Do you own more than one home? Perhaps you spend the winter in your warm Florida or Arizona home and the summer enjoying your cool Maine or Michigan cottage.
Millions of U.S. residents share your situation of owning a vacation or second home. Depending on your circumstances, you might be overlooking significant tax savings.
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If you keep careful tax records for both homes, you might be entitled to big tax breaks during ownership and when you decide to sell. Just in case you are audited by the IRS, it’s best to keep your residence tax records “forever.”
For example, last year James and Jean Guinan received the bad news from the U.S. District Court their profit on the sale of their northern Wisconsin home was taxable and they owed $45,009 capital gain tax. Although they met the two-out-of-last-five-years ownership and occupancy tests of Internal Revenue Code 121 to claim the $500,000 principal residence sale tax exemption (up to $250,000 for a single home seller), the court ruled this was not their principal residence. The key factor was they didn’t file income tax returns from their Wisconsin home. (Guinan v. U.S., 2003-1 USTC 50475).
VACATION OR SECOND-HOME BENEFITS DURING OWNERSHIP. If you itemize your income tax deductions, your property taxes and mortgage interest are always deductible for your principal residence and a second or vacation home. But there can be additional ownership deductions, depending on your personal use of your secondary home. There are four possibilities:
1–NO PERSONAL-USE TIME. If you didn’t personally use your second home in 2003, other than for a few days for repair and maintenance work, and if it was rented or available for rent the rest of the year, then your rental income and expenses should be reported on Schedule E of your income tax returns.
This is where your rent and applicable expenses, such as mortgage interest, property taxes, insurance, utilities, repairs and depreciation deductions, are entered. You can also deduct reasonable travel expenses to inspect (but not occupy) your rental property (especially if it is in Hawaii!).
In this category, your tax result will probably be a “tax loss” (mainly due to the non-cash depreciation deduction). That means your second home is primarily a rental property.
Uncle Sam considers your rental home a “passive activity,” even if you select the tenants and manage the property. If you earned below $100,000 adjusted gross income in 2003, in this category of no personal use you can deduct all of your tax loss from your second home, up to $25,000 per year.
Any annual tax loss exceeding $25,000 must be “suspended.” That means it can be used in future tax years, or to offset your taxable profit when you eventually sell the second home.
However, if you are a full-time “real estate professional,” such as a real estate broker, then there is no annual limit to your qualified rental property tax loss deductions against your other ordinary income.
If you didn’t “materially participate” in managing your second home, or if you own less than a 10 percent interest, or if you put your property into a resort rental pool, then your tax loss greater than the rental income is “suspended” for future tax deduction use. It cannot be deducted against your ordinary income from other sources, such as job salary, due to your lack of material participation in management of the rental.
2–UNDER 14 DAYS OF ANNUAL RENTAL. If you rented your second or vacation home less than 14 days last year to tenants, regardless how much rent you received, that rent is tax-free and need not be reported to Uncle Sam. But you can still deduct the itemized mortgage interest, property taxes, and any uninsured casualty loss (such as rain or snow damage) deductions.
3–ANNUAL PERSONAL USE OVER 14 DAYS OR 10 PERCENT OF THE RENTAL DAYS (IF RENTED OVER 14 DAYS LAST YEAR). In this category of heavy personal use of a second or vacation home, but modest rental income, the rental income and expenses must be reported on Schedule E of your tax returns. But any excess deductions exceeding rental income cannot be used to offset your ordinary taxable income. Unused losses are “suspended,” as explained above, for future tax benefits.
The correct order for deducting expenses is mortgage interest, property taxes, uninsured casualty losses, operating expenses, and depreciation. When mortgage interest, property taxes, and uninsured casualty losses exceed the rental income received, however, these excess deductions should be itemized on Schedule A.
4–ANNUAL PERSONAL USE IS UNDER 15 DAYS OR 10 PERCENT OF THE RENTAL DAYS. This is a very desirable second home category because there is no limit to your tax loss deductions against ordinary taxable income (except for the $25,000 annual passive activity loss limit explained above).
To illustrate, suppose you rented your second home to tenants for 240 days in 2003. You personally occupied it just 10 days. Because your annual personal use is less than 15 days, or 10 percent of the rental days, you can deduct up to $25,000 of qualifying losses against your ordinary income. However, Internal Revenue Code 183 says you must show a rental activity profit at least three of every five years in this category.
SUMMARY. Although second or vacation homes are not great tax shelters during ownership, they can save tax dollars, depending on which of the four categories you meet. Hopefully, they are also appreciating in market value.
When you sell your second home, if you meet the “aggregate” two-out-of-five-year ownership and occupancy test, and can prove it was your principal residence during those two years, you may be able to qualify for up to $250,000 tax-free sales profits (up to $500,000 for a married couple filing jointly). Consultation with your personal tax adviser is recommended to maximize your second- or vacation-home tax benefits.
Next week: How to deduct real estate casualty losses.
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