Tax reform has introduced several changes in tax treatment of your wealthy clients’ vacation and second homes—even to the point of providing tax-free sales.
But “while many of my wealthy clients are aware of the tax advantages of owning more than one home, few are aware of the provision regarding personal use of vacation homes that also generates rental income,” said James McGrory, a CPA with Drucker & Scaccetti in Philadelphia.
A vacation home is treated as a residence during a tax year if personal use exceeds the greater of 14 days or 10 percent of the days the property is rented to others at a fair rental.
“Due to the passive-activity rules as well as percentage-of-use rules, rental properties do not generally offset a high-net-worth client’s taxable incomes,” said Aaron Blau, a CPA in Tempe, Ariz. “Of course, exceptions do apply, especially when the taxpayer has other passive-activity income.” There are special rules for certain rental properties with an average use of 30 days or less, or properties with average use of seven days or less, he added.
“If the property is held out as a rental (full or partial) and there is a net loss for the year, in general, most HNW clients may not be able to deduct that loss in that year if there is no other passive income to offset it,” said Lynn Conover, a CPA with The Curchin Group in Red Bank, N.J. Such clients don’t lose that deduction, she added, but can carry it forward until it can be used against future rental or passive income or the property is sold.
Misconceptions about tax conditions of vacation homes also continue. The owner staying at the property to make repairs and maintenance doesn’t count as personal-use days even if family members use the property for recreation on the same day. “Rental to friends and family members for less than fair market value rent is considered personal use,” Conover said. “Many of my clients think that if they donate nights of stay in their vacation home/rental unit, they can take a charitable contribution. This is not the case.”
Clients often lack detailed knowledge of rules such as depreciation, depreciation recapture and the passive-activity loss limitations, according to Greg Horning, a CPA and co-founder of the SC&H Group in Sparks, Md. Depreciation recapture is the portion of the gain attributable to depreciation deductions previously allowed during the period your client owned the property (generally taxed at 25 percent). Under reform, taxpayers can now claim an itemized federal deduction for the interest on up to $750,000 of acquisition debt.
Conversion of a rental property to a principal residence for at least two years prior to a profitable sale can definitely shelter some of the gain from tax.
Tax-free profits are possible where a taxpayer sells their regular home, moves into what had been the vacation home and uses it as their principal residence. If they later sell the vacation home, the gain on the vacation home as well as on the sale of the prior main home is generally eligible for an individual exclusion of up to $250,000 ($500,000 for married taxpayers) if each home is owned and used as a principal residence for at least two of the five years preceding the sale date of each and two years elapse between the sales.
Added Horning, “A portion of the gain may also not be eligible for the exclusion if the property was previously a vacation or rental home ... based on the proportion of the ownership period for which the property was used for each purpose.”
Headline reform changes such as elimination of the property tax deduction or the drop in the mortgage-interest deductibility from $1 million to $750,000 seem unlikely to deter wealthy clients from owning a vacation home, accountants said. “My wealthy clients have purchased second homes for the enjoyment of having one,” McGrory said. “I wouldn’t think that the loss of deductions has factored much into their purchase price negotiations.”