The Myth of Second Home Tax Advantages : Investment: The IRS has strict rules on what you can deduct when you rent out vacation home and also use it yourself.

Once upon a time there was a vacation home real estate salesperson who promised prospective buyers that if they bought a second home they could enjoy virtually cost-free vacations, rent out their second homes when they weren’t using them, so the rent would pay the carrying costs, deduct all the expenses, shelter some of their other ordinary income from taxes, enjoy endless appreciation in market value of their second home and live happily ever after.

If you believe that myth, I hate to bring you back to reality, but it isn’t true. But many buyers of vacation or second homes still think they are buying a great tax shelter as well as a place to enjoy vacations.

The truth is, owners of vacation or second homes are lucky to deduct $1 for every $1 of actual expenses paid. However, depending on the circumstances, they may not be able to deduct all their expenses for the vacation property.

The basic rule is that mortgage interest and property taxes for a second or vacation home are tax deductible on Schedule A of your income tax returns, just as they are for your principal residence.

Additionally, an uninsured casualty loss to your second home for a “sudden, unexpected or unusual event,” such as a fire, flood, theft, tornado or hurricane, is deductible for the loss amount exceeding 10% of your gross income.

Mortgage interest, property taxes and casualty losses are your only deductions if you do not rent your second home for any part of the year to tenants.

But additional expenses may become deductible if your second home is rented part of the year to tenants. Your deductions must then be allocated between the rental and personal use periods. There are four possibilities:

1--If your vacation home is rented to tenants less than 15 days per year and is either used by your family or is vacant the rest of the year, then you need not report the rental income to Uncle Sam. However, you can only deduct mortgage interest, property taxes and casualty losses exceeding 10% of your adjusted gross income.

2--Going to the other extreme, if you do not personally use your second home and it is not occupied by close relatives such as your spouse, brothers, sisters and lineal descendants during the year, but is rented to tenants who pay fair market rent, then it is a “trade or business property.”

In this category, your rental income and expenses should be reported on Schedule E of your income tax returns. Even if a loss results, your mortgage interest, property taxes, insurance premiums, utilities, repairs, depreciation and other expenses are deductible, even if a loss results.

However, the maximum annual passive loss rule of IRC 469 applies, so you cannot shelter more than $25,000 of your ordinary income from tax with the loss from your second home.

3--If your second home is rented more than 15 days per year, but you and your relatives use it less than 15 days, or 10% of its rental days, then you are not considered to have made any personal use of the vacation home.

The happy result is no limit to your deductions, including depreciation, even if a tax loss results. However, the $25,000 maximum passive loss limit applies in this category. Use Schedule E to report your rental income and expenses. But the IRS says its profit motive rules of IRC 183 apply and a profit must be shown at least three of every five years in this category.

4--When personal use exceeds 14 days, or 10% of the rental days and annual rental exceeds 15 days, expenses can only be deducted up to the amount of rental income received.

The result is that no tax loss is permitted. On Schedule E, where rental income and expenses are reported, the order of deducting expenses is mortgage interest, property taxes, casualty losses, operating expenses and depreciation. However, any mortgage interest, property taxes and casualty losses that exceed the rent collected can be itemized as deductions on Schedule A.

The Tax Court said in the Bolton decision (694 Fed.2d 556) that mortgage interest and property taxes can be allocated on a daily basis. But the IRS disagrees. It says expenses that apply to both rental and personal use days must be allocated by dividing the days of fair market rental use by the total days of rental and personal use time. Days the vacation home is available for rent, but not actually rented do not count as rental days, according to the IRS.

Vacation or second homes are no longer great tax shelters. Although mortgage interest, property taxes and casualty losses exceeding 10% of the owner’s adjusted gross income are always deductible, if you rent the property part of the year, the other expenses are not deductible if your personal use time exceeds 14 days, or 10%, of the rental days. Please consult your tax adviser for full details.

Next week: How the passive loss rules can benefit realty investors.