Maximize Vacation Home Tax Benefits

from www.biz.yahoo.com


Investor's Business DailySweet Summer Shelter: Maximize Vacation-Home Tax BenefitsThursday August 16, 7:00 pm ET Jeff Schnepper
Opportunities to buy a vacation home abound, now that the worst housing slump in 16 years has put buyers in control of the market.
Need extra impetus to find the perfect weekend retreat? Consider that the Internal Revenue Service can subsidize plenty of ownership costs, if you structure your purchase right.
Sluggish sales mean house-hunters get a wide selection and room to negotiate prices. New home sales are 22.3% below a year ago, and existing home sales are off 11.4%.
Add some sophisticated tax planning to good timing and you can take a big cut out of the cost of owning a second home, says South New Jersey Realtor James Buividas.
"People don't plan to fail; they fail to plan," he said.
Here are ways to find savings.
Slash your effective APR. Interest paid to buy or substantially improve a second home can be deductible. If you use the place personally (the greater of 14 days or 10% of the time it's leased out), you'll keep the deduction from being slammed by the Alternative Minimum Tax (AMT), which hits so many middle and upper-income taxpayers.
What can deducting interest save on your federal income tax return? If you're in the 35% tax bracket, it's as if a 6.75% loan drops to 4.39%.
One caveat is the cap: Generally, you can deduct qualified residence interest on just $1 million of acquisition debt and $100,000 of home equity debt, on up to two homes.
Another caveat is that the AMT bars deducting home equity interest unless what's borrowed goes to buy or substantially improve a home. That's the case even if your normal tax computation allows the deduction.
Take tax off your taxes. Real estate taxes paid are allowable deductions no matter how many properties you own. Just keep in mind that taxes listed among your itemized deductions, including taxes on a vacation home, increase your exposure to the AMT, which seeks to limit the savings from some expense and income treatments.
You get such deductions under your normal tax calculation. But they're added back for the AMT computation. The end result: You still get a deduction, but it's minimized if you owe additional tax under the AMT.
Here's how it works: Say your marginal tax bracket is 35% and you have listed a $10,000 deduction for real estate tax paid. But then you refigure what you owe according to AMT rules.
For that calculation, the $10,000 gets thrown back into the income pot to be taxed at a maximum AMT rate of 28%. Absent the AMT, your deduction would've saved you $3,500, but the AMT adds back in a tax of $2,800. It makes your actual savings just the difference between the two: $700.
Get unreportable income. How you use your vacation home can impact your taxes. You can rent it out up to 14 days each calendar year without having to report the income on your tax return. Of course, you don't get to deduct your rental expenses for the time period, such as a share of your insurance, utilities, maintenance, supplies, repairs and the like.
Be careful. If you rent the place out for a 15th day, all the income becomes subject to taxation.
Congress put the 14-day provision in the tax code decades ago, so that taxpayers who rent out homes short-term wouldn't have to allocate home expenses over the time.
Renting out the place for a couple weeks can be an especially winning proposition for owners of vacation homes near big event venues. Consider that Miami has hosted nine Super Bowls and will see its 10th in three years.
Mastic Beach, N.Y., financial planner Paul Malagoli suggests taking this to the next level.
"Rent your vacation home to your corporation and suck out dollars on a tax-free basis," he said. "If your corporation rents the vacation home for business purposes, say a board of directors meeting each month, then the payment of rent is not only tax-free to you, but deductible by the corporation."
You can strategize even more. If you have a subchapter S corporation, income and expenses are passed through to you. So, if you rent to your sub-S corporation, not only are the dollars paid tax-free, but they become deductible on your tax return. That's because the payments for the corporation's business purposes reduce any corporate income passed through to you.
Take money out of one pocket and put it in another, and what do you have? No income on one side and a deduction on the other.
Avoid tax on a property sale. Before you buy a vacation home, consider the long view: How and when might you sell it? Unless the home is your principal residence for two of the five years leading up to your sale, you'll be hit with capital gains on all appreciation when you sell.
Or you can get creative. RBC Dain Rauscher financial consultant Steve Leightman suggests converting the home into an investment property.
"Rent the house for a year and then sell it using a Section 1031 exchange to upgrade to a bigger place," he said.
A section 1031 exchange lets you sell one investment property and defer the capital gains if you put the proceeds into another. You'll have to rent out that new property, too, to qualify for the tax deferral. But after renting the property out for a year, you can convert it back to personal use. There's still no tax until you sell.
Here's a another nifty idea. Just move into the house when you retire. Sell your old principal residence and exclude as much as $250,000 in capital gains ($500,000 on a joint return). Enjoy your new place the rest of your life.
Your heirs will get a stepped-up basis to fair market value at your death. So all of the gain, even on the original sale of that first vacation property, escapes income taxes.
House Ways and Means Committee member Pete Stark, D-Calif., once remarked, "It'd take a genius to invest in real estate and pay taxes."
Perhaps he then took off for his vacation home.
Schnepper is a New Jersey lawyer and CPA, personal finance columnist and the author of several books on tax strategies.