The Tax Byte
The Tax Byte

Planning for the Tax-Free
Sale of Your Home

(Vacation Home Deduction -- A Tax Guide)

Do you own a vacation or second home that you can treat as:

  • A personal home
  • A business lodging complex
  • Part personal home and part rental property
  • Part personal home and part hobby rental
  • A one-unit motel
If "yes," you will love this article because it will help you put more money in your pockets.

What is a vacation home?

Technically, tax law says a "vacation home" is a dwelling you use for both:

  • Personal, and
  • Rental purposes
A dwelling includes a house, apartment, condominium, mobile home, motor home, yacht, boat, recreational vehicle and similar property. To be a dwelling, the property must have basic living accommodations, like:
  • Sleeping place
  • Toilet
  • Cooking facilities
Thus, any dwelling used for both personal and rental is a vacation home, subject to special tax law vacation-home rules. The dwelling does not have to be at the beach or in the mountains. Tax law makes the dwelling a vacation home when you have both rental and personal uses.

What if I have no rental use?

With no or even limited rental use, you do not have a vacation home. Instead, you have a business property, a personal home, or a combined business and personal use property.

Business Use of Vacation Home

Do you use your vacation dwelling solely for business lodging? If "yes," you escape the dreaded vacation-home rules and may deduct your business-lodging costs. The vacation-home section of the Internal Revenue Code says that nothing in the vacation-home section shall disallow any deduction for business travel (unless that travel is for the business of renting dwelling units).

This means that the IRS may not apply the vacation-home rules to deny a business travel deduction.

Congressional floor debates show that in appropriate circumstances, ownership of a home can qualify for deductible business lodging expenses. In fact, Members of Congress can deduct the business portion of their out-of-town lodging expenses while serving in the United States Congress. When Congress enacted the vacation-home rules, then Senator Bob Dole states that the new 280A(f)(4) provision "will clarify that the personal use rules of section 280A will not be construed to deny otherwise allowable business expenses for travel away from home."

This means that if you use your vacation home for business and never as a rental property, you do not consider the adverse impact of the vacation-home rules.

Personal Use of Vacation Home

Rent or use by relatives: Personal use is more than meets the eye. You have personal use of a vacation home when you rent to or allow user by a relative. The rent charged makes no difference. Paying and nonpaying relatives who use your vacation home complicate your deductions. Such relative use is personal use by you. For this purpose, your relatives include your:

  • Mom and dad
  • Brothers and sisters
  • Sons and daughters
  • Grandchildren and grandparents
  • Spouse
Planning tip: Do not rent to relatives.

Planning note: Co-owners must count use by their relatives as use by themselves. Thus, if you own the vacation home with others, make sure you ask your co-owners for use not only by them but also by their relatives.

Charitable use produces personal days: No matter how much the charitable donor pays for use of your vacation home, the IRS counts the charitable use as personal use by you. If you donate a week of vacation-home use to your high school's annual auction, you have a week of personal use. It makes no difference what the successful bidder pays for that week of use.

Double whammy: Your charitable gift of the right to use your vacation home for the week does not produce a deductible contribution for you. The Regulations deny a charitable contribution deduction for a gift of the right to use property.

Swaps produce personal use: Similarly, you have personal use when you swap vacation homes with a friend or under an exchange agreement. Swaps and bargains produce personal days. You count as personal use of your vacation home, any days that you:

  • Allow a person to use your unit under an agreement that lets you use another dwelling, or
  • Charge less than fair rent.
Example 1: You and Nelson swap one week of vacation-home use. Nelson's use of your vacation home during the one-week swap counts as personal use by you.

Example 2: You charge the first baseman on your baseball team only 77% of the fair rent. The first baseman's use counts as personal use by you.

Repair days do not equal days of personal use: Tax law says that you do not use your vacation home on days when your principal purpose for such use is repair or maintenance. To qualify the day as a repair day, you must spend substantially full-time repairing or maintaining the vacation home.

Example 1: You arrive Thursday evening, after a long drive, but in time for a late dinner at the cottage. You spend a normal work day on both Friday and Saturday getting the until ready for rental. Your spouse relaxes. You depart Sunday, a little before noon. According to the IRS's examples, your principal purpose for that trip is maintenance. You do not count Thursday, Friday, Saturday, or Sunday as days of personal use.

Example 2: You own a mountain cabin that you rent in the summers. During the week you spend at the cabin, your family members work substantially full-time repairing the cabin. You spend about 3 to 4 hours a day helping, and the rest of the time on the lake fishing. According to the IRS, your family's principal purpose of that week's stay is maintenance.

