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Tax Talk with George Saenz

Ask the tax adviser

Investment property or vacation home?

Dear Tax Talk:
I wanted to start by saying your column is excellent!

I've read your answers regarding second mortgages, vacation rentals and investment property deductions.

However, I plan to buy a condo in Hawaii, and I'm trying to determine if there is a simple rule of thumb to follow that says I should consider it an investment property (straight rental) or vacation property (follow the 15 day, 10-percent rule). I can follow the rule that would make it more advantageous for me. That is, if I need to, I can stay in the property for the 10-percent requirement.

In terms of maximizing deductions and minimizing capital gains from selling the property, is there generally one option better than the other?
Thanks,
Wiley

Dear Wiley:
You certainly know how to get your question answered. Flattery will get you everywhere!

There are two aspects to owning the home: deductions related to owning the property and gain on the sale. In certain cases, making the property a second home may get you a larger current deduction than if it were a rental property.

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In either case, the capital gain on the sale would be taxable if the property were sold. If the property was only rental, you could exchange it tax-free, which would not be the case if it were a second home.

If the property were purely personal, you would get a current tax benefit from the deduction for second-home mortgage interest as well as property taxes. You can deduct these amounts as itemized deductions on Schedule A generally without any limit provided your mortgages on your first and second home are less than $1.1 million.

If you rent the property and do not use it personally, then you need to report the income and deductions on Schedule E. An overall loss on the property cannot be deducted if your adjusted gross income exceeds $150,000. A loss suspended in this fashion is carried forward to future tax years where it is either offset by gain on similar property or can be deducted when your AGI falls below $150,000. Therefore, if the property is rental as opposed to vacation, you might not receive any current tax benefit, but the losses carry forward indefinitely. See my earlier column for more information on loss limitations.

If the property is mixed use, such as part vacation and part personal, you have to prorate your deductions between Schedule A, where you get current tax benefit, and Schedule E where you may not because of the AGI limits. Since the proration of the interest and taxes to Schedule A is based on personal use to total use, you may only be getting a small tax benefit from the mortgage interest and property tax deduction, while sacrificing the ability to carry over all losses and later do a tax-free exchange. Therefore, making the property mixed use on purpose is probably the least attractive alternative.

-- Posted: Jan. 11, 2002

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See Also
Tax pros and cons of rental property
Residential rental property and capital gains

Study up before becoming a landlord

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