Real Estate Guide

Investing In Real Estate - Questions and Answers
'Tax Considerations'

• Where do I get information on IRS publications?
• How do I reach the IRS?
• Should I buy a vacation home?
• Are taxes on second homes deductible?
• Will my vacation home qualify for a §1031 Exchange

Where do I get information on IRS publications?

See >> Real Estate Guide: Resources - Where do I get information on IRS Publications.

How do I reach the IRS?

• Call (800) TAX-1040.
• On the web ( www.irs.gov )

Should I buy a vacation home?

You can buy a vacation home today for investment purposes as well as enjoyment. And yes, there are tax benefits. Some people buy a vacation home to use as a permanent retirement home later, which allows them to get ahead on their payments. Another benefit is that the interest and property taxes on a vacation home are tax-deductible.

Some real estate experts predict that vacation homes will appreciate in value due to rising demand from the aging Baby Boom generation. You also can depreciate the property if you live in the house fewer than 14 days a year, or 10 percent of the number of rented days - whichever is greater.

You also need to consider whether you can afford to carry two mortgages, pay for the extra utilities and maintenance costs, and how this investment fits into your total personal finance picture.

Investment real estate can offer significant tax benefits both during ownership and at the time of resale or tax-deferred exchange. Not only do most investment properties appreciate in market value, but they also produce significant tax savings.

The IRS has a helpful publication (Publication 527, entitled "Residential Rental Property," available online at www.irs.gov/publications.

Are taxes on second homes deductible?

Generally speaking, mortgage interest and property taxes are deductible on a second home if you itemize, and if you don't rent it out for more than 14 days in any given tax year. Depreciation may also be taken, but the amount depends on whether you do rent for longer than 14 days, and whether or not  and how long you used the home personally.  Because of the limitations imposed  you should consult with your tax advisor before taking any deductions.

You should also note that Congress in the summer of 2008 has changed the capital gains rules for  second homes or vacation homes. The former law, allowed you to sell your principal residence and take up to $250,000 of tax-free profit ($500,000 if filed jointly) as long as you owned and lived in that home for two of the five years immediately preceding the sale.

You were than allowed to  move into your vacation home or a rental property and, if you lived there for at least two years, you got a second $250,000 ($500,000 if filed jointly) round of profit.

No longer. To help pay for the big housing bill, Congress has changed the rules so that some of your gain will be taxable if you convert your vacation home or rental unit to a primary residence after 2008.

Real estate tax code provisions can and do change at the whim of Congress. Before buying or selling real property, be sure to obtain advice from your own tax or legal advisors for the most current laws and regulations.

Will a vacation home qualify for tax deferral under IRC §1031 (commonly known as a '1031 Exchange').

Effective March 10, 2008 taxpayers will have a clear definition of the rules under which a vacation home will qualify as property 'held for investment' under §1031.

- Vacation home - the relinquished property (this is your old property, the one you sold in the exchange)

Your old vacation home will now qualify as 'relinquished property' if:

1. You own the property for at least 24 months prior to the exchange. This is known as the 'qualifying period.' The period will actually be evaluated as two 12 month periods. (The first period ending on the day before the transaction closes, and the second ending on the day before the first period begins.) In other words, they must be consecutive 12 month periods prior to the transaction.
    
2. Now it gets a little more complicated, because during both 12 month spans of the qualifying period:
   1. You must have rented the property at fair rental value to another person for at least 14 days. (and)
       
   2. Your personal use of the property must not have exceeded 14 days or 10% of the number of days, whichever is greater, during the 12 month period your property was rented at fair market rental value.

- Vacation home - the replacement property (this is your new property, the one you purchased within the exchange)

Your new vacation home will qualify as replacement property if:

1. You keep the property for a 'qualifying period of at least 24 months after the exchange. Again the qualifying period is seen as two 12 month periods. (One beginning immediately after the exchange, and the second beginning 12 months hence.)
    
2. Within each of the two 12 month periods:
   1. You must rent the property to another person at fair market rental for at least 14 days  (and)
       
   2. Your 'personal use' of the property does not exceed 14 days or 10%, whichever is greater, of the number of days during the 12 month period that the property was rented at fair market rental value.

It should be noted that even if a family member pays fair market rent value, the use of the relinquished or replacement property by a family member will be considered 'personal use' unless the property is determined to be the principle residence of the family member. Also, any time you loan the use of the property to anyone not paying you fair market rental, the use will be considered 'personal.'

It should be taken for granted that the '§1031 Exchange' of vacation homes will be subject to very strict review and narrow interpretation by the IRS, therefore, they should be carefully planned and entered into only with the guidance of a qualified tax advisor.

See also >> A Guide To 1031 Exchanges.