Dear Readers,
Vacation season is just getting under way, but it's not too late to immunize yourself from coming down with a serious case of "cabin fever." This condition is also known, depending upon where you catch it, as "condo" or "cottage" fever. The symptoms are primarily mental but, if untreated, can lead to serious financial complications. While it won't kill you, it can cause anxiety, strain relations with your partner, and put pressure on your joint checking account.

The first phase is The Big Idea.

You know what I mean: You pack up the family and head to some idyllic mountain retreat or beach locale, lugging suitcases laden with all your stuff. About the second day there you think to yourself, "Wouldn't it be wonderful to actually own a vacation cabin/condo/cottage ourselves? Just think, our clothes, toys, and other necessities would already be here waiting for us to walk through the door. The only things we'd have to pack would be a new toothbrush and some trashy novels!"

Phase two occurs immediately after you actually share this thought with someone else, such as your spouse. Your response to the eyes-rolling-to-the-ceiling look is The Rationalization: "C'mon, think about it, dear. We could actually make money on this buy renting the place out when we're not using it. And we can get a tax write-off, too. Besides, look at this location. This place is bound to go up in value. Think of the money we'll rake in when we eventually sell it."

If you're lucky, you only waste one day of your precious vacation racing around with a realtor trying to see as many properties as you can. Severe cases can wipe out two or more days of planned R&R.

The fact is, purchasing a vacation home, or any second home, for that matter, is a serious investment — one you ought to think long and hard about. It's not something you should rush into because of sun-induced delirium. Fortunately, there is a cure: take a giant dose of Reality (CPAs are good sources) and call me in the morning.

In case you can't tell, this is a rather personal column. My husband and I were struck with a (thankfully brief) case of cottage fever just last week. (What? You didn't notice I was on vacation? Filed my column from the beach....

Nonetheless, upon my return, I wanted to be sure I was completely healed, so I contacted Barbara Weltman, an attorney and author of a dozen books, including several of the "Complete Idiot's Guide to..." variety. Weltman and co-author Sidney Kess recently wrote a short review course for accountants on the subject of vacation home ownership.

Her first comments dispersed any remaining vestiges of the fever from my brain: "The biggest mistake people make is they think the place is going to be a big money-maker," she said. Over time, you learn the painful — and expensive— truth. Such as: The rentals you counted on don't materialize. Newer developments are going in right down the road, so the place doesn't go up in value much. The family is sick of going back to the same location ("Booooring!"). All you're doing is pouring money into it because the freezing winters/salt air/etc. is beating the place up.

"You need to check out the area carefully," advises Weltman, "especially in new developments. The realtor claims may be bloated."

Perhaps the best way to approach the idea of buying a second home is the same advice many experts give about purchasing expensive artwork: Buy it because [you] love it, not because you're expecting any significant financial pay-off. "If you're buying primarily for yourself," says Weltman, "and the tax breaks and rental income are gravy, that's wonderful." And, like any real estate investment, don't expect to reap a fortune overnight. Think of it as a long-term commitment.

OK. Are you thinking clearly now? Good, because now we're going to look at the tax benefits you might — MIGHT — get from owning a second home. These vary considerably depending upon two factors: a) the number of days you rent it out, and b) the number of days you (or family members, i.e. non-paying tenants) use it.

Category 1: You don't rent the property. Or, you rent it for 14 days or less during the (calendar) year.

In this case, says Weltman, you would treat the second home like your primary residence, meaning you get to write off property taxes and deduct such things as mortgage interest — to a point. The most you can deduct is the interest you have to pay on up to a million dollars of mortgage debt — that's the combined total of the mortgages on both properties— plus the interest on $100,000 worth of home equity debt.

Furthermore, you do not have to report any of the rental income you received. (And there is no dollar limit.) For example, rent your condo out for Super Bowl week, collect $15,000 and it's all tax-free.

The downside is you don't get to deduct expenses such as repairs, new appliances, or the lawn maintenance service. The cost of actual improvements (a new dishwasher, for instance) is added to your "cost basis" (what you've invested in the property) and will reduce the amount you have to declare as a profit when you sell .

