Vacation home tax planning: shaky foundations not easily repaired with software.

• Author: Bakale, Anthony

The tax benefits of owning a vacation home can add substantially to the obvious nontax benefits. However, while the tax benefits are generally well understood, the tax pitfalls are frequently less well known and are potential snares. To further exacerbate the problem, the most popular tax preparation software programs sometimes fail to alert users about the pitfalls. Unwary yet trusting software users are likely to encounter one of these. The little-known problems are (1) the deductibility of the personal portion of mortgage interest expense, (2) the definition of rental activity under the passive-activity loss (PAL) rules and (3) the hobby-loss limit rules. These warrant consideration by both tax professionals and investors, especially those who place a high level of confidence in their tax preparation software.

Personal vs. Rental Use

Many taxpayers who own vacation homes and their tax preparers are probably familiar with the rules that determine the home's purpose, based on number of days of personal use and number of days of rental use annually. Through a series of questions, tax software programs generally classify a home successfully. The home can be primarily a personal-use residence, primarily a rental or a combination of both. When a taxpayer rents a vacation home for fewer than 15 days per year, the home is primarily personal-use, and the taxpayer can exclude rental revenue from gross income. Further, for a second residence, property taxes and mortgage interest generally qualify as itemized deductions. A vacation home would be a rental if the taxpayer rents it for more than 15 days, and uses it for more than the greater of 14 days or 10% of the number of days rented.

For a vacation home that is a combination of personal and rental, the taxpayer both recognizes rental income and allocates expenses between personal and rental, based on the number of days the taxpayer used the residence for each. Assuming the vacation home qualifies as a second residence, the taxpayer can deduct the personal portion of mortgage interest and property taxes paid, deducting the expenses only to the extent of rental income. No losses are allowed under a vacation-home classification.

When personal use is fewer than 15 days (or 10% of the total rental period), the vacation home will qualify primarily as a rental, permitting associated loss deductions. However, many taxpayers may be surprised to learn that mortgage interest deductibility can be limited...