Second Home - Taxes on Vacation Homes

You are buying that home on the beach for peace and quiet. Then you start thinking about tax benefits, which get pretty complicated. You will fit into three different tax categories that are determined by how often you use the home, if you rent it out and how long it remains empty.

Rent a lot, Use a lot

The first category includes homes that are both rented often and used a fair amount by the owner. This applies to homes that are rented more than 14 days a year and are used personally by the owner more than 14 days a year or 10% of the rental days, whichever is greater. Personal use includes family members and those who pay less than market rental rates.

Vacations homes in this category are considered personal residences. This is a good thing. You are able to deduct the interest on a mortgage up to $1 million on two personal residences. Property taxes are also deductible, no matter how many homes you own. Those fortunate to own more than tow homes can pick the two with the highest mortgage interest to deduct each year.

Now you must account for the rental income and expenses for your vacation home. You can deduct the expenses incurred while you use the house, and deduct the expenses incurred while you rent it. If you do it correctly, there is no tax liability in either case.

First, you have to allocate the interest and property taxes to rental or personal use. For example, if you rent out the home for three months and use the home for two months personally. The other seven months the home is empty. An empty home is considered being used personally. You would want to deduct the personal part of the interest and taxes, or 75%, to your Schedule A as itemized deductions. The rental portion of the costs, the remaining 25%, is where it gets a little complicated.

You want to reduce your rental income to zero to eliminate your tax liability. First, you reduce the income by 25% of the interest and tax expenses. If there is any income left, you can deduct a percentage of the operating expenses, such as maintenance, utilities, insurance and depreciation, up to the point where you zero out any income from the property.

You can't count the days the house stands empty into the operating expenses. If the house is only occupied for a total of five months, as in our example, three months of the maintenance and utilities goes towards the rental and only two months is personal use. The two months of operating expenses becomes a nondeductible item.

When all is done, you should be able to fully deduct the interest and taxes paid on your second home and enough expenses to balance out your rental income. Any operating expenses that aren't deducted can be carried over to another year.

Use a little, Rent a lot

The second vacation-home tax category includes homes that are rarely used by the owner. If you rent for more than 14 days of the year and your personal use doesn't exceed 14 days or 10% of the rental days, you fall into this category. If you rent for 210 days and use the property for 21 days, you have a rental property. Stay one more day for a total of 22 days, and the property becomes a personal residence.

The interest, property taxes and operating expenses are deductible based on the number of days the house is in use. The number of days the house is used in the above example is 231, so the split is 21/231 for personal use and 210/231 for rental.

If the money you receive in rental income does not cover the cost of renting it, you can claim a taxable loss on a Schedule E. But don't start ringing in the money yet. First you have to clear some hurdles. Basically, you can deduct passive losses only to the extent of passive income from other sources.

The IRS gives you an exception. You can write off up to $25,000 of passive-rental real estate losses if you actively participate and have an adjusted gross income of less than $100,000. To be an active participant, you must make day-to-day property management decisions. The exception is phased out for adjusted gross incomes between $100,000 and $150,000. The exception also doesn't apply if you rent the property for seven days or less. The IRS will let you carry over the passive losses that you can't use this year to another year.

You need to understand that the interest incurred during your personal use of the home is nondeductible, because the home isn't a personal residence. You can still deduct the personal-use portion of your property taxes. You may benefit by adding extra vacation days and becoming a personal residence.

Rent a little, Use a lot

This category is a rarity in the tax laws - it is easy to understand and is for your benefit. Homes that are rented for fewer than 15 days a year and used for the owner for more than 14 days qualify. The home will be considered a personal residence and all you have to do is deduct the interest and property taxes on your Schedule A, just like you do for your primary residence.

And you don't have to declare any of the income.

If your vacation home is located near a major event, you could make a lot of money renting it out for just a few days. And it's all tax free.
Timeshare Issues

For many people, a timeshare is a vacation home. Today, a timeshare week can cost as much as $15,000. In fact, two winters in Beaver Creek, Colorado can cost you as much as $60,000. This is a lot of money. Many folks borrow all or part of the timeshare purchase price, often through a developer. The tax rules are not favorable if you rent out your unit.

Let's start by assuming that you use the timeshare and don't rent it out. Your share of the property taxes is deductible on the Schedule A. If you have any mortgage interest, you can also deduct it as interest on a second home.

If you rent your unit out the income isn't automatically tax free if you rent it for less than 15 days. This will only apply if all owners rent it out for a total of less than 15 days. They each must use the unit for more than 14 days.

If you rent your unit at all you should use the personal residence rules for allocating expenses between the personal and rental based on the total usage of all the owners of the unit. This approach is a nightmare. You may want to estimate the allocation based on your own usage pattern.

Gain Exclusions with Multiple Residences

There is a generous gain exclusion for the sales of primary residences - $250,000 for singles and $500,000 for married couples. If you are lucky to have one or more vacation homes, there are some tax-savings to be found there as well. The basic gain exclusion qualification rule is that you must have owned and used the home as your main residence for at least two years out of the five-year period before the date of sale. If you are married, only one of you must satisfy the ownership and both satisfy the use test.

For example, you are married and own three homes. There is your main home, which qualifies for the $500,000 exclusion and can be sold for a gain of $400,000. You sell it tax-free and move into your vacation home. You live there for two years and you can sell it for a gain of $500,000 as well. Then you simply move into the remaining home and live there for two years. Here's another $500,000.

If you are determined to own three homes, simply replace each one after it is sold with another property. You can use and sell over and over again, making happy little gains all along the way. Be sure that you double check your state income tax implications before trying this process.