Beware of improvements: The IRS tried to disallow Twohey's stays at his vacation home because he improved the property. The Tax Court ruled for Twohey and against the IRS. It appears that the IRS could try this tack again when it can make improvements the central issue.

Vacation Home Rented Less Than 15 Days

Tax-free income: If you rent your home for less than 15 days, you do not report the rental on your tax return. The income is tax free. You do not share it with the government.

Planning tip: Do you have an event coming to your area that might command high rents? Say there is a major golf tournament, Olympic event, or other activity that could allow you to rent at a high rate for a short period.

Example: You have a summer home on the beach next to a major golf tournament. You rent the home for $10,000 a week for two weeks. You have $20,000 of tax-free income.

Vacation Home Rented for 15 Days or More

Personal use of summer home: If you personally use your rental for even one measly day, you must allocate expenses between rental and personal use. The personal-use portion is explained later under deducting personal use of a vacation home. You deduct the rental portion under either the:

  • Rental property rules, or
  • Hobby rental rules
Planning note: The difference in tax benefit is significant. As a rental property, you might shelter other income with rental losses. As a hobby, you may not deduct a loss.

Technical point: The amount of personal use determines the classification of your summer home as a rental property or hobby rental. The rental part of your summer home is tax-defined rental property when your personal use is either:

  • 14 days or less, or
  • 10% or less of the days rented
Example - rental: You rent your summer home 260 days. You use it personally for 26 days. Ten percent of your summer home is a personal home. Ninety percent is a rental property.

Example - hobby: With 30 days of personal use, you have a hobby rental. You may not deduct losses on the hobby rental part.

Vacation Home as a Hobby Rental

Allocation breaks for hobby rentals: When your property falls in the hobby rental category, it means that the law treats the property primarily as a home with the rental activity simply a hobby. You get tax deductions for both the home and hobby activities. The combination opens a planning opportunity.

Planning tip: You might get huge tax breaks when you follow the Bolton case to make allocations between personal and hobby use. We noted instances where Bolton produced a 400% increase in deductions. Under Bolton, you allocate interest and taxes to hobby rentals by dividing rental days by total days in the year. This method surpasses the IRS's method where you allocate interest and taxes to hobby use by dividing rental days by total days of use for rental and personal purposes.

Example: You rent your summer cabin for 112 days and use it personally for 28 days. The IRS says that you must take 80% of your interest and taxes against the hobby. You deduct the remaining 20% as itemized deductions.

Bolton says that you must take 31% against the hobby and deduct 69% as itemized deductions. In effect, you free 49% of the hobby's deductions under the Bolton method. With $15,000 of mortgage interest and taxes. Bolton gives you a $7,350 deductions advantage.

Vacation Home as a Rental Property

Allocation breaks for rental homes: If tax law classes your summer home as a rental property, you should follow the IRS's allocation method to get the best breaks.

Personal part of interest lost: If tax law classes your vacation home as a rental property, any mortgage interest allocated to your personal use is nondeductible consumer interest (ouch!).

Planning tip: You reduce personal nondeductible interest when you follow the IRS's allocation method. With the IRS method, you push more deductible interest to the rental.

Passive-loss rules: Tax law disallows deductions for passive activity losses incurred by individuals, estates, trusts, closely held C corporations, and personal service corporations. The law defines a passive activity as (1) any activity that involves a business in which the taxpayer does not materially participate and (2) any rental activity. Under this rule, you may deducts passive losses only against passive income. You carry unused losses (called suspended losses) forward until you either use them or sell the property.

Rental activity: For purposes of the passive loss rules, a rental activity is any activity where payments are principally for the use of tangible property. Your vacation home is a rental activity if it is not a motel.

$25,000 break: Tax rules grant a deduction break to individuals who own 10 percent or more of a real estate rental activity in which they actively participate. The break goes to taxpayers who earn less than $150,000. This break allows passive loss deductions of up to $25,000 for individuals who earn $100,000 or less. The law reduces the $25,000 rental loss maximum by 50 cents for each dollar over $100,000. Thus, if you earn more than $150,000, tax law eliminates this break for you.

Seven-day rule: Your vacation home may or may not be a rental activity. To be a rental activity, the average period of customer use must exceed 7 days. The IRS treats rentals that fail the 7-day test as business activities subject to the more restrictive material participation standards for deducting passive losses. In other words, the $25,000 break is not available in cases where the average rental is for 7 days or less. However, the 7-day rule might make your vacation home a hotel with extra tax breaks.

