You Never Rent

You can have qualified residence interest from up to two personal residences -- your personal residences -- your primary home plus one vacation home. Qualified residence interest can be from either "acquisition debt" or "home equity debt" or both.

Acquisition debts are loans that (1) are secured by a qualified residence (which can include one vacation home) and (2) total up to no more than $1 million ($500,000 if you are married and file a separate tax return). The debt proceeds must be directly traceable to expenditures to acquire, construct, or substantially improve a qualified residence.

Example 1: Say you have $600,000 of acquisition debt on your primary residence. You also have $400,000 on a vacation home. Since the total doesn't exceeed the $1 million ceiling, you can claim all the interest as qualified residence interest in Schedule A. But if you have $700,000 of acquisition debt on your primary residence and $500,000 on your vacation home, you can only deduct the interest on $1 million worth of mortgage debt under these rules. As explained shortly, you can also deduct qualified residence interest on another $100,000 worth of debt under the rules for home equity debt. Interest on the remaining $100,000 is nondeductible.

Example 2: Say you own three homes that you never rent out -- one primary residence and two vacation homes. As mentioned, you can only treat the interest from mortgages on two homes as qualified residence interest. You must designate one of your vacation homes as your second residence for this purpose.

Strategy #1: You should designate the vacation home with the most mortgage interest (subject to the overall $1 million ceiling on acquisition debt). This need not be the same residence each year. For example, if the mortgage on one vacation home is paid down or refinanced at a lower rate, you can select another vacation home that yields a larger deduction for qualified residence interest.

Strategy #2: From a tax planning perspective, it's really better to pay cash for anything after the second home, because any mortgage interest will be nondeductible (unless the property is rented, as explained later in this article).

If you refinance acquisition debt, you can continue to treat the new loan as acquisition debt -- meaning it generates deductible qualified residence interest -- up to the amount of principal on the old loan as of the refinancing date. If the principal on the new loan exceeds the principal on the old loan, you can then treat up to $100,000 of "excess" principal as home equity debt under the rules explained immediately below.

You can claim qualified residence interest from home equity debt as an itemized deduction on your Schedule A. Here are the details.

Home equity debts are loans that: (1) are secured by a qualified residence and (2) total up to no more than $100,000 ($50,000 if you are married and file separately). As long as you stay under the $100,000 ceiling, you can have more than one home equity loan. The debt can be against your primary residence or up to one vacation home, or both. Unlike acquisition debt, it doesn't matter what you do with the home equity proceeds. For example, you can use the money to pay off personal loans that generate nondeductible interest (such as non-business car loans and credit card balances), to buy a boat, or to pay private school tuition for your youngsters.

Warning #1: The home equity debt plus any acquisition debt on your residence cannot exceed its fair market value. Those TV ads touting loans up to 125 percent of your home's value omit the fact that you generally won't be able to deduct all the interest.

Warning #2: The preceding two paragraphs explain the "regular tax" rules. Watch out if you pay the dreaded alternative minimum tax (AMT). In calculating the AMT, you can deduct interest from home equity debt only if the proceeds are used to acquire, construct, or substantially improve a qualified residence (including a vacation home). So if you take out a home equity loan to put in a pool, you get a writeoff for both regular tax and AMT purposes. But if the money goes to finance a fancy vacation and a new home theater system, there's no AMT writeoff. (You still get one for regular tax.)

In summary, you can generally deduct qualified residence interest on up to $1.1 million of home mortgage debt ($1 million worth of acquisition debt on up to two homes plus $100,000 worth of home equity debt on up to two homes). Interest on home mortgage debt outside these two categories is not qualified residence interest. Therefore, it's generally nondeductible (unless you rent the property). For example, say you borrow $2 million to buy a primary residence. You can only deduct interest on $1.1 million. The first $1 million is considered home equity debt. If you then borrow to buy or build a second home, you won't be able to deduct anything more under the rules for qualified residence interest, because you are already up against the $1.1 million ceiling. Sorry about that.

You can claim a Schedule A itemized deduction for all your real property taxes on personal residences. So if you have three or more residences, all the property taxes qualify as itemized deductions, even though you can only write off mortgage interest on two homes.

Warning #3: High-income taxpayers will lose part of their qualified residence interest and property tax writeoffs under the dreaded itemized deduction phase-out rule. This stealth tax increase kicks in when your adjusted gross income reaches $128,950.

Okay. That's the story on vacation home deductions if you never rent. But if you do rent (or plan to start), please continue reading.

You Rent 14 Days or Less

You need not declare one cent of the rental income on your 1040. You can't write off any operating expenses (maintenance, depreciation, etc.) attributable to the rental period, but this is still a great deal. And it can really pay off when your vacation home is fortuitously located near a major event -- like a big golf tournament. You may be able to rent the house for a few days at outrageous rates without having to share any of the profits with Uncle Sam.

You can also take advantage of this break by, for example, renting your vacation home for a short time for filming of movies or commercials. (This 14-days-or-less-tax-free-rental-income rule also applies to principal residences.

