YOUR TAXES: A SPECIAL REPORT : HOME AWAY FROM HOME : Tax Reform Has Changed Eligibility Requirements on Second Residences

The firestorm that erupted when Congress considered abolishing mortgage interest deductions for second homes as part of its 1986 tax overhaul should have come as no surprise to the lawmakers.

Millions of middle-class families now own vacation property and many of these Americans have come to view their mortgage interest deduction, like life and liberty, as an inalienable right.

Consequently, when the smoke cleared, the second-home mortgage interest deduction had survived, albeit in altered form.

Under the Tax Reform Act of 1986, well-heeled taxpayers no longer can maintain a string of vacation properties in the happy knowledge that mortgage interest on all of them is deductible.

Property owners now can deduct only the mortgage interest for a principle residence and one second home, says Pat Colin, tax partner in the San Diego office of Kenneth Leventhal & Co., a major accounting firm. The only concession to the lucky owners of multiple vacation homes is that they may elect a different home every year for their deduction.

And the Internal Revenue Service has become specific about what it regards as an eligible second home.

For starters, a second home is defined as property that you or a member of your immediate family--parent, sibling or offspring--uses as a residence more than 14 days a year or more than 10% of the days it is rented, whichever is greater.

“If you want the property treated as a residence, you have to use it,” says Colin, whose firm is recognized as an expert in real estate matters.

Additionally, you have to use the home itself as collateral for the loan. If a friend or relative extends to you an unsecured personal loan to buy your vacation getaway, you cannot deduct that interest.

A vacation property doesn’t necessarily have to be stationary to qualify for the mortgage interest deduction.

If you call a recreational vehicle, a boat or a time-share property your home away from home, interest on your financing for those purchases can be deducted as long as you meet the use requirements and secure the loan with the property itself.

Little is simple in the simplified tax code, however, and the rules applying to second-home deductions have their wrinkles.

One is the mortgage interest cap.

If the indebtedness on your primary and secondary residences was incurred before Oct. 13, 1987, there is no limit on how much total interest you may deduct on those loans, Colin explains.

On the other hand, if you borrowed more than $1 million after that date, only the interest on the initial $1 million in mortgage loans is deductible.

The only other exemption from the cap is for interest on equity financing of up to $100,000. This deduction is available to all homeowners regardless of other mortgage indebtedness.

But realizing the maximum tax advantage of your second home is more than a matter of adding up your interest payments. Colin advises taxpayers to look at their complete financial profile.

“There could be an advantage to making less personal use of the property and treating it as a rental,” she says.

Property treated as a second home is eligible only for the deduction of mortgage interest and property taxes. Improvements, repairs and homeowner association fees are not deductible. Take the same property and treat it as a rental, however, and all of those expenses may be written off. What’s more, you can depreciate a rental property, giving you a deduction without a cash outlay. With any luck, all of these expenses will add up to a “paper” loss, which could reduce your total tax bill.

The key to whether you are better off treating your second home as a residence or a rental is your adjusted gross income and its sources, Colin says.

If your annual adjusted gross income is less than $100,000 and you are actively involved in managing your property, you may deduct up to $25,000 in losses on your rental property, regardless of how your income is generated.

If, however, your adjusted gross income is more than $150,000, you may write off the rental losses only against “passive” income--income generated by a rental property or by a business that you are not actively involved in managing, such as a limited partnership.

(Taxpayers whose adjusted gross income falls between $100,000 and $150,000 are subject to a sliding scale of allowances for rental losses. For every $2 of income over $100,000, the $25,000 limit on deduction of losses is reduced by $1.)

“If you have no passive income and your adjusted gross income exceeds $150,000, you may be better off to deduct in full the mortgage interest on your second home,” Colin says. “If your income is less than $100,000, you may make out better as a rental.”

Again, there are the wrinkles.

If you acquired rental property before Oct. 22, 1986, you may deduct 65% of the losses that exceed passive income in 1987 even with an adjusted gross income of more than $150,000. But this is a temporary escape. The percentage of “excess” losses you can deduct will drop annually until it reaches 10% in 1990 and then is eliminated altogether in 1991.

At that point--or today, if you bought after the 1986 cutoff date--you will be able to deduct rental losses only when you sell the home. (This applies if you’re in the $150,000-plus bracket, don’t use your second home enough to qualify it as a residence and don’t have passive income to cover your expenses.) Accumulated expenses and depreciation that exceed your capital gain can be taken as a loss against ordinary income in the year of the sale.

To support your claim of a second home as either a residence or rental, Colin advises keeping a contemporaneous calendar of when you use your second home and when you rent it and retaining receipts and other supporting documents.

Although a second home--whether treated as a rental or as a residence--still can generate substantial deductions, Colin doesn’t advise taxpayers to race out and buy one as a tax shelter.

Fundamentally, vacation homes tend to be less than stellar real estate investments, so you can’t count on substantial appreciation in the property itself.

“When the economy deteriorates, vacation home locations tend to deteriorate faster,” Colin says. “People who need money want to dispose of their second homes, while people with money defer major purchases. This depresses values.”

And now, in the post-reform era where lowered tax rates mean the government isn’t subsidizing as much of your debt, the deductions aren’t worth what they once were.

“If you want a second home, fine,” Colin says. Otherwise, “You can probably earn more on your money from other investments than the after-tax deduction on your second home is worth.”