Vacation Home Tax Planning: Shaky Foundations Not Easily Repaired with Software

The tax benefits of owning a vacation home can add substantially to the obvious nontax benefits. However, while the tax benefits are generally well understood, the tax pitfalls are frequently less well known and are potential snares. To further exacerbate the problem, the most popular tax preparation software programs sometimes fail to alert users about the pitfalls. Unwary yet trusting software users are likely to encounter one of these. The little-known problems are (1) the deductibility of the personal portion of mortgage interest expense, (2) the definition of rental activity under the passive-activity loss (PAL) rules and (3) the hobby-loss limit rules. These warrant consideration by both tax professionals and investors, especially those who place a high level of confidence in their tax preparation software.

Personal vs. Rental Use

Many taxpayers who own vacation homes and their tax preparers are probably familiar with the rules that determine the home's purpose, based on number of days of personal use and number of days of rental use annually. Through a series of questions, tax software programs generally classify a home successfully. The home can be primarily a personal-use residence, primarily a rental or a combination of both. When a taxpayer rents a vacation home for fewer than 15 days per year, the home is primarily personal-use, and the taxpayer can exclude rental revenue from gross income. Further, for a second residence, property taxes and mortgage interest generally qualify as itemized deductions. A vacation home would be a rental if the taxpayer rents it for more than 15 days, and uses it for more than the greater of 14 days or 10% of the number of days rented.

For a vacation home that is a combination of personal and rental, the taxpayer both recognizes rental income and allocates expenses between personal and rental, based on the number of days the taxpayer used the residence for each. Assuming the vacation home qualifies as a second residence, the taxpayer can deduct the personal portion of mortgage interest and property taxes paid, deducting the expenses only to the extent of rental income. No losses are allowed under a vacation-home classification.

When personal use is fewer than 15 days (or 10% of the total rental period), the vacation home will qualify primarily as a rental, permitting associated loss deductions. However, many taxpayers may be surprised to learn that mortgage interest deductibility can be limited under this scenario. Because the home does not qualify as a second residence, a portion of the mortgage interest is nondeductible personal interest. If the taxpayer is counting on deducting the interest, the taxpayer can easily manipulate the number of personal-use days. However, the tradeoff will likely be an inability to deduct losses under the combined rental and personal-use scenario. For example, if a taxpayer has a vacation home that is primarily a rental, the taxpayer might lose a deduction on the personal portion of mortgage interest. This is an unfortunate side effect of a vacation home that produces income. The taxpayer can plan accordingly on the number of days of use to classify the property as a combination. On the other hand, if the home produces a loss, the taxpayer will likely prefer to lose a small portion of the interest deduction to take advantage of the real estate loss deduction under the PAL rules.

PALs and Software Problems

Taxpayers who opt for a primarily rental classification and recognize losses are probably aware that the activity will be classified as passive, limiting loss deductibility to the level of passive income. Most probably also know about the popular exception to the PAL rules under Sec. 469(i), which allow a taxpayer to deduct up to $25,000 in passive real estate rental losses when the taxpayer actively manages the property and has adjusted gross income below $100,000. A taxpayer with a vacation home that is primarily a rental is thus likely to conclude that losses are deductible, within the stated constraints.

What most taxpayers fail to realize, however, is that Temp. Regs. Sec. 1.469-1T(e)(3)(ii)(A) defines rental activity to specifically exclude activities whose average rental period is less than seven days. Therefore, if the vacation home is rented to multiple tenants for stays of less than an average of seven days, the $25,000 loss recognition is disallowed. This pitfall goes undetected by many taxpayers due to the obscure definition of a "rental activity," especially when taxpayers simply rely on tax preparation software or Treasury publications. If a taxpayer reduces the number of personal-use days deliberately, to deduct a real estate loss, the taxpayer may unwittingly take an incorrect loss deduction. This might occur even if the taxpayer carefully answers every question asked by the tax preparation software program.

The purpose of the seven-day rule in the regulations was to exclude short-term rentals (such as videotapes, cars and hotels), but several court cases (e.g., Barniskis, TC Memo 1999-258, and Toups, TC Memo 1993-359) have upheld the seven-day rule for vacation homes. Despite this, the law's intent may be misrepresented in the regulations. Congressional action will probably be necessary to correct the deficiency.

To add to the possible confusion surrounding PALs, two popular tax preparation software programs fail to appropriately explain the potential pitfall to taxpayers. Turbo Tax does not mention the seven-day rule for vacation home rentals in the interview process, nor does the help menu acknowledge the rule. The only reference to the rule is buried deeply in a help discussion about passive activities. Similarly, Tax Cut mentions the seven-day rule only in its vacation-home help discussion, buried deeply in the text and difficult to find. In essence, only a well-informed user would be likely to locate the rule in either software program. A novice may be unaware of the pitfall that the software does not adequately address and may unknowingly file an inaccurate tax return.

Official Treasury Information

Similar problems can arise when taxpayers rely on Treasury for information. IRS Pub. 527, Residential Rental Property, mentions the $25,000 exception but fails to address the seven-day rental-period requirement. However, the publication refers taxpayers to Pub. 925, Passive Activity and At-Risk Rules, for a full discussion of the law. Although this publication defines a rental activity as one that excludes an activity with a less-than-seven-day rental period, the definition appears in a discussion unrelated to the $25,000 exception. The average taxpayer would probably conclude incorrectly that the loss is deductible. CPAs, their clients and the IRS should be concerned about this. Even if the taxpayer had consulted Treasury publications, the taxpayer would probably arrive at the same conclusion as the software package and file an inaccurate return.

Hobby-Loss Limits

Even if a taxpayer clears the hurdle of the seven-day rule, a loss may still be disallowed under the Sec. 183 and Regs. Sec. 1.183 hobby-loss rules. According to the regulations, losses incurred by individuals, attributable to a not-for-profit activity, are generally deductible, but only to the extent of income produced by that activity. An activity would not be considered a hobby if profits result in any three of the five tax years previous to the tax year in question. If the property is frequently profitable, occasional PALs are hardly a concern, as the taxpayer can carry the loss forward. Additionally, tax preparation software packages generally do not classify such an activity as a hobby, thus limiting the losses. Again, it is up to taxpayers to become familiar with the intricacies of the hobby-loss rules, rather than relying on software packages to make correct determinations.

Conclusion

Most of the enjoyment and intrinsic value taxpayers draw from a vacation home may totally dissipate by having to sort through the murky waters of the vacation-home tax laws. Although many taxpayers with vacation homes and their tax preparers have become familiar with most rules, they often overlook a few. As a result, taxpayers could end up with a large tax bill. The three areas of concern are the deductibility of the personal portion of mortgage interest expense, the definition of rental activity for the PAL rules and the hobby-loss rules.

Although tax preparation software is likely to address the deductibility of the personal portion of mortgage interest expense, taxpayers should not rely solely on their software for the seven-day and hobby-loss rules' analyses.

From Tracy J. Noga, CPA, Ph.D., Assistant Professor of Accounting, Suffolk University, Boston, MA, and Brett R. Wilkinson, Ph.D., Assistant Professor of Accounting, Baylor University, Waco, TX (Neither affiliated with Baker Tilly International)