You Rent Some and Use a Lot

Personal use means use by you, other family members, and anyone else (family or otherwise) who pays less than fair market rental rates. Family member means your brother, sister, spouse, ancestor or lineal descendant. Only actual days of personal and rental occupancy are counted. Days of vacancy are ignored.

Example 3: Say your vacation home is rented out to strangers at market rates for 30 days and used by your family for a month. The property falls into Category 1, because it's rented more than 14 days and personal use exceeds both the 14-day standard and the 10-percent-of-rental-days standard.

Basically, Category 1 Properties (like the one in the preceding example) are considered personal residences for tax purposes. Therefore if you count the vacation home as your second residence, you can generally deduct all the mortgage interest under the qualified residence rules explained earlier. And you can claim the property taxes as an itemized deduction no matter what. That's simple enough, but stay tuned because here's where it starts getting complicated.

Since your Category 1 Property is rented part of the time, you must allocate expenses between rental and personal usage and account for the rental income. The following example and worksheet explain how.

Completed Tax Worksheet for Vacation Home (See Example 4)
1. Actual personal use time	2 months
2. Actual rental use time	3 months
3. Vacant time	7 months
4. Personal allocation % for int & taxes (1 + 3) / (1 + 2 + 3)	75%
5. Rental allocation % for int & taxes (100% - 4)	25%
6. Rental allocation % for operating expenses (maint., util., fees, ins., deprec.) 2 / (1 + 2)	60%
7. Gross rental income (report on Schedule E)	$10,500
8. Interest	13,000
9. Property taxes	2,500
10. Operating expenses	15,000
11. Interest allocable to personal use (8 x 4) (deductible on Schedule A)	9,750
12. Prop. tax allocable to personal use (9 x 4) (deduct on Schedule A)	1,875
13. Interest allocable to rental use (8 - 11) (deduct on Schedule E)	3,250
14. Prop. tax allocable to rental use (9 - 12)	625
15. Rental income remaining after deducting allocable interest and prop. tax (7 - 13 - 14)	6,625
16. Operating exp. allocable to rental (10 x 6)	9,000
17. Operating exp. allocable to personal (10 - 6) (completely nondeductible)	6,000
18. Currently deductible rental operating exp. (lesser of 15 or 16, deduct on Schedule E)	6,625
19. Disallowed rental operating exp. carried over to next year (16 - 18, if negative enter zero)	2,375

Example 4: Say your vacation home is rented three months, used by your family two months, and vacant seven months. Here is the step-by-step approach you should follow to handle the tax implication.

Step 1: Allocate interest and property taxes between rental and personal usage. For this calculation, count all the time the property was not actually rented as personal. In this example, you would allocate 25 percent (3/12) of the interest and taxes to the rental period and 75 percent (9/12, which includes the periods of vacancy) to personal use. Write off the personal part of the interest (subject to the qualified residence interest rules) and taxes as Schedule A itemized deductions.

Step 2: Offset your gross rental income by the allocable interest and taxes from Step 1 (25 percent in this example).

Step 3: If there's any gross rental income left after Step 2, you can deduct allocable operating expenses -- maintenance, utilities, association fees, insurance, and depreciation. But operating expense deductions are allowed only to the point where they "zero out" the gross rental income remaining after Step 2. In allocating these operating expenses, consider only the actual rental and personal use days (ignore periods of vacancy). So in this example, 60 percent (3/5) of the maintenance, utilities, etc., is allocated to rental usage and 40 percent (2/5) to personal usage. Unfortunately, that 40 percent evaporates as a totally nondeductible item.

Step 4: Report 100 percent of the gross rental income on Schedule E (Supplemental Income and Loss) of your tax return. Report as Schedule E expenses 25 percent of the interest and taxes and the allowable operating expenses (up to the point where rental income is zeroed out). Any disallowed operating expenses are carried over to future years where they can be deducted if you have rental profits (in real life, this rarely occurs).

Step 5: Under a special ordering rule, disallowed operating expenses consist first of depreciation and then a pro-rata portion of all your other operating expenses. To the extent your depreciation writeoff is disallowed, you need not reduce the tax basis of your vacation home.

In most cases, the bottom line on your Schedule E will be zero because your gross rental income will be zeroed out by allocable interest, property taxes, and operating expenses. See the completed worksheet, based on this example. When all is said and done, the Category 1 Property rules usually allow you to deduct all your interest and taxes (part on Schedule A and the rest on Schedule E) and enough operating expenses to offset your rental income. This is a pretty good outcome.

You Mainly Rent

Say you rent your vacation home for 210 days and vacation there with your family for 21 days. You have a Category 2 Property. However, if personal use was 22 days, the property would fall back into Category 1, because personal days would not exceed 10 percent of rental days. For Category 2 Properties, you must allocate mortgage interest, property taxes, and operating expenses based on actual usage (in this example: 21/231 to personal use and 210/231 to rental). You are allowed to generate a taxable loss on Schedule E when allocable rental expenses exceed income. Unfortunately when you have a Schedule E rental loss, it will usually be covered by the unfavorable passive activity loss (PAL) guidelines. The general PAL rule is: you can currently deduct passive losses only to the extent you have current passive income from other sources, such as rental properties that produce tax return profits or taxable gains from sales of rental properties. Losses disallowed under this general rule are carried over to future years. You can then deduct the carryover losses when you have enough passive income in a future year or when you sell the property.