Real Estate Professionals Escape Passive Loss Rules

General rule: Rental activities are passive activities. Other business activities are passive activities if you do not materially participate.

Exceptions for real estate professionals: Rental activities in which you materially participate during the year are not passive activities if, for that year, you were a real estate professional.

Requirements: You are a "real estate professional" if you spend:

  • More than half your time, and
  • More than 750 hours
In a business that develops, redevelops, constructs, reconstructs, acquires, converts, rents, operates, manages, leases, or sells real property.

Example: You sell real estate for a living. You meet the requirements of a real estate professional.

Technical note: The requirements above come from IRS Publication 17. Some tax advisors feel that IRS regulations do not cover real estate agents. We disagree. We think that the IRS included real estate agents in its IRS Publications on purpose.

Special employee rule: You may not count services performed as an employee as performed in a real property trade or business, unless you own more than 5% of the stock, capital, or profits of the employer.

Married persons: In a joint return, you meet the requirements for time spent performing services only if either you or your spouse separately satisfies the requirements. Do not count services performed by the other spouse.

Vacation Home as a One-Unit Motel

No personal use: Obviously, with no personal use, your summer home qualifies as a rental property. But no personal use may make it better than your average rental property. With no personal use, tax law might classify your vacation home as a one-unit motel exempt from the rental-property rules.

Planning note: Motel businesses report losses on Schedule C where such losses could cut self-employment and Medicare taxes.

Motel definition: Your summer home meets the criteria to be a one-unit motel when:

  • Average customer stays are 7 days or less
  • You do substantially all the work to care for, rent, and account for the property
If you do not do all the work personally because you have help, you must work:
  • More than 100 hours; and
  • More hours than anyone else works.
This level of effort makes your summer home a motel exempt from the rental property rules.

Warning: One day of personal use eliminates the motel benefit.

Beware of relatives: Remember, relative use, paid and unpaid, fair rent or not, equals personal use by you.

Planning tip: Tax law subjects all businesses, including one-unit motels, to the passive-loss rules. To deduct your passive losses against other income, you must materially participate in the business.

Vacation Home Deductions

Purchase price: Assuming your started using your vacation home in the year of purchase, you write off your ownership the following ways:

  • Split the purchase price between land and building.
  • Keep track of the land cost (it is part of your basis and produces benefit when you sell the property).
  • Write off the part of the building you use for business lodging over 39 years (commercial use of business lodging property).
  • Write off the part of the building you use for rental over 27.5 years (residential rental property).
  • Divide the mortgage interest into business, rental, and personal parts.
  • Divide maintenance, utilities, and other expenses into deductible business, deductible rental, and nondeductible.
Planning note: You purchase price includes legal fees, recording fees, settlement fees and closing costs needed to obtain proper title to the property. Generally, the costs treated as part of your purchase price (basis) and then split between land and building include:
  • Abstract fees
  • Charges for installing utility services
  • Surveys
  • Transfer taxes
  • Title insurance
  • Amount you pay for the seller such as back taxes, interest, recording or mortgage fees, charges for improvements or repairs, and sales commissions.
Lender's fees: You deduct the expenses you pay to obtain the mortgage, such as points and other lender's fees, over the life of the mortgage.

Planning tip reminder: If your vacation-home rental comes out as a hobby under the rules, use the Bolton allocation method to increase tax benefits.

Business Allocations

What happens if you use the vacation home for personal, rental, and business purposes during a year? Neither Congress nor the IRS gives guidance in this situation. We think it is logical to first allocate to business and vacation home use (rental and personal) and then to:

  • Deduct the business portion under the business rules
  • Deduct the personal and rental uses under the vacation home rules

Mortgage Interest Deductions

Home Mortgage Deduction: the interest paid on your vacation-home mortgage may qualify for a home-mortgage interest deduction under the qualified-second-home-mortgage-interest rules.

Rule 1: If you have no rental use of the vacation home during the year, you may treat the interest you pay on your vacation home as deductible mortgage interest.

Technical note: For purposes of the interest deduction, the IRS deems that the vacation home "has rental use" when the taxpayer:

    Holds the vacation home out for rental or resale or
  • Repairs or renovates the vacation home with the intention of holding it out for rental or resale
Example: You own a vacation home and use it for business lodging and personal purposes only. You deduct the business portion of the interest as a business expense. Since you did not try to rent the vacation home, you many claim the remainder of the interest as second-home interest.

