(This is Part 2 of an eight-part series.)
Taxpayers are entitled to claim deductions for theirprincipal residence and one vacation or second home. Except for unusualsituations, the ownership tax breaks for a primary residence are generallylimited to the mortgage interest and property tax deductions.
However, tax savings from owning a second or vacation homeare a bit more complicated and are often greater. Depending on yourpersonal-use time, and with some advance tax planning, your vacation or secondhome can produce significant tax savings.
Purchase Bob Bruss reports online.
FOUR TAX CATEGORIES FOR SECOND OR VACATION HOMES. Mortgageinterest and property tax payments for your second or vacation home are alwaystax-deductible. However, if you own a third home, it does not qualify for themortgage interest and property tax deductions unless it is a rental property.
Your personal use time determines which of the four categoriesapply to your second or vacation home:
1. NO PERSONAL-USE TIME. If your second home wasrented or available for rental during all of 2006, with zero personal-use time,it is treated as rental property. Even if you occupied it a few days whilemaking repairs, your second home falls into this desirable category.
The tax result is your rental income and expenses arereported on Schedule E of your income tax returns. Don’t forget the non-cashdepreciation deduction for wear, tear and obsolescence, which can result insubstantial tax savings, either in the current tax year or”suspended” for use in a future tax year.
Applicable deductible expenses in this category includemortgage interest, property taxes, insurance, homeowner association fees,utility bills you paid, repairs, and depreciation. You can also deductreasonable “ordinary and necessary” travel expenses to inspect (butnot occupy) your rental property, even it is in such remote hardship locationsas the U.S. Virgin Islands, Puerto Rico, or Hawaii.
When you hire a professional property manager to rentvacancies and collect rents, to claim the deductions specified above you must”materially participate” in managing your second home. That means itcannot be in a “rental pool” managed by others and you must own atleast a 10 percent interest in the property.
Material participation includes setting standards fortenants, establishing the rent and approving tenants, even if the day-to-daymanagement is left to others.
If you materially participate in managing your second-homerental and if your 2006 adjusted gross income is $100,000 or less, then you candeduct up to $25,000 of second-home tax loss from your other ordinary taxableincome.
If your adjusted gross income is between $100,000 and$150,000, then your second-home tax loss gradually phases out. Above $150,000adjusted gross income, you cannot claim any second-home tax loss.
But the good news is any unused tax loss exceeding the$25,000 limit can be “suspended” for use in a future tax year or whenthe property is sold to offset taxable gains.
However, if you are a “real estate professional”spending at least 750 hours annually on your real estate activities, then youcan claim unlimited deductions from your rental property from your ordinaryincome. One spouse can qualify and need not hold a realty license, even if theother spouse works full-time elsewhere.
2. LESS THAN 14 DAYS OF ANNUAL RENTAL. If yourent your second or vacation home less than 14 days per year, in this taxcategory you can deduct your mortgage interest, property taxes and anyuninsured casualty loss, such as water damage. But other expenses such asinsurance premiums and repair costs are not tax deductible.
In this category, if you rent your second home less than 14days per year, that rental income is completely tax-free and need not bereported on your income tax returns.
3. ANNUAL PERSONAL USE BELOW 15 DAYS OR 10 PERCENT OF THERENTAL DAYS. This is the most desirable tax category for a second home.There is no limit to your tax loss deductions against your ordinary taxableincome (except the $25,000 annual passive loss limit explained above). Rentalincome and deductible expenses are reported on Schedule E of your tax returns.
To illustrate, suppose you occupied your second home for12 days in 2006 and you rented it to tenants for four months in the summer (orwinter). Since your personal occupancy time was below 15 days per year, andbelow 10 percent of the rental days, you can deduct up to $25,000 of expenselosses exceeding the rental income, including depreciation, from your adjustedgross income not exceeding $100,000. But Internal Revenue Code 183 says youmust show a rental-activity profit at least three of every five years in thiscategory.
4. ANNUAL PERSONAL-USE TIME OVER 14 DAYS OR 10 PERCENT OFTHE RENTAL DAYS (IF RENTED MORE THAN 14 DAYS IN 2006). Thiscategory of heavy personal use and modest rental time results in the lowest taxsavings benefits.
Rental income must be reported on Schedule E, along with theapplicable rental expenses. However, in this category, any resulting tax losswhen rental expenses exceed the rent collected cannot be deducted againstordinary income from other sources, such as job salary. But unused losses are”suspended” for use in future tax years so keep track of these unusedtax losses.
The proper order for deducting second- or vacation-homeexpenses in this heavy personal-use category is mortgage interest, propertytaxes, uninsured casualty losses, operating expenses applicable to the rental periodsuch as insurance and repairs, and depreciation for the rental period.
If mortgage interest, property taxes and uninsuredcasualty loss expenses exceed the rental income, they become itemized personaldeductions on Schedule A of your tax returns.
CONCLUSION: Second or vacation homes are notgreat tax shelters, but they can save significant tax dollars while theproperty usually appreciates in market value for future resale profits.
A possible tax benefit, when you are thinking about sellingyour second or vacation home, is to move in to convert it to your full-timeprincipal residence for at least 24 of the last 60 months before its sale. Thenup to $250,000 principal-residence-sale capital gains will be tax-free (up to$500,000 for a qualified married couple filing joint tax returns in the year ofsale). Full details are available from your tax adviser.
Next week: Big tax savings for your residential movingcosts.
(For more information on Bob Bruss publications, visit his
Real Estate Center).
Copyright 2007 Inman News