Vacation Home, Rental Property or Both?

By Benny L. Kass
Saturday, July 21, 2007

Q: Our principal residence is in the District, and we have a second home in Delaware. I know that when we sell our principal residence, we will be eligible for the exclusion of tax on up to $500,000 of the gain. I also know that we can deduct our main home's mortgage interest and real estate taxes when we file our annual income tax return. However, we do not know how to handle this for the vacation home. Can you give us some guidance?

A: It depends on how you use your second home. This is one of the most convoluted issues in our tax laws.

Let's start with a definition of personal use. According to the tax laws, your use of the second home is "personal" if on any day (or part of a day) it is used by anyone who owns an interest in the property, or their relatives, such as spouses, brothers, sisters, grandchildren or grandparents. Personal use also includes use by any other person who does not pay a fair rent.

Vacation homes include houses, apartments (such as condominiums and cooperatives), and even trailers or boats. For a boat to be considered a "home," it must have sleeping, cooking and toilet facilities.

The Internal Revenue Service explains the rules for tax treatment of rentals in Publication 527, "Residential Rental Property." The publication is available free on the IRS Web site, http://www.irs.gov.

If you rent out the property and never make personal use of it, it is considered rental property, and all appropriate deductions are available to you.

If you never rent out the property, it is treated as a second home. As with your principal home, you can deduct real estate taxes and mortgage interest, subject to any limitations such as the alternative minimum tax.

The complications come when there's a mix of personal and rental use. The IRS groups such properties in two ways, and their tax treatments differ:

ยท Primarily as a home: Count the number of days of your personal use of the property during the year. If your use exceeded the greater of 14 days or 10 percent of the number of days the property was rented out to others, the property is a home.

Then count the number of days that you rented the property out. If you rented your home for fewer than 15 days during any one year, any income you receive is yours to keep and need not be reported on your tax return as income. However, you cannot deduct any rental expenses.

This can be a windfall when there are special events in your area. For example, many people rent out their second home in Annapolis for the boat shows in October or for the Naval Academy's graduation-week celebrations.

However, if the property qualifies as a home (because of the amount of personal use) and you also rent it out for more than 14 days, you must declare your rental income. You can deduct your rental expenses, but only up to the amount of the rent you received. You also must divide your expenses between personal and rental use based on the number of days of each.


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