By the way, when you do sell, the entire gain, if any, is taxable. If you've owned the cabin/condo/cottage for more than a year, you will pay long-term capital gains on the proceeds. The "Homeowner's Exclusion"— $250, 000 for a single person, $500,000 for a couple, provided you have owned and used the home as your primary residence for 2 out of the past 5 years— only applies to your primary residence.

Of course, savvy investors know there is a simple technique for making a second home their primary residence: Sell your current residence and move into your vacation home. After two years, it qualifies as your primary residence. Assuming it's owned by a couple, when they sell, they can exclude up to $500,000 of the profits.

Category 2: You rent the property for more than 14 days AND your personal use amounts to more than 14 days or 10 percent of the rental days, whichever is higher.

For example, you rent your beach house for 60 days. You personally use it for one month (30 days).

In this case, you have to report the rental income you received. However, you are allowed to deduct the expenses you incurred — but only up to the point that they equal the amount of rent you collected.

Deductible expenses, according to Weltman, include all of the "normal homeowner expenses such as mortgage interest, real estate taxes, casualty losses. " In addition, you get to deduct things you normally can't deduct on your primary residence: maintenance costs, repairs, utilities, real estate management fees, for instance, but only in proportion to the total number of days the home was rented.

In the above example, the home was rented out for 60 out of a total of 90 days. This means you have to allocate, or portion out, your expenses, reporting them on two different tax forms — with, in this case, two-thirds (60 divided by 90) going toward rental expenses and the remainder assigned as personal.

For instance, assume you pay $6,000 in mortgage interest over the year. This means $4,000 would be deducted as a rental-related expense on Schedule E. The remaining $2,000 would be deducted as a personal expense on Schedule A.

You also get to depreciate the value of the property. But here Weltman strongly advises you seek professional tax advice. "It's tricky."

And since your deduction cannot exceed the amount of rent you collect, "you can't really create a tax loss than you can use against your other income."

At most, you can zero out your rental income so you don't pay any income tax on that. If you're looking for a tax write-off, we have to move to...

Category 3: You rent the property for more than 14 days out of the year and your personal use does not exceed the 14-day/10-percent test.

For instance, you rent the ski condo for 6 months and your mother-in-law uses it for a week (no, you did not make her pay for this).

Now you're getting into the area of the tax code which pertains to "passive" gains and losses. These include rental property (as long as you're not a realtor) and other income-producing ventures where you don't actually work for the company, you're just an investor. (Remember those oil and gas partnerships back in the '80's?) If you fall into this category, you definitely need to be using a tax professional. By the way, mortgage interest is considered another expense, just like utilities, property management fees and so forth.

In this case, your losses might be able to offset your other taxable income. In a nutshell, you add up all of your passive gains from various sources and subtract your passive losses on Schedule E. If your losses exceed your gains, you're not home-free until you can meet two critical tests.

First, you have to show you own the property with the intention of generating a profit. If you can't demonstrate this, then there is no deduction. However, says Weltman, "You don't have to actually make a profit every year. You could show that you purchased the property because of the expected appreciation."

The second test is where you get into the passive loss rules. According to Weltman, "It's very complicated. If you hope your property losses can offset other income, you'd better sit down with a professional to see if it's going to work out that way."

That's because there are income limits that restrict who is eligible to take passive losses. The maximum amount of excess passive losses you can use to reduce your other income is $25,000/year and ONLY if your Adjusted Gross Income (AGI) is $100,000 or less. Above this amount, the deduction is phased out. You don't lose it forever, however. Weltman points out that you can eventually recognize the loss when you sell the property.

Okay, let's assume you've had enough of being an absentee vacation rental landlord and want to sell it. If you fall into one of the first two categories, the cabin/condo/cottage is considered a "personal asset," meaning you do not get a tax deduction if you sell it at a loss. As I mentioned, if you make a profit, you will pay capital gains tax on this. (If you haven't owned the place for at least a year, then you'll pay ordinary income tax rates.

Only Category 3 owners get to take a loss.

If, despite what you've just read you're still not cured of cabin/condo/cottage fever, you might like to know what qualifies as a vacation home. This is important because it determines whether or not you can deduct the mortgage interest. The answer:" Any dwelling that has "sleeping, cooking, and toilet facilities," according to Weltman. Yes, this includes a boat and a mobile home.

Enjoy your vacation!


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