BUYING THAT CHALET in the Arizona mountains may get you some much-needed peace and quiet. Then come the tax rules, which are pretty complicated.
Depending on how often you use your vacation home yourself, how often you rent it out and how long it sits empty, you will fall into one of three different tax categories.
Use a Lot, Rent a Lot
The first category includes homes that are rented often but that are still used a fair amount by the owner. Specifically, this applies to homes that are rented more than 14 days a year and have personal use of more than 14 days or 10% of the rental days, whichever is greater. Personal use includes use by family members and anyone else who pays less than market rental rates.
Vacation homes fitting this description are considered personal residences. This helps you, because Uncle Sam lets you deduct interest on up to $1 million of mortgage debt (and up to an additional $100,000 for home equity loans). Property taxes are generally deductible, no matter how many homes you own. Those fortunate enough to own more than two homes can pick the two with the most mortgage interest each year — usually the main residence and the vacation home with the biggest loan.
Now for the hard part: accounting for rental income and expenses for your dacha. Basically, there is one way to deduct the expenses incurred while you use the house, and another way to deduct expenses incurred while you rent it. But if done correctly, there is generally no tax liability in these cases.
The first step is to allocate interest and property taxes between rental and personal use. For example, say the home is rented for three months, used by you and your family for two months, and vacant for seven months. Since vacant time is considered personal use, you allocate three months' worth, or 25%, of the interest and taxes to the rental period and nine months' worth, or 75%, to personal use. Write off the personal part of the interest and taxes as itemized deductions on Schedule A. In the past, the IRS has disputed this method of allocating the interest and taxes, but the tax court has ruled it's okay.
So far, so good. Now buckle up your chin strap, because there's white water ahead. The goal here is to reduce the rental income to zero to eliminate any tax liability. First, you reduce the income by 25% of the interest and tax expenses you incurred while renting. If there's any rental income left, you can deduct a percentage of operating expenses — maintenance, utilities, association fees, insurance and depreciation — but only to the point where you "zero out" that remaining income.
There is one difference, though: When you calculate operating expenses, you don't count the days the house stood empty. In our example, the house was occupied for only five months, so three months' worth, or 60%, of the maintenance, utilities etc. goes to the rental period and two months' worth, or 40%, to personal use. That 40% evaporates as a totally nondeductible item. On your tax return, you will use Schedule E (Supplemental Income and Loss) to report 100% of the rental income, 25% of the interest and taxes and 60% of the expenses. In many cases, the bottom line on Schedule E will be zero because the rental income and expenses will be a wash.
When all is said and done, this procedure should allow you to fully deduct interest and taxes (part on Schedule A and the rest on Schedule E) and usually enough operating expenses to wipe out your rental income. Any operating expenses that you cannot deduct are carried over to future years, when they can be deducted if you have rental profits. (In real life, this rarely occurs.) Overall, this is not a bad deal once you master the paperwork.
Rent a Lot, Use a Little
The second vacation-home tax category typically applies to houses that are used very little by the owner. Your home will fall under the tax rules for rental properties rather than for personal residences if you rent more than 14 days a year and if your personal use doesn't exceed 14 days or 10% of the rental days, whichever is greater. For example, assume you rent 210 days and vacation 21 days — you have a rental property on your hands. (Vacation 22 days, and you're back under the personal-residence rules explained earlier.) Interest, property taxes and operating expenses should all be allocated based on the total number of days the house was used. The total number of days used in this example is 231, so the split would be 21/231 for personal use and 210/231 for rental.
Here, if the money you get from renting the house does not cover the cost of renting it, you can post a taxable loss on Schedule E. But don't start tallying up your deductions just yet. First you must successfully clear the hurdles set up by the Internal Revenue Service in the form of passive-loss rules. In general you can deduct passive losses in a given tax year only to the extent of passive income from other sources (such as rental properties that produce gains).
There is an exception, though. The IRS will let you write off up to $25,000 of passive-rental real estate losses if you "actively participate" and have adjusted gross income under certain income thresholds. Making the day-to-day property management decisions will get you over the active participation hurdle. Unfortunately, the exception is phased out once you reach a certain income level, and the IRS says the exception doesn't apply anyway when the average rental period is seven days or less. But it's not a total loss: The IRS will let you carry over the passive losses you can't take this year into future years. The reality is that many owners find their hoped-for tax losses deferred by the passive rules.
