Summertime brings with it the "high season" for clients who are seriously considering purchasing vacation homes, or switching from one vacation home to another.The majority are looking to take advantage of certain tax breaks to help them carry the property. For others, tax savings are an added bonus to validate their decision. In either case, tax advisors often get a hurried call to explain the options.
While the basic tax rules on vacation homes have been kicking around for a while, it's surprising, based on new case law, how many aggressive variations are being tested each year. It also is eye-opening how many other taxpayers seem to misinterpret the basic principles. This article reviews the basics and variations for the tax practitioner, using a recent Tax Court decision as an anchor for the discussion.
THE MOORE CASE
The couple in Moore, TCM 2007-134, sold their vacation home and purchased another using an escrow agent. The Internal Revenue Service determined, and the Tax Court agreed, that they were not entitled to exclude the gain from the sale of the first home under Code Sec. 1031, because the properties were not held primarily for use in a trade or business or for investment. The Tax Court ruled that holding the property partially because its value was expected to increase was insufficient to qualify the transactions for Code Sec. 1031 gain exclusion.
The evidence in the case established that the couple and their children used the property as a vacation retreat on weekends about 26 days each year, did not rent it out or claim depreciation or investment interest expenses on it, and stopped maintaining the first property when they no longer used it for personal purposes.
While the Moore decision may have been a simple case of aggressive non-reporting coupled with a no-settlement position by the IRS, the case does serve as a roadmap to what steps should be taken to qualify a vacation property for like-kind treatment in less extreme circumstances, in addition to assessing what questions may be left unanswered for situations "closer to the line."
Investment property is entitled to like-kind exchange treatment. Unfortunately, just because something is likely to appreciate in the future is insufficient reason to consider it investment property for like-kind exchange treatment or for purposes of deducting losses.
Purchasing real estate has been pitched as a good "investment," especially during the recent run up in prices. Even with the recent cooling of the market, anyone buying real estate expects it to appreciate, especially in the long term. Simply holding property for appreciation and using it in the meanwhile for fun, however, is not enough to qualify for like-kind exchange down the road (or, perhaps more relevant, for loss deductions if the vacation properties market turns south).
The problem confronted by the Tax Court in Moore was that allowing such "investment-based" reasoning "carried to its logical extreme" would open the floodgates to claims that any principal residence would be purchased for appreciation under a buy-versus-lease analysis.
The decision, however, begs the question of when a vacation property can become investment property sufficient to support a like-kind exchange. A look at the income tax deduction rules provides a starting point to answering that question.
In Moore, the couple did not rent or even attempt to rent their vacation properties. Bad move. The lesson learned from the court's opinion appears to be that renting out a vacation property to maximize investment yield is critical to helping prove that investment purpose was "primary," especially if the owner/taxpayer also uses the property.
The Tax Court emphasized, "It has long been the rule that use of property solely as a personal residence is antithetical to its being held for investment ... . The holding of a primary or secondary (e.g., vacation) residence motivated in part by an expectation that the property will appreciate in value is insufficient to justify the classification of that property as property 'held for investment' under Code Sec. 212(2) and, by analogy, Code Sec. 1031."
SECTION 280A DEDUCTIONS
Rental income and expenses are generally reported on Form 1040, Schedule E, Supplemental Income and Loss. Code Sec. 280A, "Disallowance of Certain Expenses in Connection with Business Use of Home, Rental of Vacation Homes, Etc." serves as the principal limitation on tax benefits for the vacation homeowner. It divides allowable deductions into the extent to which the property is used:
* Minimal rental use. If the home is used by the taxpayer during the tax year as her residence and it is rented for fewer than 15 days during the tax year, no deductions attributable to such rental are allowable and no income derived from such rental is includible in gross income. Other allowable deductions in connection with the residence, such as interest on a mortgage, state real estate taxes, and casualty losses, may still be deducted in full on Schedule A as an itemized deduction.
* Infrequent personal use. If the vacation property is not used for personal purposes for more than 14 days during the tax year or, if greater, more than 10 percent of the number of days during the year for which the home is rented at a fair rental, it is not considered a residence of the taxpayer and is not restricted by the Code Section 280A limitations. The hobby-loss five-year test for profits or the facts and circumstances test, however, still may apply under Code Section 183.
On the opposite end of the timeline, however, personal use of a dwelling unit on even a single day during the tax year requires under Code Section 280A(e)(1) an allocation of expenses based on days of personal use and days that the property was rented.
* Other than infrequent personal use. If the vacation home is rented for 15 or more days during the tax year and is used for personal purposes for the greater of more than 14 days or more than 10 percent of the number of days during the year for which the home is rented, deductions attributable to the rental activity are limited under Code Sec. 280A(c)(5) and the passive activity rules.
But while the IRS wants owners to allocate using the order specified in Code Sec. 183, the Tax Court, with the blessings of the Ninth and Tenth Circuits, has allowed a more liberal computation. Basically, it is the Tax Court's position that mortgage interest and real estate taxes deductible under Schedule A are not subject to the same percentage limitations that apply to other expenses.
Most people who acquire a vacation home must take out a mortgage, with the deductibility of the mortgage interest paid each month critical to their cash flow. Qualified residence interest, which is the only personal interest that is deductible, is interest that is paid or accrued during the tax year on acquisition or home equity indebtedness with respect to any qualified residence.
A qualified residence includes the principal residence of the taxpayer, and one other residence (i.e., a vacation home). A dwelling unit is deemed a taxpayer's residence for interest-deduction purposes if used for personal purposes (including use by family and rent-free friends) for the greater of 14 days or 10 percent of the number of days that it is rented at its fair rental value.
No matter how many days a property is rented, if actual personal use exceeds the greater of 14 days or 10 percent of days rented, the vacation home will be considered a residence of the taxpayer. As a result, mortgage interest is deductible pro rata as personal residence interest up to $1 million combined debt on two personal residences (and an additional $100,000 in home equity loans).
If personal use does not exceed that personal usage, then the vacation property is not a residence of the taxpayer, making mortgage interest only deductible to the extent permitted under the passive activity rules as applied to Schedule E income and deductions.
VACATION HOME AS INVESTMENT
For like-kind exchange treatment, determining whether the vacation home is an investment property appears to be an all-or-nothing proposition, in contrast to a Code Sec 280A determination, in which pro-rata deductions are condoned. How much rental activity must take place before the vacation property is ready for like-kind treatment? Or is the line in denying like-kind benefits drawn based on the extent of personal use, perhaps based on use that determines when a dwelling is a residence under Code Sec. 280A (based on the 15 day/10 percent rule) or a rental property?
With all the appreciated vacation properties in play, these questions are bound to be answered eventually by the courts. In the meantime, trying to convert investment property into a principal residence to win a Code Sec. 121 gain exclusion, or trying to convert personal vacation property into investment property to qualify for like-kind exchange treatment, will require an artful dance.
The challenge also will be in constructing a convincing trail of evidence to prove that any favorable change of heart was not merely made to gain the tax benefits so tempting under the circumstances, but was made true to an intention to use the property foremost as a residence or as an investment.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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