For a number of years, tax season has brought pleasant news for log home owners and even better news for vacation rental home owners. The picture changes slightly in January 2009, and the IRS is still not raining on our parade.
Below is a special focus on new strategies to deal with the $250,000 tax exclusion amendment enacted when President Bush signed The Housing Assistance Tax Act, plus a roundup of ongoing homeowner and vacation home owner tax benefits.
What’s Changed with the Section 121 $250,000 Capital Gains Tax Exclusion ?
The new regulations affect you if you currently own or are thinking of building a vacation or rental home with a long-term strategy of moving into it as your primary residence.
This strategy of investment rental first, then retirement living later has garnered log home owners numerous monetary benefits over the years. Most of us can’t support the dream of having a vacation home without extra rental income. Some of us have started out with other rental property over the years, and now look forward to a 1031 trade from that property into a rental vacation home that we convert to our personal residence later.
During the time we use the home as a rental, we not only have the extra income, we can write off maintenance, insurance, utilities and other expenses against that income, making that rental income even more valuable to our finances.
Even further down the road when we go to sell our home, we look forward to enjoying the $250,000 per person capital gains tax exclusion on the sale granted under Internal Revenue Code Section 121.
A couple of years ago, the IRS mandated that when you convert a 1031 rental property into a primary home, you need to own it at least five years before you can sell and qualify for the Section 121 exclusion.
This year, they went even further. Whether you use your log home as a rental or as a second home after January, 2009, you’ll need to prorate your tax exclusion.
How to Calculate Your $250,000 Capital Gains Exclusion
Starting in January 2009, a vacation home owner who first uses the home as a rental or as a second home will not be able to take the full $250K per person exclusion. Instead, the exclusion will be prorated between the percentage of time owned and the percentage of time after January 1, 2009, but prior to occupying the home as a primary residence.
Here’s an example of how it would work. A couple who bought a home on Jan. 1, 2008, used it as a rental for three years (2008, 2009, and 2010), moved into it Jan. 1, 2011, lived there for two years, and sold it would only be able to exclude 60% of their gain up to a maximum of $150,000 per person. Their five-year ownership as both a rental and a primary residence would be calculated as:
- Year 1 (2008): Not counted in the new pro_rata reduction; the home was bought before January 1 effective date of the laws. Note, however, that 2008 does count toward the number of years of ownership calculation and therefore essentially counts as a primary residence non-eligible year.
- Years 2-3 (2009/2010): When used as a rental or as a vacation home, it would be prorated as non-primary home use (and therefore non-eligible) years.
- Years 4-5 (2011/2012): Used as a primary residence and would be prorated as eligible primary residence years.
- Result: The couple would have three eligible years out of five years of ownership. This means they would only be eligible for 60% capital gains tax savings (with a cap of $300,000 for the two of them).
New Tax Strategies
Note: The following scenarios have been reviewed by Julian Block, tax attorney, ex-IRS criminal investigator, syndicated columnist, and author. His online book, The Home Seller’s Guide to Tax Savings, is updated and available here.
Block cautions that any time you are making a decision based on tax benefits, you should discuss the issue with your own tax preparer to be sure the strategy will work for you.
- Strategy #1: The non-primary use pro_rata calculations are only for years after January 1, 2009 and prior to becoming a primary residence. So if you have two homes and are planning to change the vacation to your residence, do so ASAP use your first home it as a part-time second home for a couple of years or rent while you make your transition. The first residence will continue to qualify for the full $500K capital gains exclusion for up to three years after you move your primary residence.
- Strategy #2: Give up on the plan of converting the vacation home or rental property into a primary residence. At least a year before you sell, make sure your property qualifies as a 100% rental (used more than 90% of the time as a rental), then 1031 into another rental property.
- Strategy #3: Don’t plan on reselling the vacation home after converting to your primary residence — just live there forever. Its taxable value to your estate will be the same whether or not it’s a primary residence.
- Strategy #4: Look carefully and with input from your accountant if you’re thinking about doing a 1031 tax exchange trade of a rental property into a place you’ll want to use as a primary residence in the future. You’ll need to keep a 1031 property as a rental for a significant amount of time after a 1031 trade, and all of that time will be deducted from the qualified Section 121 capital gains exclusion.
Other Tax Deductions
Tax deductions for mortgage interest and real estate taxes described are among the best tax deductions you can take. They’re itemized on the same two lines of your Schedule A. Schedule A items are deducted from your ordinary work income, so they give you a better net after tax income figure.
You can only take these Schedule A deductions against one primary and one second/vacation home. If you happen to own three or more homes, you don’t get to deduct their mortgage interest and real estate taxes on your Schedule A. If you use the other homes as rentals, however, you can deduct all expenses from your taxable rental income. See the following section.
- The largest dollar tax deductions you can take are for investment property.The IRS doesn’t make these deductions easy, however, and there are several sets of rules. The first two are the easiest to calculate:
- Property Mostly Used for Personal Use and Rented Out Less Than 15 Days During the Year. You don’t have to file any Schedule E. You can’t deduct anything but the basic Second Home real estate taxes and mortgage interest expenses on Schedule A. Here’s a nice gift from the IRS, as explained in Publication 527, Residential Rental Property: You do not have to report the income. Anybody for tax-free income during Christmas ski weeks?
- Both Rental Use and Personal Use Exceed IRS Maximums. If you rent the property longer than 15 days and use it personally more than 15 days or 10% of the total days it is rented to others, you’ll need to figure a percentage for the deductible Schedule E expenses and, if the property has a net loss, you won’t be able to deduct all of the rental expenses (deductions cannot exceed rental income from that property).
- Mostly Income Property Use with Minimum Personal Time. If your log home is in an area where it’s easy for you to rent out the home most of the year to other vacationers, and you retain only a small amount of time for your family’s use, you may be able to write off all Schedule E deductions as though the property had no personal use whatsoever.
To qualify, you must not use the home for yourself or your family for more than 15 days or more than 10% of the total days it is rented to others at a fair rental price, whichever is longer. Because of the 10% rule, if you’re able to rent your place for 11 months, you should be able to use it personally the 12th month and still deduct 100% of the expenses on Schedule E.
Special Notes Regarding Sales Tax Deductions
Many vacation areas levy sales tax on vacation rentals. Check with your local tax collector to find out what is the situation where your home is located. If you have to pay sales tax, deduct that amount from the gross rents you receive prior to listing Rents Received for the IRS as this expense can be 100% deducted on a home partially used as a personal residence.
Shari Steiner is a licensed real estate broker, a speaker and the co-author of Steiners Complete How to Talk Mortgage Talk and Steiners Complete How to Move Handbook. She’s worked with numerous people needing to update their tax planning. You can ask her questions as The Moving Doctor at the www.movedoc.com website.
Please note: We are not tax preparers. This article has been assembled from interviews and excerpts from IRS publications. There are several specific tests that you must meet to qualify for various deductions, and the tax code is constantly changing. Whenever you list expenses or exclusions on your tax return, be sure to check with your personal tax preparer to be sure the deductions you’re claiming are currently correct.
Here are various IRS publications covering most of log homeowner situations. They may be downloaded from www.IRS.gov or ordered by calling 800-829-3676.
- Publication 523, Selling Your Home
- Publication 527, Residential Rental Property (includes Rental of Vacation Homes)
- Publication 544, Sale of Other Assets (includes Second Homes and Vacation Rental Homes)
- Instructions for Schedule A – Personal Expense Deductions