SECOND HOME TAXATION

Finally, a dream comes true. You just became the proud owner of that vacation cabin by the lake you have coveted for all these years. In the excitement of making the buying decision, you vaguely recall the phrase “tax advantages of second home ownership.”

There are special tax rules that apply for vacation home ownership and use as a rental property. For these rules to apply, the property must meet the definition of a dwelling unit. A dwelling unit is a house, apartment, condominium, mobile home, boat or similar property. It has basic living accommodations, such as sleeping areas and cooking facilities. It does not meet the definition if the property is used solely as a hotel, motel, inn or similar type of establishment that is regularly available for rental and is not used by the owner as a home.

You may deduct, as itemized deductions, the mortgage interest you pay on one second home. You may also deduct state and local real estate taxes. In the future if you sell the property you will be taxed on the realized gain as in any other sale of property, unless you qualify the property as your full-time, personal residence for at least two of the last five years.

If you decide to rent out the property when you are not using it, another set of rules applies to the inclusion of the rental income and the deduction of ownership expenses. Under IRS rules, the extent to which you use your vacation home for personal reasons affects its tax treatment. Generally, if you only rent out your vacation home, and do not use it for personal reasons, you include all of the income and can deduct all of the expenses associated with the home. If you sometimes use the home for personal reasons, but not more than 14 days or 10% of the days it is rented to others, all the income is taxable and you must allocate expenses between personal and rental. Expenses greater than income, in this case, are deductible but may be limited under passive activity rules.

If your use is greater than the 14 and 10% rule, your use is considered significant and a special rule applies. If you have a net loss, you may not be able to deduct all of the rental expenses.

These rules require that the dwelling be rented a minimum number of days in order for property expenses to be deductible. If you use the dwelling as a home and rent it for fewer than 15 days a year, neither the income nor the expenses can be included in your tax calculations.

On the other hand, if the property is rented more than 14 days per year, and your use was significant, you may deduct property expenses, pro rata, to the number of days of rental/number of days of personal use. Expenses that exceed income in this instance are not deductible as a loss.

Rental income may include payments other than typical rent. A canceled lease payment from a tenant may be included as rent. Also, if the tenant provides services or other property in lieu of rent, such as property maintenance, the fair market value of those services or property is includable as rent.

Rental expenses include such items as repairs and maintenance. Improvements are a capital item and not deductible. For example, painting the deck is deductible, building a new deck is not.

Property and liability insurance premiums are deductible, as are charges for services, such as property management and maintenance, utilities and trash collection. Travel required for collecting rents or otherwise managing or maintaining the property is deductible, as are condominium and property association dues.

Because of these restrictive rules, the decision to acquire a second home should not be driven by tax considerations. Rather it should be considered a “quality of life” issue.