Vacation homes.

• Author: Koppel, Michael D.

The definition of a vacation home falls under the definition of a dwelling unit, which includes a house, apartment, condominium, mobile home, boat or similar property (Sec. 280A(f)(1)(A)). It must have basic living accommodations, such as sleeping space, toilet and cooking facilities. The property must provide shelter and accommodations for eating and sleeping, regardless of size. Sec. 280A also defines vacation home expenses and provides special rules that limit the rental expense deductions that a taxpayer can take. Because the ownership of a second home may have both personal and profit motives, the IRS may disallow or limit deductions for expenses related to the rental of a vacation home that the taxpayer also used as a residence. Two specific criteria are used to determine which rules to follow: (1) how often does a taxpayer use the vacation home and (2) how often does he rent it out?

How Often Does a Taxpayer Use a Vacation Home?

The first category deals with vacation homes that a taxpayer rents often, but still uses for a reasonable amount of time. This includes homes that are rented longer than 14 days a year and personally used by the taxpayer for more than 14 days or 10% of the rental days (whichever is greater). "Personal use" is use of the vacation home by the taxpayer or family members and anyone else who pays less than market rental rates (Sec. 280A(d)(3)(A)).

The Service considers vacation homes qualifying under these criteria as personal residences (Sec. 280A(d)(1)). The fact that the IRS treats these vacation homes as personal residences is extremely beneficial to taxpayers. The benefits include interest deductions of up to $1 million of mortgage debt on two personal residences and an additional $100,000 for home-equity loans. Taxpayers can deduct mortgage interest on both a primary residence and a vacation home. Another benefit is that taxpayers can deduct property taxes, regardless of the number of homes owned.

Although the vacation homeowner receives great benefits from a vacation home, the calculation of the deductible expenses is difficult. There are two types of deductions. The first deduction involves expenses incurred during the rental period, while the second involves expenses incurred during the time the taxpayer uses the house. The taxpayer must first allocate interest and property taxes between rental and personal use. The problem is that there are two allocation formulas available (depending on jurisdiction). The Service uses one formula, while the Ninth (Bolton, 694 F2d 556 (1982)) and Tenth (McKinney (1983)) Circuits allowed taxpayers to use a different allocation formula.

Basically, the formulas differ as to the number of days in the denominator. The IRS uses only the number of days that a taxpayer uses a vacation home for the year, while the courts use the total number of days in the year. In McKinney, the Service disputed whether the Tax Court used the correct formula in its decision to allocate interest and taxes between rental and other use, urging that it should have used the statutory formula provided in Sec. 280A(e)(1). The Tenth Circuit case quoted the Ninth Circuit's...