Keep, Rent Out, or Sell Your Vacation Property

The value of vacation properties, like the value of principal residences, has fallen on average by 25% in this dismal housing market. The number of sales has plummeted as potential buyers are squeezed in a tough economy by stock market declines and fears of job loss. Also, there are no government incentives for buyers to purchase vacation property (the first-time homebuyer credit applies only to buying a principal residence). If you already own a vacation home but are finding the financial burden too steep today, what can you do? Here are some tax breaks to ease the cost of ownership. You might also considering renting or selling the vacation home.

Write-offs for Keeping the Home

You can deduct certain costs related to ownership of vacation property if you itemize deductions:

• Mortgage interest. You can designate a second home to qualify for deductible mortgage interest. The same limits for a principal residence apply to a vacation home ($1 million for acquisition debt, plus $100,000 for home equity debt). If you paid any points to obtain the mortgage, the points are deductible ratably over the term of the loan; they can’t be deducted in the year of the home’s purchase like they can with a main home.
• Real estate taxes. Any property taxes paid on a vacation home are deductible as an itemized deduction; there is no limit. If you don’t itemize your personal deductions, in 2009 you can still deduct real estate taxes on your vacation home up to $500 ($1,000 for joint filers) as an additional standard deduction. Of course, this deduction is not much if you also pay taxes on a main home; the dollar limit applies to combined real estate tax payments for the year.

Renting the Property

Even in a tough economy, well-situated vacation homes-near beachfront, ski slopes, or other desirable locations-can still bring in cash. This money can be used to cover the insurance, taxes, and other costs of ownership of the vacation home; it may even produce positive cash flow in the right circumstances.

The amount of time you (and family members) use your home and the days it’s rented to others at a fair rent determine your tax breaks:

• If the rental is no more than 14 days-the rental income is fully tax free. You can, of course, also deduct ordinary home ownership expenses, such as mortgage interest and real estate taxes (described earlier). However, you can’t deduct any maintenance or other costs.
• If the rental is more than 14 days and your personal use is more than 14 days or 10% of the rental days–some additional expenses, such as maintenance, insurance, and depreciation, are deductible within limits. You can only deduct costs beyond the usual home ownership deductions to the extent of your rental income.
• If the rental is more than 14 days but personal use is not more than 14 days or 10% of the rental days-the vacation home is now considered investment property. You can deduct all of your rental expenses, subject to the passive loss rules. While these rules generally restrict annual rental losses to the extent of rental income, those with adjusted gross income (AGI) of no more than $100,000 are allowed to claim rental losses each year up to $25,000 (the $25,000 rental loss allowance phases out for those with AGI between $100,000 and $150,000).

Selling the Property

If you’ve owned the vacation property for years, a sale may still generate a profit in this tight real estate market. Taxwise, any gain on the sale of a vacation home doesn’t qualify for the home sale exclusion; the exclusion of $250,000 ($500,000 on a joint return) applies only to a principal residence.

If you previously used a vacation home that you now use as your principal residence, you can qualify for the exclusion if you’ve owned and lived in the home for at least 2 years prior to the date of sale. However, the exclusion does not apply to any gain related to “nonqualified use.” Nonqualified use means using the residence as a vacation home after 2008. Thus, if you use the vacation home for all of 2009 and start using it as your principal residence on January 1, 2010, a sale after January 1, 2012 (when the two-year rule is met) can qualify for the exclusion, but not the portion of gain related to the nonqualified use in 2009.

Tax-free exchange. If you can’t claim the exclusion for any reason (it is still your vacation property), you may be able to postpone reporting the gain by trading the property for other vacation property. Under the like-kind exchange rules, a trade qualifies if both the property relinquished and the newly acquired property are held for investment. Thus, you’ll have to show that both the old and replacement property are being used as investment properties (e.g., rented out for a minimum period).

There is a safe harbor under which the IRS will not challenge whether a dwelling unit qualifies as investment property for purposes of the like-kind exchange rules. The properties are considered investment property if three conditions are met: (1) each property is owned for at least 24 months, (2) the owner rents the property at a fair rental for 14 days or more during those 24 months before and 24 months after the trade, and (3) the homeowner’s personal use does not exceed 14 days or 10% of the number of rental days during a 12-month period (for each of the two 12-months prior to the trade and two 12-month periods after the trade).

Sale at a loss: If you sell your vacation home at a loss, you cannot deduct the loss. No write-off is allowed for a loss on a personal asset.

Foreclosure. If you default on the mortgage and your lender forecloses on your vacation home, forgiving any remaining mortgage balance, you are taxed on this debt forgiveness. The break for cancellation of debt income applies only to a principal residence and not to vacation property.