Tax breaks encourage buying second homes
Now you can trade down to a less expensive house and use the profit from the sale of the larger place as a down payment on a second home. Here's a quick look at the tax rules that apply to second homes.
Mortgage interest
If you use the place as a second home—rather than renting it out—interest on the mortgage is deductible within the same limits as the interest on the mortgage on your first home.
You can write off 100 percent of the interest you pay on up to $1.1 million of debt secured by your first and second homes and used to acquire or improve the properties. (That's a total of $1.1 million of debt, not $1.1 million on each home.) The rules that apply if you rent out the place are discussed later.
Property taxes
You can deduct property taxes on your second home, too. In fact, unlike the mortgage interest rule, you can deduct property taxes paid on any number of homes you own.
If you rent out the place
Lots of second-home buyers rent out the property part of the year to get others to help pay the bills. Very different tax rules apply depending on the breakdown between personal and rental use.
If you rent the place out for 14 or fewer days during the year, you can pocket the rental income tax-free. Even if you're charging $5,000 a week, the IRS doesn't want to hear about it. The house is considered a personal residence, so you deduct mortgage interest and property taxes under the standard rules for a second home.
Longer rentals mean different rules
Rent for more than 14 days  and you must report all rental income. You also get to deduct rental expenses, and that gets complicated because you need to allocate costs between the time the property is used for personal purposes, and the time it is rented.
Consider this example
If you and your family use a beach house for 30 days during the year and it's rented for 120 days, 80 percent (120 divided by 150) of your mortgage interest and property taxes, insurance premiums, utilities and other costs would be rental expenses. The entire amount you pay a property manager would be deductible, too. And you could claim depreciation deductions based on 80 percent of the value of the house. If a house is worth $200,000 (not counting the value of the land) and you're depreciating 80 percent, a full year's depreciation deduction would be about $5,800.
You can always deduct expenses up to the level of rental income you report. But what if costs exceed what you take in? Whether a loss can shelter other income depends on two things: how much you use the property yourself and how high your income is.
Your use can be limited
If you use the place more than 14 days, or more than 10 percent of the number of days it is rented—whichever is more—it is considered a personal residence and the rental loss can't be deducted. (But because it is a personal residence, the interest that doesn't count as a rental expense—20 percent in our example—can be deducted as a personal expense.)
Why maintenance pays
If you limit personal use to 14 days or 10 percent, the vacation home is considered a rental property and up to $25,000 in losses might be deductible each year. That's why lots of vacation homeowners hold down leisure use and spend lots of time "maintaining" the property.
Fix-up days don't count as personal use. The tax savings from the loss (up to $7,000 a year if you're in the 28 percent tax bracket) helps pay for the vacation home. Unfortunately, holding down personal use means you have to forfeit the write-off for the portion of mortgage interest that does not qualify as either a rental or personal-residence expense.
Passive losses
We say such losses might be deductible because real estate losses are considered "passive losses" by the tax law. And passive losses are generally not deductible. But there's an exception that might protect you.
If your Adjusted Gross Income (AGI) is less than $100,000, up to $25,000 of such losses can be deducted each year to offset income such as your salary. (AGI is basically income before subtracting your exemptions and deductions.) As income rises between $100,000 and $150,000, however, that $25,000 allowance disappears. Passive losses you can't deduct can be stored up and used to offset taxable profit when you ultimately sell the vacation house.
Tax-free profits
Although the rule that allows home sellers to take up to $500,000 of profit tax-free (up to $250,000 if you're unmarried) applies only to a sale of your principal residence, there is a way to extend the break to your second home: make it your principal residence before you sell. That's not as wacky as it might sound. Some retirees, for example, are selling the big family home and moving full-time into what had been their vacation home.
Once you live in that home for two years, up to $500,000 (or $250,000) of profit can be tax-free. Any profit attributable to depreciation while you rented the place, though, would be taxable. Depreciation reduces your tax basis in the property and, therefore, increases profit dollar-for-dollar. Also, due to a recent change in the law, if you use the property after 2008 for purposes other than your principal residence, part of the eventual gain on sale won't be eligible for the $500,000/$250,000 exclusion.
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