A special exception to the general rule allows you to write off up to $25,000 of current-year passive rental real estate losses if you "actively participate" and have adjusted gross income (AGI) under $100,000. Making the property management decisions will get you over the active participation hurdle. Unfortunately, this favorable exception is phased out between AGI of $100,000 and $150,000.

Regardless of your AGI, the IRS says the $25,000 exception is unavailable when your property's average rental period is seven days or less. Why? The government claims that, for purposes of the passive loss rules, such short rental periods make your vacation home rental operation a "business" as opposed to a "true" rental real estate activity. Nevertheless, your "business" is still a passive activity unless you "materially participate" (more on that later). The bottom line: you may be stymied by the general PAL rule, meaning you can only deduct passive losses currently to the extent you have passive income from other sources.

Observation: Many owners of Category 2 Properties find their hoped-for tax losses deferred indefinitely by the PAL rules.

Another problem is the interest allocable to personal use of a Category 2 Property (21/231) in this example) is nondeductible, because the property doesn't qualify as a personal residence for tax law purposes. (The personal use portion of property taxes is still deductible on Schedule A.)

Example 5: Say you rent your vacation home for 230 days and use the property yourself for 20 days. Since your personal use -- 20 days -- doesn't exceed the greater of 14 days or 10 percent of the rental days, you have a Category 2 Property on your hands. You must allocate your expenses between personal and rental use by using 230/250 as the rental use fraction and 20/250 as the personal use fraction. This means 20/250 of the mortgage interest will be nondeductible. Also, 20/250 of your operating expenses (insurance, utilities, maintenance, depreciation, etc.) will be nondeductible. However, the personal use portion of your property taxes is deductible on Schedule E, you subtract 230/250 of the total expenses (mortgage interest, property taxes, and operating expenses) from your rental income to determine if you have overall income or loss from the rental activity. If you have a loss, you must determine if it's limited by the PAL rules. Remember, you'll be ineligible for the $25,000 rental real estate exception if your average rental period is seven days or less or if your AGI is too high. If you strike out on either or both counts, consider spending some extra personal days at your home. If you slip in just four more personal days, your vacation home falls back in Category 1 (because your personal days will now total 24, which would exceed 10 percent of your rental days). Under the Category 1 rules, you could (1) deduct all your mortgage interest (assuming it meets the definition of qualified residence interest), (2) deduct all your property taxes, and (3) deduct your operating expenses to the extent of your remaining gross rental income.

Strategy #3: As explained at the end of the Example 5, you may actually benefit from spending some extra personal days in your vacation home between now and year-end. The downside is this means you won't generate any passive loss carryover which could be deducted in future years.

Strategy #4: Say you have plenty of passive income. Or your AGI is below $100,000 and you have no problem with the seven-day rule. You should be able to currently deduct your passive rental loss in full (because you have plenty of passive income or because you qualify for the $25,000 PAL exception). If the nondeductible personal interest expense will be a drop in the bucket, you should minimize your personal use days for the rest of the year if your objective is to maximize your deductible rental loss.

Say you are adversely affected by the seven-day rule. Consider these planning alternatives.

Strategy #5: Try to extend your property's average rental period beyond seven days by renting for longer periods. This restores your eligibility for the $25,000 PAL exception (assuming your AGI is not so high that this break is phased out).

Strategy #6: If it's impossible to extend your average rental period, you can try to "materially participate" in the "business" of renting your vacation home. If you can meet the material participation standard, your vacation home rental activity is considered non-passive and you can currently deduct your Schedule E losses against taxable income from any source (salary, Schedule C income, capital gains, etc.). The three easiest ways to meet the material participation standard are:

• By doing substantially all the work related to the property.
• By spending over 100 hours dealing with the property and making sure no other person spends more time than you.
• By spending over 500 hours dealing with the property.

Example 6: Say you can't take advantage of the $25,000 passive loss exception because your Category 2 vacation home's average rental period is seven days or less. You have zero passive income from other sources, so you've been piling up carryover passive losses. Here's the good news. If you can rig things so you pass one of the three material participation standards listed above, your Schedule E vacation home loss will be exempt from the PAL rules. That means you can currently deduct the loss against your other income.

Example 7: Say the average rental period for your Category 2 vacation home is longer than seven days, but you are ineligible for the $25,000 passive loss exception because your AGI is too high. Therefore, you have been piling up carryover passive losses. In this case, the solution is to reduce your average rental period to seven days or less. As far as the IRS is concerned, that magically transforms your rental activity into a "business." Now if you can pass one of the material participation tests, you can currently deduct your Schedule E vacation home loss.

Conclusion