residence are generally limited to the mortgage interest and property tax deductions.
However, tax savings from owning a second or vacation home are a bit more complicated and are often greater. Depending on your personal-use time, and with some advance tax planning, your vacation or second home can produce significant tax savings.
FOUR TAX CATEGORIES FOR SECOND OR VACATION HOMES. Mortgage interest and property tax payments for your second or vacation home are always tax-deductible. However, if you own a third home, it does not qualify for the mortgage interest and property tax deductions unless it is a rental property.
Your personal use time determines which of the four categories apply to your second or vacation home:
1. NO PERSONAL-USE TIME. If your second home was rented or available for rental during all of 2006, with zero personal-use time, it is treated as rental property. Even if you occupied it a few days while making repairs, your second home falls into this desirable category.
The tax result is your rental income and expenses are reported on Schedule E of your income tax returns. Don’t forget the non-cash depreciation deduction for wear, tear and obsolescence, which can result in substantial tax savings, either in the current tax year or “suspended” for use in a future tax year.
Applicable deductible expenses in this category include mortgage interest, property taxes, insurance, homeowner association fees, utility bills you paid, repairs, and depreciation. You can also deduct reasonable “ordinary and necessary” travel expenses to inspect (but not occupy) your rental property, even it is in such remote hardship locations as the U.S. Virgin Islands, Puerto Rico, or Hawaii.
When you hire a professional property manager to rent vacancies and collect rents, to claim the deductions specified above you must “materially participate” in managing your second home. That means it cannot be in a “rental pool” managed by others and you must own at least a 10 percent interest in the property.
Material participation includes setting standards for tenants, establishing the rent and approving tenants, even if the day-to-day management is left to others.
If you materially participate in managing your second-home rental and if your 2006 adjusted gross income is $100,000 or less, then you can deduct up to $25,000 of second-home tax loss from your other ordinary taxable income.
If your adjusted gross income is between $100,000 and $150,000, then your second-home tax loss gradually phases out. Above $150,000 adjusted gross income, you cannot claim any second-home tax loss.
But the good news is any unused tax loss exceeding the $25,000 limit can be “suspended” for use in a future tax year or when the property is sold to offset taxable gains.
However, if you are a “real estate professional” spending at least 750 hours annually on your real estate activities, then you can claim unlimited deductions from your rental property from your ordinary income. One spouse can qualify and need not hold a realty license, even if the other spouse works full-time elsewhere.
2. LESS THAN 14 DAYS OF ANNUAL RENTAL. If you rent your second or vacation home less than 14 days per year, in this tax category you can deduct your mortgage interest, property taxes and any uninsured casualty loss, such as water damage. But other expenses such as insurance premiums and repair costs are not tax deductible.
In this category, if you rent your second home less than 14 days per year, that rental income is completely tax-free and need not be reported on your income tax returns.
3. ANNUAL PERSONAL USE BELOW 15 DAYS OR 10 PERCENT OF THE RENTAL DAYS. This is the most desirable tax category for a second home. There is no limit to your tax loss deductions against your ordinary taxable income (except the $25,000 annual passive loss limit explained above). Rental income and deductible expenses are reported on Schedule E of your tax returns.
To illustrate, suppose you occupied your second home for 12 days in 2006 and you rented it to tenants for four months in the summer (or winter). Since your personal occupancy time was below 15 days per year, and below 10 percent of the rental days, you can deduct up to $25,000 of expense losses exceeding the rental income, including depreciation, from your adjusted gross income not exceeding $100,000. But Internal Revenue Code 183 says you must show a rental-activity profit at least three of every five years in this category.
4. ANNUAL PERSONAL-USE TIME OVER 14 DAYS OR 10 PERCENT OF THE RENTAL DAYS (IF RENTED MORE THAN 14 DAYS IN 2006). This category of heavy personal use and modest rental time results in the lowest tax savings benefits.
Rental income must be reported on Schedule E, along with the applicable rental expenses. However, in this category, any resulting tax loss when rental expenses exceed the rent collected cannot be deducted against ordinary income from other sources, such as job salary. But unused losses are “suspended” for use in future tax years so keep track of these unused tax losses.
The proper order for deducting second- or vacation-home expenses in this heavy personal-use category is mortgage interest, property taxes, uninsured casualty losses, operating expenses applicable to the rental period such as insurance and repairs, and depreciation for the rental period.
If mortgage interest, property taxes and uninsured casualty loss expenses exceed the rental income, they become itemized personal deductions on Schedule A of your tax returns.
CONCLUSION: Second or vacation homes are not great tax shelters, but they can save significant tax dollars while the property usually appreciates in market value for future resale profits.
A possible tax benefit, when you are thinking about selling your second or vacation home, is to move in to convert it to your full-time principal residence for at least 24 of the last 60 months before its sale. Then up to $250,000 principal-residence-sale capital gains will be tax-free (up to $500,000 for a qualified married couple filing joint tax returns in the year of sale). Full details are available from your tax adviser.