Tax Advantages of Owning a Second Home

You've probably heard that owning a second home provides some tax relief—and, it can. There are some special tax rules and regulations that apply to second properties, however, and they can be a little confusing. Hang in there, we'll try to make this as clear as possible.

To figure out what type of tax breaks you might get as related to your vacation home, you need to know how you'll use the property, and how the Internal Revenue Service will categorize it.

Your vacation home will be considered a residence if you use it for personal purposes at least part of the year. If you rent it all year, it's considered to be a rental or investment property.

The first rule to remember is that you can't deduct the mortgage interest on your vacation home as home mortgage interest on line 10 of Schedule A if it's not considered to be a residence. Refer to the IRS Web site at www.irs.gov to select and print a copy of Schedule A.

That doesn't mean, however, that you can't rent a vacation home and still have it be considered a residence. It's all a matter of timing.

The IRS says in order to have your vacation home qualify as a residence, you need to spend at least 14 days there, or 10 percent of the amount of time that the property is rented.

Let's say that you own a home on a lake, very close to some good ski areas. The location makes your home attractive to skiers and snowmobilers in the winter, and to families and others who enjoy the lake, hiking, and so forth in the summer. There's a big demand for these properties, and you have no trouble renting your home for 210 days out of the year.

You might think the rental income is great, but if you don't use the house for at least 21 days, the IRS will consider the home to be a rental property and you won't be able to deduct your mortgage or real estate taxes entirely on Schedule A. Part of the mortgage interest will need to be declared against the rental income on Schedule E of your tax return. Refer to the IRS Web site at www.irs.gov to select and print a copy of Schedule E.

On the other hand, if you own a vacation home and rent it for less than two weeks, you get a tax break because you don't need to report the rental income on your tax return. All that rental income is, essentially, tax free.

If your property is considered a residence, but you rent it for more than two weeks a year, you'll need to report the rental income. You'll also be able to take advantage of some allowable tax deductions, but since it's a vacation home, you can't have more expenses than income. You can come out to zero, but the IRS doesn't permit you to take a tax loss on a vacation home.

The income and deductions offset each other when you rent a vacation home for more than two weeks. Deductions include the following:

• Mortgage interest

• Upkeep

• Maintenance

• Mortgage insurance

• Utilities

• Real estate taxes

• Insurance

• Depreciation

• Supplies and miscellaneous expenses

The trick is, rental deductions, on a vacation home, can't exceed gross rental income, less interest, taxes, and costs to advertise the property. If you rent out your beach home for 12 weeks, for instance, at $1,000 a week, your rental income will be $12,000, less the interest, taxes, and advertising costs.

If all the deductions listed earlier total more than the $12,000 of rental income received, you won't be able to list the loss (the excess expenses) on your income tax return.

If you use your vacation home as a rental property, the system changes. First of all, you can't use the home for more than 14 days or 10 percent of the time that it's rented. The second difference is that passive loss rules kick in on rental property. Passive loss is when you lose money from a passive activity, such as renting property or participating in a limited partnership.

If you lose money on your rentals—that is, if the expenses you can deduct are greater than the income from your rental property, the loss can be offset by passive income. You can claim up to $25,000 of losses in a year from vacation home rentals if your income is less than $100,000. If your income exceeds $100,000, the allowable loss decreases until income reaches $150,000, when the allowable loss is eliminated.

You also may be able to deduct the value of your rental property over a period of years. This is called depreciation, and is intended to reflect the wear and tear on a property and its contents over time. Depreciation applies to a home and its contents, but not the value of the land.

In summary, try to keep these simple rules in mind when considering possible tax advantages of owning a vacation home:

• If you don't use the property, all your expenses are deductible against the rent.

• If you rent the property for less than 14 days a year, the rent you receive does not have to be reported on your tax return.

• If you use the property for more than 14 days a year, your expenses are prorated against your income.

Tax considerations shouldn't be the only reason you consider buying a vacation home. Hopefully, you'll find lots of other ways to enjoy it, too.

Excerpted from The Complete Idiot's Guide to Personal Finance in Your 40s and 50s © 2002 by Sarah Young Fisher and Susan Shelly. All rights reserved including the right of reproduction in whole or in part in any form. Used by arrangement with Alpha Books, a member of Penguin Group (USA) Inc.

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