Monday, September 13, 2010

Buying a Vacation Home? Part Deux

A vacation home is a nice thing to have. There are tax advantages and disadvantages to having one.

To begin with, if you obtain a mortgage to buy a vacation home, that interest is tax-deductible.  Note that an RV or Boat can qualify as a vacation home, provided it can be lived in (bathroom, bedroom, and kitchen) which may explain the popularity of small boats in the sub-30-foot range which have kitchens, baths, and bedrooms.

And does this sound like welfare for the upper middle class?  Well, yes it is.

If you sell your vacation home and make a profit, then that profit is taxable.  Unlike your primary residence, where if you live there 2 years out of the last 5, profits are largely tax-free (up to $250K single $500K jointly).  However, that illustrates a loophole in the law.  If you plan on selling a vacation home in the next two years, you might want to call it your principle residence for tax purposes for the next two years.  You would, however, have to establish residency in the State, however.

One area of injustice is that while a vacation home profits are taxable when you sell, any losses are not deductible.  This is a heads-I-win, tails-you-lose scenario for the IRS and is, in some ways, grossly unfair.

However, if your vacation home is a rental property - rented out for profit when you aren't there, it may be considered an "investment" property and thus any losses on the sale are deductible.  However any gains on the sale are also taxable as well.

So what do we glean from this?  Well, as I noted in my converting capital gains to ordinary income posting, if you can rent out your vacation home as an "investment" then you can depreciate it and deduct a depreciation allowance from your income taxes.  When you sell, you may have to pay that back as capital gains (25% for the depreciation part, 15% for the rest) or you may be able to deduct a loss, if there is one.

But of course, there is no free lunch.  You cannot use a vacation home as a rental AND as personal residence.  See this IRS publication for the complicated "Personal Use Rules".  There is a limit as to how long you can stay at a vacation home if you are going to claim it as a business asset.  Usually anything more than the greater of 14 days or 10% of the rent-able income for personal use renders the dwelling a personal residence.  I suppose you could pay yourself rent and declare a profit (and pay tax) on that rent.  Even then,  such an arrangement might be viewed as self-serving.

So renting your vacation home out part of the time might be a good idea for tax purposes - and offset some of your expenses.  Note that if the rental is 15 days or less per year, it is not reportable income - and this could be a good way of making a little extra money without the hassles and paperwork of an investment property.

But a vacation home is a personal property, generally, not an investment property, so losses on the sale are not deductible.  But for some reason, the IRS things profits on such a sale should be taxable.  For many people, it is not a difficult matter to "move" the vacation home for two years and declare this a personal residence and avoid the tax.  Most people, in fact, move from their primary home to retire to their vacation home, and thus it is never an issue.

From the H&R Block website:

Selling Your Second Home
If you sell your second home, the gain will be taxed as capital gain, long-term if you owned it for more than a year and short-term if you owned it 1 year or less. A loss on the sale can't be deducted. If the second home was rented for profit, gain generally is taxed as capital gain and a loss can be deducted. The part of the gain attributable to depreciation is taxed at a maximum rate of 25%. If you used the home for personal purposes and rented it, you have to treat the sale as part personal, part business.

If the second home was your main home for at least 2 years during the 5-year period ending on the date of sale, you can exclude up to $250,000 of the gain (up to $500,000 if Married Filing Jointly and you both used the home as your main home for the required period). You can't claim the exclusion if you sold another home within the 2-year period ending on the date of sale and claimed the exclusion for that sale.

If you don't meet the 2-year ownership or use requirement, you may claim the exclusion only if you sell the home because of a change in health, place of employment, or another "unforeseen circumstance." In this situation, the maximum exclusion will be reduced. You may not exclude any gain attributable to depreciation you claimed after May 6, 1997.

If you sell a second home and use it other than as a principal residence (nonqualified use) at any time after 2008, the gain eligible for the exclusion may be limited. For this purpose, nonqualified use does not include:
  • Any nonqualified use before 2009.
  • Any period during the 5-year period that is after the last period of use as a principal residence.
  • A period of temporary absence of up to 2 years for reasons of health, employment and unforeseen circumstances.
  • Any period (not to exceed 10 years) during which the taxpayer or spouse was serving on qualified official extended duty.

From the IRS "10 facts about Capital Gains and Losses" website:

10 Facts About Capital Gains and Losses

IRS Tax Tip 2010-35

Have you heard of capital gains and losses? If not, you may want to read up on them because they might have an impact on your tax return. The IRS wants you to know these ten facts about gains and losses and how they could affect your tax situation.
  1. Almost everything you own and use for personal purposes, pleasure or investment is a capital asset.

  2. When you sell a capital asset, the difference between the amount you sell it for and your basis – which is usually what you paid for it – is a capital gain or a capital loss.

  3. You must report all capital gains.

  4. You may deduct capital losses only on investment property, not on property held for personal use.

  5. Capital gains and losses are classified as long-term or short-term, depending on how long you hold the property before you sell it. If you hold it more than one year, your capital gain or loss is long-term. If you hold it one year or less, your capital gain or loss is short-term.

  6. If you have long-term gains in excess of your long-term losses, you have a net capital gain to the extent your net long-term capital gain is more than your net short-term capital loss, if any.

  7. The tax rates that apply to net capital gain are generally lower than the tax rates that apply to other income. For 2009, the maximum capital gains rate for most people is15%. For lower-income individuals, the rate may be 0% on some or all of the net capital gain. Special types of net capital gain can be taxed at 25% or 28%.

  8. If your capital losses exceed your capital gains, the excess can be deducted on your tax return and used to reduce other income, such as wages, up to an annual limit of $3,000, or $1,500 if you are married filing separately.

  9. If your total net capital loss is more than the yearly limit on capital loss deductions, you can carry over the unused part to the next year and treat it as if you incurred it in that next year.

  10. Capital gains and losses are reported on Schedule D, Capital Gains and Losses, and then transferred to line 13of Form 1040.
For more information about reporting capital gains and losses, see the Schedule D instructions, Publication 550, Investment Income and Expenses or Publication 17, Your Federal Income Tax. All forms and publications are available at or by calling 800-TAX-FORM (800-829-3676).