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Tax Planning for Vacation Editor: This case study has been adapted from PPC’s Guide to Tax Planning for High Income Individuals, 6th Edition, by Anthony J. DeChellis and Patrick L. Young, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ((800) 323-8724; ppc.thomson.com). All vacation homes are not treated the same. Instead, the amount of personal and rental usage dictates how the property is treated for tax purposes. While an owner’s use of the property will normally be driven by nontax considerations, the tax implications cannot be ignored. Practitioners should discuss the various tax treatments (i.e., residence, vacation home or rental property) with clients to ensure they are receiving the tax treatment or tax benefits they expect. In some cases, it may simply be a matter of advising a client to either slightly increase or decrease personal usage so that the desired tax treatment is achieved. Also, it is important to make clients aware of the types of usage that qualify as personal usage, so they do not mistakenly believe that only their direct personal usage is counted. The following points are some of the considerations practitioners may want to pass on to clients. Because each client’s tax situation is different, determining the most beneficial use from a tax perspective requires an overall analysis.
Understanding the 14-Day/10% Rule Because a client has more control over the personal use of his or her vacation home than just about any other factor, understanding how this rule works is a key point in maximizing vacation home write-offs. If, for example, a client wants to write off an anticipated loss, his or her personal use cannot exceed the 14-day or 10%-of-rental-days threshold.
Passive Loss Restrictions If a property qualifies as a rental with personal use less than the greater of 14 days or 10% of rental days, the passive loss rules normally apply. If the property is thus treated as a rental activity and the taxpayer is eligible to claim the special $25,000 rental real estate loss allowance, it may be beneficial for the taxpayer to monitor personal usage closely to ensure such use does not exceed the 14-day/10%-of-rental-days test. Alternatively, many vacation home rentals fall victim to the less-than-seven-day rental-period exception to the passive loss rental activity rules. These rentals are not eligible for the special $25,000 rental real estate loss allowance and, instead, the owner’s material participation becomes a factor.
Loss of Mortgage Interest Deductions Whenever a vacation property qualifies as a rental with personal usage (because personal use was not greater than 14 days or 10%), the portion of the mortgage interest allocable to the owner’s usage is no longer deductible; the property does not qualify as a personal residence. Thus, if the interest allocable to personal usage is significant, owners may want to take steps to reduce this allocation or avoid the rental treatment altogether.
Generate Nontaxable Income Taxpayers with vacation homes used exclusively for personal purposes may benefit if they rent the unit for no more than two weeks each year. Under a special rule, if rental days are fewer than 15 days during the year, the rent need not be included in income. The same would be true for taxpayers who rent out their primary residences for fewer than 15 days per year. This may be particularly beneficial when taxpayers can receive high rents for a short period because of a special event (e.g., the Olympics) taking place in the vicinity of their residence or vacation home.
Financing with Home Equity Loans Financing the purchase of a vacation home with a home equity loan on a primary residence (rather than acquisition indebtedness) may increase a taxpayer’s overall allowable deductions. Although interest paid on a mortgage for a second residence is deductible, the portion allocable to the property’s rental offsets rental income. On the other hand, if the interest is on a home equity loan (up to $100,000 maximum), it is deductible as an itemized deduction without regard to the use of the debt proceeds. Thus, none of the interest reduces rental income. For vacation home owners, using a home equity loan to finance property may offer the following advantages: 1. If the Sec. 280A vacation home rules limit rental deductions, deducting the interest as an itemized deduction can increase overall deductions. Because it does not reduce the rental income, other rental deductions can be claimed. 2. If the property is considered a rental property, the interest allocable to personal use is not deductible; however, if the interest is home equity interest, it is fully deductible. 3. If the property is treated as a rental and the interest is not treated as a rental expense, the rental may produce net income, which would be passive income that can offset other passive losses. (Under Sec. 469(j)(7), interest treated as qualified residence interest is disregarded when computing passive income or loss.) The downside to using a home equity loan is that: 1. The taxpayer is using his or her home equity to replace a loan that generally generates deductible interest. 2. Interest on a home equity loan is deductible only to the extent of $100,000 of debt. 3. The interest is deducted as an itemized deduction rather than as a deduction that might reduce adjusted gross income (AGI) (and, thus, increase other AGI-sensitive items). For high-income taxpayers, certain itemized deductions will be disallowed when AGI exceeds the applicable statutory threshold ($150,500 in 2006 for other than married filing separately). For these clients, applying interest expense against rental revenue could be more advantageous than claiming it as an itemized deduction.
Example Individual T plans to purchase a vacation home for $100,000. The property will actually be treated as a rental because his personal usage will not exceed the greater of 14 days or 10% of the days it is rented at a fair rental. He intends to finance the purchase with a $90,000 mortgage secured by the vacation home. Because of its rental status, the interest on the loan allocable to the rental use will be a rental expense for computing the property’s income or loss. The income or loss will normally be passive. If T uses a home equity loan instead to purchase the vacation home, the interest would be deductible as an itemized deduction rather than a rental expense (assuming T has no other home equity interest expense and he does not elect out of the home equity debt treatment). Thus, he has less rental expense, and the property will generate either a smaller passive loss or (possibly) passive income. |
