Bill Lowe is looking forward to escaping the crush of city life and spending time in his new vacation home in the woods of northwestern Illinois. But as much as he yearns for the outdoors, no amount of clean air or rolling hills could convince him to stay more than 14 days a year at his retreat.
To do so would upset the careful plan of Lowe (not his real name) to operate his three-bedroom, two-bath, air-conditioned "cabin" as a business and to rent it out as much as possible. By limiting his use of the property to no more than two weeks, Lowe is eligible for the maximum tax benefits bestowed on vacation home owners by the Internal Revenue Service, and he gets the chance to offset his second home's costs, make a little profit and reduce his total tax bill.
"And we have a vacation place," adds Lowe, a husband and father of two and an Evanston, Ill., homeowner. "If we can get a couple of good, relaxing weeks out of the year, that's fine by us. "The rest of the year we're making money."
Lowe knows his plan isn't foolproof, that he must have enough rental income to "wash" the more than $500 monthly expenses on his newly constructed $70,000 home with its 10 1/2 percent mortage. (Remember 10 1/2 percent mortgages? Lowe got his last Christmas.) The vacation home is an investment with all the attendant risks, of any investment, but with one pleasing difference.
"You can't play with gold or frolic with Treasury bills," Lowe says. "But I can sit on the front porch of this investment and watch the leaves turn brown."
This ability to mix business with pleasure has enticed many people to invest in vacation homes. One vacation industry consultant estimates that one quarter of the approximately 3.5 million vacation homes in the United States are rented out for some period during a year.
But the ranks of such investors have thinned in the last five years as the tax laws on vacation rental property have become somewhat more restrictive and the costs of buying and financing a second home have swelled.
"It used to cost an average of $25,000 for a lot and house. Now, the cost is at least $50,000 or $60,000," says Carl Burlingame, editor of a California-based vacation industry newsletter. "You probably can't find a resort condominium unit in Hawaii priced under $125,000."
For those who can afford today's housing prices, vacation home tax benefits make buying a second home more palatable. They also make it easier to retain a presumably appreciating property until it is sold or until an owner decides to make it his or her retirement home.
A vacation homeowner can take the same tax deductions allowed for a principal residence: mortgage interest, property taxes and casualty losses. If the home is rented out for some period additonal deductions, such as operating expenses and depreciation, are allowed.
According to the accounting firm of Coopers & Lybrand, if a house is used primarily by its owner and is rented out 14 days or fewer in a year, then rental income need not be reported on a tax return.
If the owner uses the house for more than 14 days, he or she must report rental income but can deduct a prorated share of operating expenses and deductions for the rental period. The owner, however, cannot claim a tax loss -- tax dedutions cannot exceed the rent collected -- and thus income from other sources cannot be offset.
For the owner like Bill Lowe who plans to limit his use to no more than 14 days, prorated business deductions and tax losses are allowed.
Lowe's home is in the Galena Territory, a resort development outside of Galena, Ill. Lowe's home will be managed, maintained and leased by the resort developer, the Branigar Organization, which will receive a management fee (deductible for Lowe) of 30 percent or 45 percent of gross receipts, depending on the duration of a renter's stay.
Assume that Lowe's monthly payment on a $55,000 mortgage at 10 1/2 percent interest is $500, his real estate taxes $1,000, his cost of furnishing the house $5,000, and his rental income $85 a day with 40 percent going to the management company. Assume, too, that he uses the home 10 days and rents it out 110 days (or 110-120 of total use).
Richard Hanson and David Pavela of Coopers & Lybrand estimate that Lowe can deduct from his total rental income of $9,350 his pro-rated rental share (110-120ths) taxes ($917), interest payments $5,225), management fees ($3.428), straight-line depreciation on his furnishings ($573) and on the home ($2,567). Subtracting his rental income ($9,350) from his total yearly expenses ($12,710) gives Lowe a taxable loss of $3,360.
Because Lowe and his working wife are in the 50 percent tax bracket, their tax saving is $1,680 (half of his taxable loss) from the rental of the vacation home.
Computing Lowe's total tax benefit is complicated to all but accountants. Pavella estimates that after Lowe's initial $15,000 downpayment, he can "live free" in the vacation home and pocket several hundred dollars at year's end (assuming the rental income in the example).
It sounds good, but there can be problems in such investments, as financial consultant Thomas Hynes points out.
"Aside from the tax benefits, you still have to evaluate the location of your property," says Hynes of Ayco Corp., an Albany N.Y., financial planning firm. "If you buy something in the desert, you'll get all the tax advantages but not renters. And you'll never get your money out."