A Place to Call (Our Other) Home – Part Three

Part Three: Vacation Home/Rental Property Tax Considerations

According to a general rule of thumb, you can afford a house that costs two and a half times your annual salary. But determining how much you can afford to spend on a house is more complex. Since most people finance their home purchases, buying a house usually means getting a mortgage. So, the amount you can afford to spend on a house is often tied to figuring out how large a mortgage you can afford. To figure this out, you’ll need to consider your gross monthly income, housing expenses, and any long-term debt. Many real estate and personal finance websites on the Internet can help you with the calculations

Renting the property for fewer than 15 days

If you rent out a vacation property for fewer than 15 days in a given year, the property is considered a second home, regardless of the amount of personal use. Any rental income you collect in this case is tax-free, and no rental expenses (e.g., repairs, utilities) can be deducted. However, as with your primary residence, mortgage interest and property taxes can be deducted as itemized deductions (subject to specific limits).

Minimal personal use of the property

If you rent your vacation property for 15 days or more, the tax treatment depends on your personal use. If you limit your personal use of the property to 14 days or 10 percent of the time the property is rented, you will not be considered to have used the vacation property as a home. Instead, the property is considered investment property.

Tip: Under the 14-day/10-percent rule, if you rent the home for 90 days, you can use the property for up to 14 days without affecting the tax treatment. If you rent the home for 200 days a year, you can use it for up to 20 days (the greater of 14 days or 10 percent of the time the property was rented).

You must report all rental income you collect. You can deduct expenses directly attributable to rental use (e.g., advertising). Other expenses, like mortgage interest and depreciation, must be divided between rental and personal use. For example, if you rented the property for 90 days and used it yourself for 10 days, you can take only 90 percent of mortgage interest and depreciation as a rental deduction. Prorated rental expenses that are deductible include mortgage interest, property taxes, insurance, repairs, utilities, and other operating costs. Expenses allocable to personal use are generally not deductible, other than real estate taxes and any casualty losses, which can be claimed as itemized deductions.

You cannot claim the portion of mortgage interest allocated to personal use as an itemized deduction because your personal use of the property is minimal, and the property will not qualify as a personal residence for purposes of the mortgage interest deduction rules. IRS Publication 527, Residential Rental Property, explains that expenses should be allocated without considering days the property was unoccupied. However, court cases have allowed the allocation method to factor in days the property stood unoccupied. Talk to a tax professional for details.

If rental expenses exceed rental income, the loss you can deduct may be limited. In general, losses from rental real estate can only be deducted against income from other passive activities. However, you may be able to deduct up to $25,000 from other income if you “actively participated” in managing the property. This allowance begins to phase out for taxpayers with adjusted gross incomes over $100,000 and is eliminated for incomes above $150,000.

You may be treated as “actively participating” if you make management decisions in a significant and bona fide sense. Although hiring a professional property manager is permissible, you must make at least significant decisions, such as setting rental rates, approving new tenants, and authorizing major expenditures.

Points paid to a lender on a vacation home are not immediately deductible as they generally are for your principal residence; they must be deducted over the life of the loan.

If you rent to relatives at discount rates, the IRS may rule that the house is not actual rental property and disallow some of your deductions.

More substantial personal use of the vacation property

Suppose you rent out vacation property for at least 15 days in a given year, and your personal usage exceeds the greater of 14 days or 10 percent of the time the property is rented. In that case, the property is considered both rental property and a second home. You must report all rental income you receive. As with minimal personal use property, you can deduct expenses directly attributable to rental use (e.g., advertising). In contrast, other expenses, like mortgage interest and depreciation, must be allocated between rental and personal use. Even though most expenses allocable to personal use are generally not deductible, mortgage interest allocated to personal use can be claimed as an itemized deduction in addition to real estate taxes and any casualty losses.

Rental expenses are deductible only to the extent of rental income and they must be allocated in the following order (1) expenses directly attributable to rental use, (2) interest and taxes, (3) operating costs, and (4) depreciation. If expenses exceed rental income, the loss may not be used to offset other income. However, the excess can be carried forward to the next year and treated as rental expenses for the same property.

