Second in a series BY ROBERT J. BRUSS www.bobbruss.com
Taxpayers are entitled to claim deductions for their principal residence and one vacation or second home. Except for unusual situations, the ownership tax breaks for a primary residence are generally limited to the mortgage interest and property tax deductions.
However, tax savings from owning a second or vacation home are a bit more complicated and are often greater. Depending on your personal use time, and with some planning, your vacation or second home can produce significant tax savings.
Mortgage interest and property tax payments for your second or vacation home are always tax-deductible. However, if you own a third home, it does not qualify unless it is a rental property.
Your personal use time determines which of the four categories apply to your second or vacation home:
* No personal-use time. If your second home was rented or available for rental during all of 2006, with zero personal-use time, it is treated as rental property. Even if you occupied it a few days while making repairs, your second home falls into this desirable category.
The tax result is your rental income and expenses are reported on Schedule E of your income tax returns. Don’t forget the non-cash depreciation deduction for wear, tear and obsolescence, which can result in substantial tax savings, either in the current tax year or “suspended” for use in a future tax year.
Applicable deductible expenses in this category include mortgage interest, property taxes, insurance, homeowner association fees, utility bills you paid, repairs, and depreciation. You can also deduct reasonable “ordinary and necessary” travel expenses to inspect (but not occupy) your rental property.
When you hire a professional property manager, to claim the deductions specified above you must “materially participate” in managing your second home. That means it cannot be in a “rental pool” managed by others and you must own at least a 10 percent interest in the property.
If you materially participate in managing your second-home rental and if your 2006 adjusted gross income is $100,000 or less, then you can deduct up to $25,000 of second-home tax loss from your other ordinary taxable income.
If your adjusted gross income is between $100,000 and $150,000, then your second-home tax loss gradually phases out. Above $150,000, you cannot claim any second-home tax loss.
But the good news is any unused tax loss exceeding the $25,000 limit can be “suspended” for use in a future tax year or when the property is sold to offset taxable gains.
* Less than 14 days of annual rental. If you rent your second or vacation home less than 14 days per year, you can deduct your mortgage interest, property taxes, and any uninsured casualty loss, such as water damage. But expenses such as insurance premiums and repair costs are not tax deductible.
In this category, the rental income is completely tax-free and need not be reported on your income tax returns.
* Annual personal use below 15 days or 10 percent of the rental days. This is the most desirable tax category for a second home. There is no limit to your tax loss deductions against your ordinary taxable income (except the $25,000 annual passive loss limit explained above). Rental income and deductible expenses are reported on Schedule E of your tax returns.
* Annual personal-use time over 14 days or 10 percent of the rental days (if rented more than 14 days). This category of heavy personal use and modest rental time results in the lowest tax savings benefits.
Rental income must be reported on Schedule E, along with the applicable rental expenses. However, in this category, any resulting tax loss when rental expenses exceed the rent collected cannot be deducted against ordinary income from other sources, such as job salary.
A possible tax benefit, when you are thinking about selling your second or vacation home, is to move in and convert it to 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 qualified married couple filing joint tax returns in the year of sale).
Next: Big tax savings for your residential moving costs.