(This is Part 2 of an eight-part series. See Part 1, Part 3, Part 4, Part 5, Part 6, Part 7 and Part 8.)
If you or someone you know is among the millions of taxpayers who own a secondary residence, you can maximize tax savings from your vacation or second home. Depending on your personal use time, a bit of advance tax planning can result in saving hundreds or even thousands of tax dollars.
FOUR TAX CATEGORIES FOR SECOND HOMES. Although your second-home mortgage interest and property taxes are always tax deductible if you itemize deductions, the amount of your personal use time determines additional income tax deduction savings:
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1.) LESS THAN 14 DAYS OF ANNUAL RENTAL. Personally, my second home falls into this category. The tax result is that I can deduct only my mortgage interest, property taxes, and any uninsured casualty loss cost. But other expenses such as insurance and repairs are not deductible.
If I rent my second home up to 14 days per year, I don’t have to report that rental income to Uncle Sam. However, if I rent to tenants for greater than 14 days annually, then my second home will fall into one of the following categories.
2.) ANNUAL PERSONAL USE EXCEEDING 14 DAYS OR 10 PERCENT OF THE RENTAL DAYS (IF RENTED OVER 14 DAYS IN 2005). In this category of heavy personal use and modest rental time, second-home owners must report their rental income on Schedule E of their tax returns, along with applicable expenses.
But in this category any resulting tax loss when rental expenses exceed rent collected cannot be deducted against ordinary income from other sources, such as job salary. However, unused losses are “suspended” for future tax deduction benefits so it pays to keep track of such losses.
The correct order for deducting second or vacation home expenses in this category is mortgage interest, property taxes, uninsured casualty loss expenses, operating expenses such as insurance and repairs, and depreciation for the rental period. However, when the mortgage interest, property taxes, and uninsured casualty loss expenses exceed the rental income, they become itemized deductions on Schedule A.
3.) ANNUAL PERSONAL USE BELOW 15 DAYS OR 10 PERCENT OF THE RENTAL DAYS. This is the most desirable tax category for a second home. The reason is there is no limit to your tax loss deductions against your ordinary taxable income, (except for the $25,000 annual passive loss limit explained below). Rental income and deductible expenses are reported on Schedule E of your tax returns.
Let’s suppose you personally occupied your second home for 10 days in 2005 and you rented it for four months. Because your personal use time is below 15 days per year and under 10 percent of the rental days, you can deduct up to $25,000 of qualifying expense losses, including depreciation, against your ordinary income. However, Internal Revenue Code 183 says you must show a rental activity at least three of every five years in this category.
4.) NO PERSONAL USE TIME. If you didn’t personally use your second home during 2005, other than a few days while making repairs, and it was rented or available for rent the entire year, then your second home falls into this rental property category.
The tax result is that all your income and expenses, including depreciation, are reported on Schedule E of your tax returns. Virtually every applicable expense is deductible on Schedule E, such as mortgage interest, property taxes, insurance, homeowner association fees, utilities you paid, repairs, and depreciation.
In addition, you can deduct reasonable “ordinary and necessary” travel expenses to inspect (but not occupy) your rental property, even if it is in Hawaii, Puerto Rico, or the U.S. Virgin Islands.
In this category, you are very likely to have a “tax loss,” primarily due to the non-cash rental depreciation deduction. However, even if you select the tenants and collect the rents, rentals are a considered “passive activity” taxwise.
That means if your 2005 adjusted gross income is $100,000 or less, you can deduct up to $25,000 tax loss from your rental passive activity. But any rental tax loss exceeding $25,000 must be “suspended” for use in a future year, or when you sell the property to offset capital gains.
However, if you qualify as a “real estate professional,” such as a full-time sales agent, then the $25,000 passive activity loss limit does not apply.
To deduct “passive activity” rental property losses against your ordinary income, subject to the limits explained above, you must have “materially participated” in managing your second home. This means you must own at least a 10 percent interest in the property and others cannot manage it in a “rental pool.”
Without material participation, your rental tax loss is not deductible from ordinary taxable income and it must be “suspended” or saved for use in a future tax year.
SUMMARY: Although second or vacation homes are not great tax shelters, they can save tax dollars while usually appreciating in market value for future resale profits. An additional possible future benefit, when you get ready to sell, is to move into your second home to make it your full-time principal residence for at least 24 of the 60 months before its sale. Then up to $250,000 principal residence sale capital gains will be tax-free (up to $500,000 for a married couple filing joint tax returns). For full details, please consult your tax adviser.
Next Week: How To Maximize Casualty Loss Tax Deductions.
(For more information on Bob Bruss publications, visit his
Real Estate Center).
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