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Deducting Mortgage Interest Tricky On Three Homes

Why is mortgage interest deductible without limit on two homes and not just the primary residence?

Some accountants have jokingly referred to the concept as the “Congressman’s Rule” because some of our lawmakers have a residence in the nation’s capital and another in their home state.

But what if you happen to own more than two homes? Granted, many people have a difficult time finding the funds for a primary residence let alone a getaway in the mountains or a condo on a desert golf course. But more and more parents are leaving homes to their children, giving the kids a huge asset, sometimes without much notice.

Before 1987, mortgage interest on all residences could be deducted without limit. Since then, consumers with more than two residences are required to choose two “qualified” residences where mortgage interest could be deducted, but the selected residences are allowed to be juggled into the “qualified” category from year to year.

For example, let’s call my personal residence “Seattle” and my vacation home “Palm Springs.” Suppose I’m transferred to Phoenix and decide to buy a home there. Depending upon the purchase prices and considering when “Phoenix” was purchased, I may decide to claim Seattle and Palm Springs as my two residences for this tax year. If Seattle is sold next year, I likely would pick Palm Springs and Phoenix as my residences for next year, depending on when in the calendar Seattle was sold.

A home does not actually have to be used to qualify as a selected residence. If there is no rental or personal use of a residence for an entire year, it can be designated as a selected residence and interest can be deducted. If it is rented or used only occasionally by the owner, no interest can be deducted under the personal-residence rule unless there are at least 15 days of personal use.

The personal-residence rule requires that personal days must exceed the greater of 14 days or 10 percent of rental days. The personal-usage requirement must be met before a property can be designated as a selected residence. If the home is rented more than 140 days, there will have to be 15 days of personal usage before the interest can be fully deducted under the residence rule.

Longer rental seasons are a bonus under the 10 percent rule. For example, a mountain resort home near the ski slopes (for winter sports) and a lake (summer water sports) might be rented for 250 days a year, allowing the owner to use it for 25 days.

Personal use does come at a cost. Depreciation is limited only to the percentage of time that a house is rented. If you rented for 90 days and used it yourself for 10 days, you can take only 90 percent of the total expenses and depreciation.

Another way to catch a few hours at the beach without eating into or exceeding your 14-day or 10 percent limit is to clean the house yourself between renters. Days spent maintaining the house do not count toward the personal-use limit. You can even deduct travel costs to get to the house and expenses such as paint and cleaning supplies.

But if the Internal Revenue Service determines that you were at the house more to sit in the sun than to clean the kitchen and refinish the deck, those days may be added to your personal use and could jeopardize your tax savings.

The house also is supposed to be rented at fair-market value to qualify as a legitimate investment property. If you rent to relatives at discount rates, the IRS may rule that the house is not a business and disallow many of your deductions.

One of the more effective uses of a vacation home as a tax shelter is for future retirement. For example, if you are 50 years old, you can buy a vacation home, furnish it and have renters pay for it while you capture the depreciation for 15 years. When you have taken most of the tax advantages out of it, you can move in and/or convert it to a private residence.

And because most mortgages “front load” interest, you will have used up most of your tax deductions from the mortgage in the 15 years you were working and renting the home before you reached the traditional retirement age of 65. In the later years of the mortgage, when interest deductions are relatively low, you probably will be less concerned about deductions because your income will have fallen off after retirement.

So, if you have home loans, it’s always a good idea to look down the road to see how long mortgage interest will really be a benefit — on one or more homes.