As our family watched the television highlights of Meg Mallon winning the recent United States Women’s Open golf championship in front of several gorgeous homes in South Hadley, Mass., my mind rolled back to California’s Monterey Peninsula some 30 years ago.
While attending college in the San Francisco Bay Area, I often visited longtime family friends on the famous 17-Mile Drive between the gorgeous communities of Carmel and Pebble Beach. These folks often rented their home during prestigious golf tournaments, and continued to be stunned by the unsolicited rental amounts offered by corporations seeking cozy getaways for important clients.
I wondered if my friends, now long retired, still rented their home – perhaps to executives eager to see Tiger Woods stroll in front of their lawn. The tax-free cash would be difficult to turn down.
But you don’t have to be a retired resident of an exclusive community to pocket tax-free rental cash. If you are headed out of state to a family reunion with uncles and aunts you never knew existed and are feeling anxiety pains because the family summer home will go vacant during prime time, consider this:
- You can derive tax-free income from renting your getaway, provided you rent it out for 15 days or fewer and don’t claim any of the tax deductions typically allowed on rental property, such as for depreciation or maintenance. This option can come in handy for folks who do not want to be in the rental game, yet occasionally find they could rent their place.
The rules change, however, if the getaway house becomes a designated rental or investment property. Under current federal tax laws, the owner can still use a rental vacation home for 14 days or 10 percent of the amount of time the house is rented, whichever is greater, without jeopardizing its status as a rental property and tax shelter.
The owner who rents “full time” is getting three benefits: First, the renters are buying the house for you. Second, you still can cash in on any appreciation that might result from rapidly increasing property values. And third, you can depreciate the building – not the property it stands on – which can provide substantial tax benefits.
Depreciating an asset means you are taking a deduction for the value lost as an asset ages. According to the accounting firm of Ernst & Young LLP, the period of time over which you depreciate your property has long been the subject of controversy. Often, it depends upon when the property was put “in service.”
Investors in vacation homes must use the tax benefits from depreciation to cover their costs. What is left for them then is profit made from the appreciation in the value of the property.
The 14-day-maximum, personal-use rule means a house at the ocean with a 90-day rental season can be owner-occupied for 14 days, instead of the nine days that would be allowed under the 10 percent rule. With longer rental seasons, however, the 10 percent rule can be a bonus.
For example, a mountain resort home near winter ski slopes and summer lakes might be rented for 250 days a year, allowing the owner to use it for 25 days. Personal use does come at a cost. Depreciation is limited only to the percentage of time that a house is rented. If you rented for 90 days and use it yourself for 10, you can take only 90 percent of the total expenses and depreciation.
But another way to catch a few hours at the beach without eating into or exceeding the 14-day or 10 percent limit is to clean the house yourself between renters. Days spent maintaining the house do not count toward the personal-use limit. And you can deduct travel costs to get to the house and expenses, such as paint and cleaning supplies.
However, if the Internal Revenue Service determines that you were at the house more to sit in the sun than to clean the bathrooms and paint the porch, those days may be added to your personal use and could jeopardize your tax savings.
The house also must be rented at fair market value. If you rent to relatives at discount rates, the IRS may rule that the house is not actual rental property and disallow many of your deductions. One of the more effective uses of a vacation home as a tax shelter is for future retirement.
For example, if you are 50 years old, you can buy a vacation home, furnish it and have renters pay for it while you capture the depreciation. When you’ve gotten every shred of tax advantage out of it, you can move in and convert it to a private residence. And, because most mortgages “front-load” interest, you will have used up most of your tax deductions from the mortgage in the 15 years you worked and rented the home. In the later years of the mortgage, when interest deductions are relatively low, you probably will be less concerned because your income will have fallen off after retirement.
Now, if I could only afford to consider Pebble Beach…
Tom Kelly’s new book “How a Second Home Can Be Your Best Investment” (McGraw-Hill, $16.95) was co-written with John Tuccillo, former chief economist for the National Association of Realtors, and is now available in local bookstores. He can be reached at email@example.com.
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