Rule 2: One day of rental use combined with personal use triggers the division of vacation-home expenses into rental and personal components. You may deduct interest on the personal component only if use of the vacation home meets the definition of a qualified home under the rules for deducting mortgage interest.

Big question: Did you use the vacation home more than 14 days or more than 10 percent of the days you rented the vacation home at fair rent, whichever is longer?

"Yes" answer: If "yes," you have a second home and can choose to deduct interest allocated to the home part as second-home interest. The rental part is a hobby and you get maximum benefit when you allocate to the hobby and rental using the Bolton allocation method.

"No" answer: If "no," you have a rental property and the personal part of the vacation-home mortgage produces nondeductible personal (consumer) interest. The rental part produces rental deductions.

Tax Rules for Sale of Vacation Home

Overview: Tax laws can make life miserable, especially when you get clobbered by an unexpected tax. The vacation home has the potential to bring great misery, unless you know the rules - which you will by the time you finish the sale section of this article. When you know the rules, you can find unexpected pleasure - more deductions than you thought possible.

Positive results: The sale of a vacation home triggers different rules, depending on how the law classes your vacation home. The various positive results include:

  • Deductions unamortized points
  • Writing off previously suspended passive losses
  • Claiming a loss on sale
  • Freeing passive losses from other rentals
Allocation required: If you used your vacation home for personal, rental, and business purposes, you must allocate gain or loss to personal, rental, and business activities. In its passive activity rules section, the IRS says that you make that allocation based on activity during the 12 months before disposition. Should the passive loss rules not apply, you might review the Wigfall case for a fascinating allocation method that can substantially reduce your tax bite. Wigfall measured the business percentage by taking the depreciation claimed and dividing it by total basis of the vacation home.

Example 1: You use the vacation home 90% for rental and 10% for personal. Depreciation on the rental equals 40% of basis. Using Wigfall, you cut your losses by allocating 40% of the sales proceeds to the low-basis rental and 60% to the high-basis home.

Example 2: In the 12 months before salem you use the vacation home solely as a rental. Using the IRS's passive-loss-allocation method you allocate the entire gain on sale to the passive activity and release suspended passive losses.

Planning tip: Before you sell the property, make an analysis of how the allocations can work to your advantage. Then, set the stage for the most beneficial allocations.

Decline in value: If the vacation home declined in value, you get more loss deductions by pushing the losses to the rental and business sides.

Reminder: You get no deductions for the loss that pertains to the personal part.

Increase in value: If the vacation home increased in value, you can benefit by allocating to the business side if that allocation releases suspended losses.

Technical note: Classification of assets at the time of sale often produces unusual results. For example, if you quit using a home office in the year of sale then buy a more expensive replacement home, the IRS says that you do not pay tax on the home office part of the old home.

Disposition Releases Vacation Home's Suspended Passive Losses

Overview: Did the passive loss rules limit your loss deductions from rental of your vacation home? If so, you have what tax law calls "suspended" losses.

Sale gives relief: When you sell your vacation home, you write off all "suspended passive losses" on that property. You deduct the losses even if you do not use the vacation home as a rental in the year of sale. Also, you deduct the passive losses in total, even if you have no passive income. Thus, sale of your vacation rental triggers realization of suspended passive loss deductions on the property sold.

Beware of Relatives: If you sell your 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 when an unrelated third party owns the property. Thus, should you sell to a relative, you get to write off suspended losses only when your relative sells to a third party.

Beware of personal use: If you rent and use the vacation home for personal purposes, your personal use could make the vacation property a home for tax purposes. If it is a home, then the rental is a hobby. As a hobby rental, tax law puts a ceiling equal to rent income on rent deductions. You carry over excess deductions to the next year where you apply them to rental income from that year. But when you sell the property, you lose your carried over(unclaimed) deductions.

Planning tip: Control personal use. Make sure tax law considers your vacation home a rental property that produces deductible losses. Rentals produce tax benefits far better than a combined second home and hobby rental.

Vacation Home Sold at a Gain

General rule: Gain from sale of a passive activity produces:

  • Capital gain
  • Release of suspended losses on the passive property sold
  • Release of suspended losses on properties other than the property sold (to the extent of excess gain)
In other words, you compute gain or loss on sale in the usual way. Then, you treat the gain as passive income from the activity. As passive income, the gain first offsets losses from the activity. Any excess gain frees suspended losses on other passive-loss properties.

