Are you one of the millions of U.S. residents who own more than one home, which you occupy part of each year? If that is your fortunate situation, you might be overlooking significant tax savings from your secondary home. Depending on your personal situation, you may be entitled to tax savings both while you own your second home and when you eventually sell it.
KEEP CAREFUL TAX RECORDS FOR YOUR SECONDARY HOME. Just in case you need to prove to an IRS auditor how much time you actually occupied your vacation or second home, it’s smart to keep all your tax records for it “forever.” The best proof you actually lived in the home are your paid utility bills with your cancelled checks. If there’s ever a question about your property tax and mortgage interest payments, your cancelled checks are the best proof. Both during ownership, and at the time of sale, there is no substitute for your carefully saved tax records. Without accurate records, you might even incur an IRS negligence penalty for failure to document your tax deductions.
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WHEN IS YOUR SECOND HOME YOUR PRIMARY RESIDENCE? The only time most of us think about which is our principal residence is when we decide to sell. However, if you own two (or more) residences which you occupy part of each year, determining your principal residence can become a taxing question.
To qualify for these generous exemptions, the seller must have owned and occupied his/her principal residence an “aggregate” two of the five years at the time of sale. However, the home need not be the seller’s principal residence at the time of sale. New IRS regulations, explained in Chapter 1, indicate the home where you spend the most time is your principal residence. Although not conclusive, additional evidence of “main home” principal residence occupancy includes utility bills, voter and automobile registration, business or retirement income, driver’s license, place of income tax filings, and other indicia of primary residence while living there.
SECONDARY HOME TAX BENEFITS DURING OWNERSHIP. Presuming you itemize your income tax deductions, the property taxes and mortgage interest paid on your secondary home are always tax deductible. But there can be extra tax benefits from your secondary home, depending on how much time you personally use it and if you rent it to others. There are four possible classifications:
1–NO PERSONAL-USE TIME. If you didn’t occupy your secondary residence during 2003, and it was rented or available for rent the entire year, then all your rental income must be reported on Schedule E of your income tax returns. This is also the place to deduct applicable expenses such as mortgage interest, property taxes, insurance, utilities, repairs and depreciation deductions from the rental income. In addition, you can deduct reasonable travel expenses to periodically inspect (but not occupy) your rental property (especially if it is in Hawaii!).
But there’s a catch. You must have “materially participated” in the rental property management. If you didn’t materially participate in managing your rental property, such as being a limited partner owning less that a 10 percent interest or you put your resort property into a “rental pool,” then your tax loss exceeding rental income is not tax deductible due to lack of material participation.
If you didn’t materially participate, don’t panic. Although your rental property tax loss is not fully deductible against your other ordinary income, such as from your job, you can “suspend” your un-deducted loss for use in future tax years, usually when you sell the rental property. However, if you are a full-time “real estate professional,” such as a real estate broker, then there is no limit to your qualified rental property tax loss deductions against ordinary income. Please see chapter 7 for more details.
2–LESS THAN 14 DAYS ANNUAL RENTAL TIME. In this classification, if you rent your secondary (or primary) home to paying guests less than 14 days annually, regardless how much rent you received, that rent is yours to keep tax-free and it need not be reported to Uncle Sam. However, you can still deduct the mortgage interest, property taxes, and any uninsured casualty losses suffered (such as snow or rain damage) as itemized personal deductions.
3–ANNUAL PERSONAL USE IS BELOW 15 DAYS OR 10 PERCENT OF THE RENTAL DAYS. In this very desirable classification, if your personal use is less than 15 days per year, or 10 percent of the rental days, which exceed 14 days annually, there is no limit to your tax loss deductions (except for the $25,000 annual passive activity loss limit explained above).
EXAMPLE: Suppose you rented your secondary home to tenants for 120 days in 2003 and you personally occupied it only 10 days. Because your personal use was under 15 days or 10 percent of the rental days, you fall into this advantageous category. However, the IRS says Internal Revenue Code