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:

· 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.

According to the IRS: "If you had a net profit from the rental property for the year (that is, if your rental income is more than the total of your rental expenses, including depreciation), deduct all of your rental expenses. However, if you had a net loss, your deduction for certain rental expenses is limited.

"If your rental expenses are more than your rental income, you cannot use the excess expenses to offset income from other sources. The excess can be carried forward to the next year and treated as rental expenses for the same property."

Deductions can include management fees and advertising costs. Additionally, items such as insurance, repairs, utilities and depreciation -- which you cannot deduct for a principal home -- can now be deducted, although on a pro rata basis, depending on the ratio of personal to rental use.

The law requires that you deduct your expenses in a particular order. Mortgage interest and real estate taxes applicable to the rental period are deducted first and are put on Schedule E of your income tax return. All the other expenses associated with the rental property are also allocated but put on Schedule A of your tax return.

Expenses relating solely to your personal use are not deductible.

· Primarily as a rental: If you do not use your property enough for it to be treated as a home, then it is a rental property. The income you receive must be reported. But now you can deduct all of your rental expenses, even though they may exceed the amount of your rental income.

Caution: There are passive loss limitations that are not addressed in this column; you should discuss them with your tax advisers.

There are, not surprisingly, complications to determining exactly how you count days of personal use and rental use. But for many people, the effect of this is that they can take a two-week vacation at their beach house and still treat it as rental property.

You also inquired about whether you could defer capital gains tax on the sale of your vacation home. This is done by using a Section 1031 exchange, also called a like-kind exchange. The answer is fairly simple: If you did not use the property for yourself or your family, it is property primarily held for investment and thus can be the relinquished property in such an exchange. However, if you never rented it out, it is not an investment property and cannot be used for an exchange.

Recently, the U.S. Tax Court decided a case involving vacation homes. The taxpayer had exchanged one vacation home for another and tried to avoid paying any capital gains tax. According to the taxpayer, he held the property in anticipation that it would increase in value, and thus it was an investment.

The Tax Court rejected this argument, primarily because the vacation home was never rented and was consistently used by the taxpayer and his family.

According to the Tax Court, for a home to qualify as investment property, that must be the taxpayer's primary purpose. Citing a long-standing rule, the court held, "The exclusive use of property by the owner as his residence contradicts any claim by him that the property is held for investment." ( Moore v. Commissioner, IRS, TC Memo 2007-134, May 30, 2007).

So how do you treat a vacation home that is used for both rental and personal use? Although I am not familiar with any case law in this area, it's my opinion that such properties would not be eligible for like-kind exchanges. If your property has appreciated considerably in value and you want to do a like-kind exchange, stop using the property for at least two full years and rent it out. Then it will be considered investment property.

But there are other possibilities besides an exchange that you should keep in mind to make the most of that vacation home financially. You could decide to hold onto it and rent it out. If you believe that there is a strong rental market and that the house will continue to appreciate, why sell it and pay the tax? Perhaps while it is still your second home, you can refinance, lowering your interest rate. Obviously, this makes you a landlord, and unless you turn the property over to a manager, you will have to endure the negative aspects of being a landlord as well as the positive.

If you hold on to the property for the rest of your life and then will it to your children or other heirs, those heirs will get what is known as a "stepped-up" tax basis for the property. In other words, even though your basis may be $100,000, if the value of the property on the date of your death is $500,000, that is the basis for your heirs. That can save them a considerable amount of tax if they decide to sell.

If you own or are considering buying a vacation home, consult your tax advisers before you get yourself into any trouble. The rules can be confusing. In this column, I have only scratched the surface. You will need all the guidance you can get.

Benny L. Kass is a Washington lawyer. For a free copy of the booklet "A Guide to Settlement on Your New Home," send a self-addressed stamped envelope to Benny L. Kass, 1050 17th St. NW, Suite 1100, Washington, D.C. 20036. Readers may also send questions to him at that address or contact him through his Web site, http://www.kmklawyers.com.