Deducting depreciation

If you are allowed to deduct rental expenses, you may also be able to deduct depreciation. You can deduct the portion of the purchase price that went for the building (the cost of land is not depreciable) over the years (currently 27½ years using the straight-line method). If you subsequently make improvements to the property, you can also depreciate them. Because different rules apply to the original purchase and each improvement, calculating the correct amount of your deduction may be complicated, and you should keep complete and accurate records to back up your computations. Also, be aware that depreciating assets reduces your ability to determine gain or loss on a later sale. Even if you did not claim depreciation, you were entitled to deduct, but you must still reduce your basis in the property by the full amount of depreciation you could have deducted.

Repairs versus improvements

Because they are treated differently for tax purposes, you need to be able to classify the work you do to the house as either a repair or an improvement. Repairs keep your property in good working order but do not materially add to its value or substantially prolong its life. Repairs are considered expenses and may be deducted as rental expenses in the year they are incurred. Improvements, by comparison, add to the value of the property, prolong its useful life, or adapt it to new uses. Improvements are classified as capital expenditures and added to your property basis, which can be recovered through depreciation.

Sale of vacation property

You should know the tax considerations involved in selling a vacation home. Such a sale (regardless of whether it is classified as rental property, a second home, or both) does not receive the same tax benefits as the sale of a principal residence. If you sell your principal residence at a gain and meet the requirements, you can exclude up to $250,000 (up to $500,000 for married couples filing jointly) from the capital gain. A vacation home will not be eligible for this exclusion.

Your vacation home may qualify for the exclusion if you sell your principal home and live in your vacation home for at least two years before selling it. However, because of provisions in the Housing and Economic Recovery Act of 2008, you may owe taxes on a portion of your capital gains from the sale even if you qualify for the exclusion. The amount excluded from tax will depend on the amount of time the property was used as a vacation or rental property after 2008 compared to the total time you have owned the property. For example, if you owned a home for 16 years before moving into it as your principal residence in 2010 and then selling it in 2012, the two years in which it was a second home AFTER 2008 (2009-2010) would represent roughly 11.1 percent of the total 18 years you owned the property (2 divided by 18=11.1 percent). That means 11.1 percent of your gain upon selling would be taxable; the rest would qualify for the exclusion.

If your vacation home is classified as a second home, second home tax rules will apply. If your vacation home is classified as rental property or part rental property/part second home, any gain must be calculated as if you had owned two properties—one for personal use and one for rental use. Gain attributable to the personal use portion is reportable as capital gain. The gain attributable to the rental portion of the vacation home may be considered part ordinary income and part capital gain.

Exchange of rental property

Section 1031 of the Internal Revenue Code provides that federal capital gains taxes can be deferred when investment real estate is exchanged rather than sold. The regulations involving what are known as like-kind exchanges represent an extremely complex area of tax law, and you should consult an experienced tax professional, but here are some basic rules:

• The property must be classified as rental/investment property (i.e., your personal usage must not exceed the 14-day/10 percent rule)
• The properties exchanged must be of “like-kind” (i.e., real estate must be exchanged for real estate, but they need not be the same grade, quality, type, or class)
• There must be an exchange of the like-kind property rather than a sale and then a separate purchase
• The exchange will be tax-deferred (gain or loss) so long as the replacement property is identified within 45 days and actually received within 180 days from the transfer of the old property

An exchange may require the receipt of money or other property to equalize the value of the exchanged properties. Such additional assets are typically referred to as “boot” and may be taxable if the gain is recognized but not above the fair market value of the boot.

Generally, the basis of the property received is the same as that of the property transferred.

Vacation home tax considerations are complex. For more information, you can refer to IRS Publication 527, Residential Rental Property, and consult your tax advisor.

Remember to keep careful tax records relating to your vacation home just in case the IRS audits your tax returns. Without good records, you could lose your vacation home tax advantages, especially regarding personal use time.

Conclusion

Over this three-part series, we’ve covered “Is a Vacation or Rental Home Right for You,” “Is the Risk Worth the Reward,” and the “Vacation Home/Rental Property Tax Considerations.” If you still have questions or would like to discuss adding a rental or vacation home to your assets, a Sequoia Financial Group advisor is just a click away to help you determine if it’s the right move for you and your family.