This summer I had the opportunity to visit several vacation resort communities. They were spectacular--beautiful homes in beautiful settings. But whether I was on the east coast, west coast, mountain or beach, I was astounded at the number of homes up for sale or rent. Furthermore, after speaking with some of these homeowners, I was even more astounded by the amount of misinformation they had regarding the tax ramifications of these homes. Many kept saying, "It's okay;" they would "just write it off as a tax loss"--either by renting it out or accepting a lower sale price.
The problem is this: They consider their second home to be an investment, while according to the IRS, it is a vacation home and not easily subject to deductible losses. With that in mind, I'd like to share with you five common misunderstandings about vacation homes that I heard this past summer.
First, let's review the basics regarding 'vacation home' as defined by the IRS. A vacation home can be categorized in one of three different ways: personal, rental, and dual purpose (mixed use). It all depends on the number of days used by the owner (or related parties) and the number of days rented.
The categories that determine the tax treatment of a property's income and deductions are:
?Entirely personal--property used as a home and rented fewer than 14 days in the taxable year.
? Entirely rental--property rented more than 14 days a year; owner's personal use does not exceed 14 days or 10 percent of the rental days, whichever is greater.
? Dual purpose--mix of personal and rental; property is rented for more than 14 days and personal use exceeds 14 days a year or 10 percent of total rental days, whichever is greater.
Unfortunately, the categories are outnumbered by the homeowners' misconceptions.
1. "I'll just sell it and write off the loss"
When property qualifies as personal use, the basic deductions are mortgage interest and property taxes taken on Schedule A, recorded just like those on a primary residence. The mortgage interest deduction is limited to interest on up to $1 million (or $1.1 million with a home equity loan) in total mortgage debt for a first or second home.
However there were some misunderstandings regarding the sale of a vacation home at a loss. A few homeowners were surprised to learn that they could not deduct the loss, and even more surprised to learn that in certain situations, they might even have taxable income. For example, homeowners would incur taxable income when they are able to "short sale" their home. In this sense, a "short sale" happens when someone is able to sell their home for less than the mortgage balance and the lender agrees to forgive the unpaid balance. The difference is considered "forgiveness of debt" and is recorded as ordinary income. In my conversations, I found that many people thought the Mortgage Forgiveness Debt Relief Act of 2007 eliminated that. Effective from Jan. 1, 2007 through Dec. 31, 2009, the new law provides that a homeowner does not have to pay tax on debt forgiven by a lender if the loan is secured by the property the homeowner lives in. But this act only applies to a borrower's primary residence--not investment properties or vacation homes. A short sale or foreclosure on such properties would still trigger a tax bill.
2. "My brother said he would rent it from me so I will be able to treat it as a rental property."
In this situation, the homeowner was ecstatic because her brother agreed to rent the house at market value. She started to list all the expenses she could then deduct. Unfortunately, I had to say, "Close, but no cigar," because when you rent to a relative, or allow a relative to use your vacation home, the government considers that to be personal use, regardless of whether you charge the user rent. Defined relatives include spouses, parents, brothers and sisters, half-brothers and half-sisters, children, grandchildren and grandparents.
If the user was not a relative, and the property was considered "mixed use," she would have been able to deduct allocated expenses up to the amount of rental income. On a positive note, I reminded her that next year, when her area hosts the Superbowl, she may have a once-in-a-lifetime opportunity to forego tax on rental income. As long as the property is considered "personal use," she will be able to rent the house for a few days--probably at an outrageous rate--with the rental income completely tax-free. This can be quite a tax boon for clients with properties located near a major golf event, beach, ski resort or Super Bowl location.
3. "I'll donate the house to a charity for the summer, and at least get a charitable deduction."
This homeowner thought he was being very clever, but IRS regulations do not allow a charitable contribution deduction for the gift of the right to use property. Furthermore, charitable use is counted as the homeowner's personal use, so that donated week is considered as a week of personal use.
4. "At least, I can deduct $25,000..."
Here is a great example of why a little bit of knowledge can be harmful. In this instance the homeowner insisted that there is a special $25,000 break for rental real estate. He was right, but wrong; the IRS code does grant a deduction to individuals who own 10 percent or more of a real estate rental in which they actively participate. But the deduction is phased out if one's modified adjusted gross income (MAGI) is $150,000 or greater. Furthermore, it was questionable whether the homeowner was really going to "actively participate" in the rental activity. To be considered "active," he must make bona fide and significant management decisions such as approving new tenants, deciding rental terms, reviewing fair-market rental fees, and approving capital or repair expenditures. Delegating all management decisions to a rental agent would most likely disqualify him as an active participant.
5. "Renting doesn't matter because I'll never get to deduct my losses..."
The frustration in this person's voice was obvious. He went on and on about how he no longer wants to use this home for vacations and wants only to rent his house out. But why bother, he asks, if he can never deduct the losses? Finally, I had some uplifting news to give someone: There are two circumstances when those suspended losses can be written off. First, when the rental property starts showing a profit, he can deduct the suspended losses up to the amount of rental income. When the property is sold he can deduct the passive losses in total, even if there is no passive income. In addition, even if rental property is temporarily vacant, the expenses are still deductible as long as the property is held out for rent.
Once again, it's best to keep sales outside of the family. If you sell a vacation home to a relative, you may not write off suspended losses until your relative sells the property to an unrelated third party. In other words, tax law says the sale is complete only when an unrelated third party owns the property.
So the opportunity to add value is right at your fingertips. Discuss this with clients who have second homes. The peace of mind you may be able to give them could be the greatest service you deliver this year.
Susan L. Hirshman, CFP, CPA, CFA, CLU, a former managing director for JPMorgan Asset Management, operates a wealth management consulting business in New York. She can be reached at firstname.lastname@example.org.