Question: We own our principal residence, which is located in the District of Columbia, and we also have a second home in Delaware by the ocean. I know that when we sell our principal residence, since we are married and have lived in house for many years, we are eligible for the up-to $500,000 exclusion of gain. I know that we can also deduct our main home's mortgage interest and our 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?
Answer: It really depends on how you use your second home. As you will see, this is perhaps one of the most convoluted issues in our tax laws, and although it really make no sense, it has to be followed when you prepare your annual income tax returns.
We first start with the definition of "personal usage." According to the Tax laws, your use of the second home is "personal" if on any day (or even a part of a day) it is used by anyone who owns an interest in the property, or their relatives -- such as spouses, brothers, sisters and even grandchildren and grandparents. The property is also considered "personal" if used by any other person who does not pay a fair rent.
Vacation homes include homes, apartments (such as condominiums and cooperatives), and even trailers or boats. However, for a boat to be considered a "home" it must have sleeping, cooking and toilet facilities.
Next, 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. On the other hand, if you never rent out the property, but enjoy it for yourself and your family, it is treated as a second home and again you can deduct real estate taxes and mortgage interest -- subject to any limitations imposed by law, such as the Alternative Minium Tax (AMT) rules.
The problem arises if you use the property for even one day, and rent it out for many more days.
If your home is used both as your vacation home as well as a rental, the IRS groups such properties in two ways:
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 that occur annually in October, or for the Naval academy graduation week celebrations. So long as you do not rent for more than 14 days, no tax is owed on this rental income.
But once you rent your home for the greater of 14 days (or 10 percent of the number of days during the year for which the property is rented, the laws change and become complex.
If your property is considered "rental," the income that you receive must be reported. But now you can take other deductions, such as management fees and advertising costs. Additionally, items such as insurance, repairs , utilities and depreciation -- which you cannot deduct for a principal or second home -- can now be deducted, although on a pro-rata basis, depending on the ratio of personal to rental use.
However, the law requires that you can deduct your expenses in a particular order. Mortgage interest and real estate taxes applicable to the rental period are deducted first, and put on Schedule E of your income tax return. All of the other expenses associated with the rental property are also allocated, but put on Schedule A of your tax return. The expenses are allocated based on the ratio that the total number of rental days relates to the total days used for all purposes during the year. Unfortunately, any expenses relating solely to your personal use are not deductible.
There is, however, a catch to this. 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.
You also inquired whether you could do a Starker (1031) exchange with your vacation home. Here, the answer is fairly simple: if you did not use the property for you or your family, it is property primarily held for investment and can be the relinquished property in such an exchange. On the other hand, if you never rented it out, it cannot be used for an exchange.
Recently, the United States Tax Court handed down a decision 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. However, the Tax Court rejected this argument, primarily based on the fact that the vacation home was never rented and was consistently used by the taxpayer and his family. According to the Tax Court, in order to qualify as "investment property" it must be the taxpayer's primary purpose. Citing a longstanding rule, the Court held that "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 that vacation home that is used both as a rental as well as for personal use? Although I am not familiar with any case law in this area, it would be my opinion that such properties would not be eligible for 1031 exchange purposes. If your property has appreciated considerably in value, and you want to do a like-kind (1031) exchange, stop using it for at least two full years, rent it out, and then it will be considered "investment" property.
You do have a number of other options available to you, however, and this column will address some of these
First, you could decide to keep the second home and rent it out. If you believe 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, so that your cash flow would not be too great. Obviously, this makes you a landlord, and unless you turn the property over to a property manager, you will have to endure the negative aspects of being a landlord as well as the positive.
Second, if you have children, on your death, the children get what is known as a "stepped-up" basis in 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, the children's basis is the value on the date of your death.
These are but a number of the options you should consider so as to avoid paying a considerable amount of money to Uncle Sam.
If you own (or are even considering buying) that vacation home by the beach, you must consult your tax advisors immediately, before you get yourself into any tax trouble with the IRS. The rules -- and the law -- are complex and confusing, and the information in this column only scratches the surface of our tax laws. You will need all the education and guidance that is available to you.
