Q: Our principal residence is in the Washington area. We also have a second home, which we have never rented, by the ocean in Delaware. If we sell the Delaware property, what are the tax consequences?
A: As you probably guess, the tax treatment of the sale of a second home is quite different from that of a principal residence. But you may find some "tax relief" if you are willing to follow some rules found in the 1997 Taxpayer Relief Act.
The basic fact is that a second home is considered investment property for real estate tax purposes. If, for example, you bought the Delaware home many years ago for $50,000 and sold it last year for $200,000, your gain would be $150,000, less any real estate commissions or other sale-related expenses. Under the new capital gains tax rate, you owe 20 percent of your net profit to the Internal Revenue Service.
You do, however, have a number of options to defer paying this tax--or avoid it completely:
* If you were to sell your Washington home, you could convert the Delaware property to your principal residence. If you then live in the Delaware house for two years you could exempt up to $250,000 of the gain (or up to $500,000 if you are married and file a joint return).
The new law repealed the "once in a lifetime" concept of the former age-55 exemption of $125,000. There are no limits on the number of houses for which you can claim the exemption; the only requirement is that the house be your principal residence and that you have lived there for two out of five years preceding its sale.
This option has opened up a lot of tax-saving doors, and you would be wise at least to consider it.
* You could convert the use of your Delaware home from personal to investment. Rent it out and do not use it at all. Under these circumstances, the rent you receive will be income, but you are entitled to deduct from this income such items as utilities, repair and operational expenses, such as cleaning; you also can take depreciation on the property.
Keep in mind, however, that unless you are a full-time real estate professional, in most cases you will be subject to the passive-loss rules. If your adjusted gross income (AGI) is less than $100,000, you can deduct up to $25,000 of "paper losses." If your AGI is more than $100,000, the amount of deductible losses phases out and finally disappears when your AGI reaches $150,000.
* If the vacation house is rented out 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 still are allowed to deduct real estate taxes, mortgage interest and casualty losses. In effect, since you are renting your property for fewer than 15 days, it is considered a true second home.
* But what happens if you still use the beach house but rent it out for more than 14 days?
Under these circumstances, the amount of business rental deductions cannot exceed rental income. However, the IRS and the U.S. Tax Court are at odds on how to calculate the amount of permissible deductions.
Mortgage interest is fully deductible, but only a certain percentage can be allocated to the rental property; the remainder is deductible on the taxpayer's Schedule A if deductions are itemized.
According to the IRS, rental deductions of interest and taxes are limited to a percentage that represents the total days rented divided by the total days used ("days used" meaning both personally and by a renter).
The tax court has rejected the IRS formula. Because mortgage interest and real estate taxes are assessed on a yearly basis, the court has said, the percentage of interest and tax deductions is derived by dividing the number of days rented by the total number of days in the year.
The formula does not limit other rental expenses, such as maintenance and commissions to leasing agents. These are fully deductible up to the amount of rental income.
Sounds complicated, but let's look at the following example. You rent your property for 85 days a year and use it yourself for 30 days during that year. You have received a total rental income of $5,000, and your expenses are mortgage interest ($4,000), property taxes ($800) and other rental expenses ($4,000).
With the IRS formula, 74 percent (85 days divided by 115 days) of the interest and tax expenses can be deducted from the rental income; with the tax court formula, 23 percent (85 days divided by 365 days) is deductible.
Although it's counterintuitive, the smaller percentage of allocable expenses (the tax-court formula) is better for the property owner because it leaves a larger amount of rental income against which to deduct other rental expenses (and thus the owner can deduct more of those expenses).
Also, the tax-court formula leaves more of the mortgage interest and property tax to be deducted along with the owner's itemized deductions on Schedule A. So in addition to the $5,000 income that has been zeroed out using either formula, the IRS formula allows an additional deduction of only $1,248, while the tax-court formula allows an extra $3,696 in deductions.
The tax court opinion has been affirmed by both the 9th and 10th circuit courts of appeals, covering such states as Hawaii, Colorado, Kansas and Hawaii. The IRS continues to press its position in all other states.
* You may want to keep the Delaware property and leave it to your children. On your death the children will get what is known as the "stepped up" basis in the property.
In other words, even though your basis may be very low (reflecting the purchase price less previous depreciation taken against the property if you have rented it), the value of the property on your death will be the basis for your children.
Thus, if the property is worth $250,000 on your death and your heirs sell it at that price, they will not be subject to any capital gains tax--although estate and inheritance taxes may be due.
* Finally, if you really want to sell, you may want to consider a "like-kind exchange" under Section 1031 of the tax code. This is another tax-deferral device, which has been addressed in other columns.
There are many rules and complexities relating to the second or vacation home. If you are considering renting your beach home this summer, now is the time to get competent tax advice--before the humidity sets in.
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. Readers may also send questions to him at that address.