Another problem: The interest incurred during your personal use (21/231 in our example) is nondeductible, because your home doesn't qualify as a personal residence. (The personal-use portion of property taxes is still deductible on Schedule A.) This means you may actually benefit from slipping in some extra vacation days this year. Then you drop back into the personal residence category — which means you can deduct the interest and taxes and usually offset all of your rental income with deductible operating expenses.
Use a Lot, Rent a Little
The final category is a rarity in the tax laws: It is simple and benefits the taxpayer. This one applies to homes that are rented for fewer than 15 days a year and used by the owner for more than 14 days. These homes are considered personal residences, so you simply deduct the interest and property taxes on your Schedule A, the same as you would for your primary residence. (There's no allocation nonsense to worry about.)
Here's the free lunch: You need not declare a penny of the income. You don't get any write-offs for operating expenses (maintenance etc.) attributable to the rental period, but who's complaining?
If your vacation home is fortuitously located near a major event — like any golf tournament featuring Tiger Woods — you may be able to rent for a few days at an outrageous rate. Under the tax rules, you can stiff Uncle Sam with a clear conscience.
What About Timeshares?
For many people, owning a timeshare is as close as they can come to having a vacation home. These days, a timeshare week can easily cost over $15,000. In fact, two winter weeks in Beaver Creek, Colorado can run you $60,000 and up, so we're not talking about trivial sums here. Many folks borrow all or part of the purchase price, often through the developer. Unfortunately, the tax rules are not particularly favorable if you rent out your unit.
But first let's assume you use your timeshare rather than rent it out. Your share of property taxes (usually buried in the annual maintenance fee number) is deductible on Schedule A. If you have mortgage interest, you can generally deduct it on Schedule A as interest on a second home. Simple enough.
Now let's say you do rent — as long as it's for less than 15 days, the income is automatically tax-free. Right? Wrong. According to the IRS, the tax-free rent deal is available only when the combined rental days for all the owners of your unit total less than 15 and you personally use the unit for more than 14 days. Not likely.
If you rent your unit at all, the Feds say you should follow the personal residence rules (use a lot, rent a lot) explained earlier by allocating expenses (interest, property taxes, maintenance, utilities, etc.) between personal and rental based on total usage by all the owners of your unit. This approach makes little sense and it's usually impossible to gather the necessary information from other owners anyway. So I advocate making the allocation based on either your own usage pattern or your best guess about total rental usage and personal usage by all the owners.
For example, if it appears that 50/50 is the appropriate split between rental and personal use, allocate 50% of the expenses to the rental period and take deductions up to the amount of your income on Schedule E. Then deduct the personal portion (50% in this example) of property taxes on Schedule A.
Unfortunately, you can't deduct the personal portion (50% again) of your interest expense unless you hang out in the unit more than 14 days during the year. That's impossible unless you own at least three weeks, and few people do. Arguably, you can write off the personal portion of the interest on Schedule A as investment interest expense if you acquired your timeshare with the expectation it would appreciate in value. (In some areas, timeshares have indeed gone up.)
Playing the Gain Exclusion Game With Multiple Residences
As you know, there is now a generous gain exclusion for sales of primary residences ($250,000 for singles, $500,000 for married couples). If you are lucky enough to have one or more vacation residences, there are some tax-saving games to be played here, if you are so inclined. The basic gain exclusion qualification rule is simple. You must have owned and used the home as your main residence for at least two years out of the five-year period ending on the date of sale. If you are married, the full $500,000 break is available as long one or both of you satisfies the ownership test and you both satisfy the use test.
So here's the deal. Say you are married and own three homes. First there's your current main home, which qualifies for the $500,000 exclusion and could be sold for a $400,000 gain. You sell it tax-free and move into your vacation home in Destin, Florida. Live there for two years, and you can unload the property and exclude up to $500,000 of gain from this sale as well – but here’s a caveat: You have to run a calculation to prorate the gain accrued during the period you used the property vs. the period it was rented. The gain built up during your use of the property is subject to the gain exclusion. Then, move into your remaining vacation home in Santa Fe, New Mexico, and live there for two years. You get the idea.
And if you are determined to own three homes, you can simply replace each one after it's sold with another property in the same or different location. Then you could start the "use and sell" rotation all over again, while happily excluding gains all along the way. Obviously relatively few people are affluent enough to be able to stiff Uncle Sam to this extent, but if you are one of them, enjoy. One more thing: Be sure to check on the state income tax implications before actually implementing this maneuver.