Example: You sell a vacation-home rental at a $20,000 gain. You had no unused losses from the vacation-home rental. You report vacation-home gain as long-term capital gain. In addition, the $20,000 gain frees up to $20,000 suspended passive losses from other properties. Special rules for rental, business, and personal use: Tax law subjects your vacation home to two special rules when you have rental and other uses, like business or personal.

Rule 1: The passive activity rules require that you allocate gain or loss to activities based on use during the past 12 months.

Rule 2: If the gain on your vacation home is greater than 120% of basis, you have a "substantially appreciated" vacation home that triggers a nasty rule that makes passive gains nonpassive. When this happens, you may not use the passive gain to release suspended losses on other (nonsold) properties.

Beat the rule: You may treat a "substantially appreciated" gain as a passive gain that releases passive losses when you:

  1. Sell the vacation home for more than 120% of its adjusted basis, and
  2. Use the vacation home in a passive activity for either:
    • 20% of the time you own it; or
    • 24 months before the date of sale.
Example: You paid for $200,000 for a vacation home. Over the years, you claimed $50,000 of depreciation. During the two years before sale for $300,000, you do not use it for personal purposes.

Results: You pass the first test by beating the 120% of basis threshold. You sold your vacation home for 200% of adjusted basis [$300,000 divided by $150,000 ($200,000 purchase price less $50,000 depreciation)].

You pass the second test by using it for rental (the passive activity) for two years before sale. You treat the $150,000 gain as a Section 1231 capital gain. That gain also releases up to $150,000 of suspended passive losses on first this property and then other properties and activities.

Planning tip: If you have both a vacation home and suspended passive losses, you may want to plan no personal use for the two years before you sell the property. With this strategy, you can release big deductions.

Vacation Home Sold at a Loss

Overview: Tax law considers a property held for rent or used for business lodging a Section 1231 asset. You want tax-favored Section 1231 tax treatment. It is the best of all worlds. When you sell a Section 1231 asset, you treat the net:

  • Gain as long-term capital gain
  • Loss as an ordinary loss.
Ownership requirement: To claim the Section 1231 business loss, you must own the business property for more than one year.

Rental requirement: For rental property, it helps if you receive rents. Although the courts have classed property as Section 1231 when the owners do not receive rents. You make your Section 1231 "rental case" strongest when you rent to tenants and maintain the property (personally or through an agent).

Planning tip: Avoid personal use of the vacation home in the 12 months before sale.

Personal part of vacation home: If tax law considers your vacation home a personal home in the year of sale, you deduct nothing. Personal losses are not deductible.

Deducting Unamortized Points

Not deductible at purchase: You deduct points only on the purchase of your principal home. Thus, any points paid to buy your vacation home were not deductible in full when you bought the property.

Amortization: You deducted points equally over the months in your mortgage (amortized them) if your vacation home was:

  • A qualified second home on which you deducted interest expense
  • A rental property
  • A business lodging facility
Annual computation: The amortization deductions followed your use of the vacation home. If you used the vacation home for business, personal and rental purposes, you allocated to the various uses. If the interest on various uses was tax-deductible, you deducted the points amortization allocated to such deductible uses. You amortize points equally over the months of the mortgage. Then, you take each year's amortization, treat it like interest, and allocate that year's amortization to the various uses.

Example: Smith pays $7,200 in points to obtain 30-year mortgage on a vacation home that he uses solely as a rental. He writes off his points at the rate of $20 a month.

Planning tip: If Smith sells the vacation home before the 360 months lapse, Smith gets to deduct the unamortized points in the year of sale.

Example: Smith sells his vacation home after 5 years. In the year of sale, Smith has $6,000 in unamortized points. He claims his deduction for unused rental-property points on Schedule E.

Planning note: Unamortized points related to business, rental-property, and personal-home uses are deductible in the year of sale. You may not deduct unamortized points related to the personal-use (consumer) portion of a vacation-home-rental property.

Summary

The vacation-home rules provide many planning opportunities. While you own and use the home, you can plan maximum deductions by controlling use and following or not following the Bolton case. Then, when you decide to sell, you have another set of planning options available that can substantially increase your tax benefits. Thus, you can put tax benefits in your pocket when you both plan your vacation-home use and plan tax options to your advantage.


Disclaimer and Acknowledgment

From Murray Bradford's Tax Reduction Letter, 170 Reservoir Rd, San Rafael, CA 94901.

The information provided is deemed reliable but is not guaranteed. PLEASE consult your tax professional regarding your own circumstances.




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