Some tax advice on vacation homes from Smart Money Magazine.

Buying that resort at the beach may get you some much-needed peace and quiet, but it will also complicate your Schedule A and your interest and property-tax deductions, and expose you to the joys of Schedule E along with the ever-popular passive-income and loss rules. But first, you've got to figure out what rules you should follow. Depending on how often you use your vacation home yourself, how often you rent it out and how long it sits empty, you will fall into one of three vastly different tax categories, with varying degrees of harshness.

Use a Lot, Rent a Lot
The first category includes homes that are rented often but that are still used a fair amount by the owner. Specifically, this applies to homes that are rented more than 14 days a year and have personal use of more than 14 days or 10% of the rental days, whichever is greater. Personal use includes use by family members and anyone else who pays less than market rental rates.

Vacation homes fitting this description are considered personal residences. This helps you, because Uncle Sam lets you deduct interest on up to $1 million of mortgage debt on two personal residences (and up to an additional $100,000 for home equity loans). Property taxes are generally deductible, no matter how many homes you own. Those fortunate enough to own more than two homes can pick the two with the most mortgage interest each year; usually the main residence and the vacation home with the biggest loan.

Now for the hard part: accounting for rental income and expenses for your dacha. Basically, there is one way to deduct the expenses incurred while you use the house, and another way to deduct expenses incurred while you rent it. But if done correctly, there is generally no tax liability in these cases.

The first step is to allocate interest and property taxes between rental and personal use. For example, say the home is rented for three months, used by you and your family for two months, and vacant for seven months. Since vacant time is considered personal use, you allocate three months worth, or 25%, of the interest and taxes to the rental period and nine months worth, or 75%, to personal use. Write off the personal part of the interest and taxes as itemized deductions on Schedule A. In the past, the IRS has disputed this method of allocating the interest and taxes, but the tax court has ruled it's okay.

So far, so good. Now buckle up your chin strap, because there's white water ahead. The goal here is to reduce the rental income to zero to eliminate any tax liability. First, you reduce the income by 25% of the interest and tax expenses you incurred while renting. If there's any rental income left, you can deduct a percentage of operating expenses, maintenance, utilities, association fees, insurance and depreciation: but only to the point where you "zero out" that remaining income.

There is one difference, though: When you calculate operating expenses, you don't count the days the house stood empty. In our example, the house was occupied for only five months, so three months worth, or 60%, of the maintenance, utilities etc. goes to the rental period and two months worth, or 40%, to personal use. That 40% evaporates as a totally nondeductible item. On your tax return, you will use Schedule E (Supplemental Income and Loss) to report 100% of the rental income, 25% of the interest and taxes and 60% of the expenses. In many cases, the bottom line on Schedule E will be zero because the rental income and expenses will be a wash.

When all is said and done, this tortuous procedure should allow you to fully deduct interest and taxes (part on Schedule A and the rest on Schedule E) and usually enough operating expenses to wipe out your rental income. Any operating expenses that you cannot deduct are carried over to future years, when they can be deducted if you have rental profits. (In real life, this rarely occurs.) Overall, this is not a bad deal once you master the paperwork.

Rent a Lot, Use a Little
The second vacation-home tax category typically applies to houses that are used very little by the owner. Your home will fall under the tax rules for rental properties rather than for personal residences if you rent more than 14 days a year and if your personal use doesn't exceed 14 days or 10% of the rental days, whichever is greater. For example, assume you rent 210 days and vacation 21 days you have a rental property on your hands. (Vacation 22 days, and you're back under the personal-residence rules.) Interest, property taxes and operating expenses should all be allocated based on the total number of days the house was used. The total number of days used in this example is 231, so the split would be 21/231 for personal use and 210/231 for rental.

Here, if the money you get from renting the house does not cover the cost of renting it, you can post a taxable loss on Schedule E. But don't start tallying up your deductions just yet. First you must successfully clear the hurdles set up by the Internal Revenue Service in the form of passive-loss rules. In general you can deduct passive losses in a given tax year only to the extent of passive income from other sources (such as rental properties that produce gains).

There is an exception, though. The IRS will let you write off up to $25,000 of passive-rental real estate losses if you "actively participate" and have adjusted gross income under $100,000. Making the day-to-day property management decisions will get you over the active participation hurdle. Unfortunately, the exception is phased out for adjusted gross incomes between $100,000 and $150,000, and the IRS says the exception doesn't apply anyway when the average rental period is seven days or less. But it's not a total loss: The IRS will let you carry over the passive losses you can't take this year into future years. The reality is that many owners find their hoped-for tax losses deferred by the passive rules.

Another problem: The interest incurred during your personal use (21/231 in our example) is nondeductible, because these homes don't qualify as personal residences. (The personal-use portion of property taxes is still deductible on Schedule A.) This means you may actually benefit from slipping in some extra vacation days this year. Then you drop back into the first category which means you can deduct the interest and taxes and usually wipe out your rental income with deductible operating expenses.

Use a Lot, Rent a Little
The final category is a rarity in the tax laws: It is simple and benefits the taxpayer. This one applies to homes that are rented for fewer than 15 days a year and used by the owner for more than 14 days. These homes are considered personal residences, so if you don't rent at all, simply deduct the interest and property taxes on your Schedule A, the same as you would for your primary residence.

If you do rent, enjoy the free lunch. You need not declare a penny of the income. Interest and taxes are still deducted on Schedule A, with no allocation nonsense to worry about. You don't get any write-offs for operating expenses (maintenance etc.) attributable to the rental period, but who's complaining?

If your vacation home is fortuitously located near a major event like any golf tournament featuring Tiger Woods  you may be able to rent for a few days at an outrageous rate. Under the rules, you can stiff Uncle Sam with a clear conscience. (This tax law quirk also applies to primary residences and was put to good use by Atlanta's homeowners during the summer Olympics.)

Christina Whipple
www.ChristinaWhipple.com

Thanks to our friends at Nanaimo Information, http://www.nanaimoinformation.com .  If you are considering a home purchase in Nanaimo, British Columbia, on Canada's west coast, visit their website for complete information on the subject.  A vacation home there would make an excellent retreat from San Antonio's summers!