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Tax Talk with George Saenz

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Defining a second home for tax-break purposes

Dear Tax Talk:
I'm interested in the treatment of and/or qualification as a "second home" going into the 2001 tax year. I've read several articles on the topic, and am confused by the fact that the info seems a bit contradictory.

From the Internal Revenue Service publications and some articles, it seems that I will be able to deduct the interest and property taxes for the "second home" as long as I use it personally for more than 14 days or 10 percent of the rental days per year, whichever is greater. In an article in this site, I read that I would have to split my interest and taxes pro-rata between Schedule A and E (as I have no "passive income" I would get no "passive loss" benefit).

Which is correct? I'm in the process of deciding whether to buy a property or not.

Dear David:
Let me try to set the record straight on the treatment of a second home for tax purposes. Let's divide second homes into two categories: 1) never rented to others and 2) sometimes rented to others. If it is always rented to others, then it is a rental property, and the second home rules don't matter.

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If the property is never rented to others, then the taxes and interest are deducted on Schedule A along with your primary home's interest and taxes. The only limitation is the overall limitations that apply to interest on home mortgage indebtedness in excess of $1 million.

Another set of rules applies to a second home that is sometimes rented out, since rent is taxable income. If the property is rented out less than 14 days a year, you can ignore the income and claim your interest and taxes as if the property was never rented out during the year. Any other rental expenses you pay are similarly ignored.

If you rent the property for more than 14 days and also use the property as a residence for more than 14 days during the year, or, if greater, more than 10 percent of the time it is rented at fair value to others, then you run into an allocation of expenses against the income. Your concern is that by allocating mortgage interest and taxes against the rental income, you may exceed the income from the property and be subject to passive loss rules. If subject to the passive loss rules, your interest and taxes do not produce a current tax benefit as they would if you did not have to make the allocation.

In practice, I have found that when you are required to allocate expenses under the vacation home rules, you do not run into a limitation on the deduction for the interest and taxes for two reasons. First, the interest and taxes are among the first items allocated against the rental income. Second, most short-term rentals of vacation homes are priced much higher than the mortgage interest and taxes paid during the rental period. Based on this, it is doubtful that you will run into this limitation. If, however, you do think you may run into the limitation, you can consider increasing your personal use of the property.

IRS Publication 527 explains the vacation home rules.

Transferring or inheriting property: Which is tax-preferable?

Dear Tax Talk:
My 83-year-old mother has lived with me for over two years. We have decided to sell her home. Her home and property is willed to me. Should we transfer title to me before selling? What is the best tax move?
AE Bell

Dear AE Bell:
The property may be willed to you, but if you transfer the property to your name, then sell it, you'll pay income tax on any gain. Generally, anytime you make a lifetime transfer of property to another person for less than fair value it is considered a gift. Unlike inherited property, the cost for tax purposes does not increase to the value at the time it is gifted. Instead your cost in property received as a gift is the same as that of the person who made the gift.

If the property qualifies as your mother's principal residence, she can sell the house and exclude up to $250,000 in gain on the sale. The house qualifies as her principal residence if she lived in and owned the house for two of the last five years at the time it is sold. Of course temporary absences from the home due to medical reasons are not considered in determining if she lived there for the two years.

When the house is sold, your mother can gift you the proceeds, and you or she won't pay income tax as a result of the sale (assuming she falls within the exclusion amount) and gift. If the gift is more than $10,000, she should file a gift tax return, Form 709.

-- Posted: Feb. 27, 2001

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