Personal residence vs. rental property: analyzing loss carryovers.

• Author: Brinker, Thomas M., Jr.

A recent surge in ownership of so-called "vacation homes" has led to a renewed interest in tax planning for such ownership. While the basic rules relating to ownership of second homes may be well-known, one aspect that has been overlooked is the interaction of the passive activity rules under Sec. 469 and the income limitation under Sec. 280A. In particular, little attention is paid to loss carryovers and their tax consequences in the year of disposition.

Loss Carryovers

In analyzing the personal residence or rental property classification, several issues must be resolved before making a final determination. Considerations include the size of the interest payments, the amount of rental income received from the property, the availability of other passive activity income and, of course, the taxpayer's adjusted gross income (AGI). Assuming vacation homeowners can control personal use, there is no simple answer. The property's classification as personal or rental can change on an annual basis.

In planning the annual classification, taxpayers often overlook the nature of their loss carryovers. Given the potential for differing classifications for different tax years, a taxpayer may have two different types of loss carryovers relating to the same property. The first is the loss carryover resulting from the passive activity rules of Sec. 469; the second is the loss carryover from the gross income limitation of Sec. 280A. These carryovers are not combined and will retain their character regardless of the classification of the property itself in future years (Sec. 280A(c)(5)). Simply stated, the passive loss carryover can only be used in years in which the unit is a"rental only" property to offset income from passive activities; the Sec. 280A loss carryover can only be used in years in which the unit is a"residence/rental" property to offset its rental income.

Given the time value of the potential tax benefits, a taxpayer would like to use these loss carryovers as quickly as possible. However, the amount and character of the loss carryforwards increase in significance when the taxpayer is planning to dispose of the property. Under ideal planning conditions, the optimal annual classification of property would absorb all loss carryovers prior to the home's disposition. Even if this is not possible, a final planning opportunity exists--arranging the classification of the property in the year of disposition.

Loss Carryover in the Final Year

If a...