Q: We own a condominium on the ocean that we only use during the summer. We are considering renting it out on a periodic basis, but have been told that there are complex tax rules regarding "vacation homes." This is not our principal residence. Can you assist us by giving an explanation of the vacation home rules?
A: In summer, thoughts of those fortunate enough to own a second home often turn to taking pleasurable vacations there. We really should not be thinking about the taxable consequences of our actions. But since 1986 when the Tax Reform Act was passed by Congress, second home owners must think about the tax considerations.
The tax laws are complex, and you should discuss your case with your own tax advisers.
Oversimplified, before the Tax Reform Act of 1986, if you owned a second home and rented it you could take all sorts of deductions, including depreciation. The less personal use you made of your second home, the greater your deductions were. However, in 1986, Congress put severe limitations on real estate deductions for investment property. Congress created the concept of "passive activity."
Under this concept, if your adjusted gross income does not exceed $100,000, you can fully deduct up to $25,000 of losses from all rental activities in which you actively participated. This could include your vacation home rental property. The $25,000 loss permitted by law is reduced $1 for every $2 of adjusted gross income of more than $100,000.
Thus, the paper losses that were so popular before 1986 have been significantly diminished -- or eliminated if your adjusted gross income is more than $150,000.
We first must look to whether your property is a "residence." If the home is used as a residence, then certain tax rules are triggered which can give you some greater benefits than if your property is not considered a "residence." Vacation home or residence has been broadly defined to include a "house, apartment, condominium, mobile home, boat or similar property." As long as the property contains facilities for cooking, sleeping and toilet use, the property will be considered your residence.
However, you must also use the property for more than 14 days during a taxable year or more than 10 percent of the number of days during the year for which the home is rented out at a fair rental value, whichever period is greater. So if you rent your property for 85 days during the year, you must ensure that you use the property for your own use for more than 14 days that same tax year.
If the vacation home is rented our for fewer than 15 days during the taxable year, you do not have to pay tax on any rental income. You are not entitled to deduct business expenses attributable to the rental -- such as advertising and management fees -- but you are still able to deduct the real estate taxes, mortgage interest and casualty losses. In effect, since you are renting this property for less than 15 days, it is considered a true second home. The interest deductions are subject to other tax rules.
If the property is considered a residence -- and meets the 14 day, 10 percent test -- and if you rent the property out for 15 or more days, the amount of business rental deductions cannot exceed rental income. Additionally, according to the IRS, the expenses are further limited to a percentage that represents the total days used divided by the total days rented. However, the tax court has rejected the IRS formula and takes the position that since mortgage interest and real estate taxes are assessed on a yearly basis, the tax court would permit the allocation by dividing the total number of days rented by the total number of days in the year.
Because this is quite confusing, let us look at the following example:
You rent your property for 85 days a year, and use it for 30 days during the year. You have received a total rental income of $5,000 and your expenses are interest, $4,000; taxes, $800; and other business expenses, $4,000. If you take the IRS formula, you have a percentage allocation of 74 percent (85 divided by 115), but if you follow the tax court opinion, you have an allocation of 23 percent (85 divided by 365).
In actual dollars, it works out as follows:
It should be pointed out that the tax court opinion has been affirmed on appeal by both the 9th and 10th circuit courts of appeals, covering such states as California, Hawaii, Colorado and Kansas, among others. In the eastern part of the country, the IRS will no doubt press their interpretation against taxpayers.
Additionally, any deduction not allowed because of the personal use limitation may be carried forward and deducted in a succeeding tax year, again subject to the maximum deduction amount for that later year.
As you can plainly see, although the IRS formula gives you deductions of $6,248 in our example, the tax court ruling gives you deductions of $8,696.
Finally, if you do not use the property for the greater of 14 days or 10 percent of the rental days, this is treated as an ordinary business investment in real estate, which is subject to the passive loss rules. 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, Suite 1100, 1050 17th St. NW, Washington, D.C. 20036.