Buyer's Remorse

I always can deduct my mortgage interest on my second home. With so many affluent clients purchasing McMansions these days, it is not uncommon to see a large mortgage on their primary residence. Remind your clients that you can generally deduct qualified residence interest on up to $1.1 million of home mortgage debt ($1 million worth of acquisition debt on up to two homes plus $100,000 of home equity debt on up to two homes). Any excess interest on home mortgage debt is generally nondeductible. Furthermore, the owner's overall interest deduction may be lessened due to the itemized deduction phase-out rule for higher-income taxpayers (for 2007 the AGI level is $156,400). This rule is expected to sunset by 2010. As such, if nothing is done, in 2011 it will revert back to a full phaseout.

I always have to report rental income. Rental income is completely tax-free for property that meets the rules for personal-use property, but has a very limited opportunity to generate rental income (generally 14 days or less). From a tax perspective, this can be quite a boon for clients with properties that can be rented at an exorbitant rate for a short time (e.g., properties located near a major golf event, Olympics, or Super Bowl location).

Vacation home donations are always a good idea. Unfortunately, the IRS considers vacation home donation days as personal use days, not rental days, since the owner did not receive a fair market rental for the use of the home. In addition to not qualifying for additional rental expenses, the owner receives no charitable deduction for donating the use of the home to charity.

I can use the capital-gains tax exclusion ($500,000) upon sale. The exclusion applies only to principal residences. Typically, to be eligible for the full exclusion, a taxpayer must have owned the home–and lived in it as his or her principal residence–for at least two of the five years prior to the sale. The property can change status but a homeowner can take advantage of the capital-gains tax exclusion only once every two years.

A 1031 (tax-deferred) exchange can be done on a vacation home. A recent Tax Court ruling (Moore, T.C. Memo 2007-134) disallowed tax-deferred treatment for a personal vacation home. The court held that a couple's exchange of vacation homes did not qualify for like-kind exchange treatment because the homes were not held for investment purposes (as required by ? 1031(a)). The court pointed to the taxpayers' use of the houses as vacation homes, their failure to rent either the old or the new property, and the personal improvements they made as evidence that the homes were for personal use, rather than for investment.

Rental income will be offset by costs. With property prices still high, some clients may believe they will offset the cost of a second home by renting it. Unfortunately, clients forget that in order to cover their costs they often will have to rent it out at peak season, coincidently the weeks they want to use it the most. Furthermore, when the house is used as both rental and personal property, on the owner's tax return, allowable operating expenses are limited up to the point where rental income is zeroed out. Any disallowed operating expenses are carried over to future years where they can be deducted if there are rental profits. In real life, this rarely occurs.

This is a "business." Many people say they manage their property and thus "materially participate." In other words, they are in the business of renting real estate and are able to take losses against other taxable income (i.e., it is not passive). (See Web extras for the IRS take on what it means to materially participate).

You can go home again. And, finally, do not "impulse buy" while enjoying a vacation.

If your clients have shown an interest in purchasing real estate at a great place where they vacationed last month, suggest that they hold off until they have "felt out the neighborhood" for a while, meaning they should visit the location a few more times. Suggest that they focus on the commute to work, the community, people, activities, and amenities, and, very important, talk to as many locals as possible, particularly those who have owned vacation homes there for some time.

Do your clients have a similar feeling of happiness each time they visit the location? Are their experiences consistent over time? If not, you have just saved your clients from a disastrous impulse buy. If it is what they dreamed of, then you now have an opportunity to help them with their financing and perhaps other assets as well.

The financial ramifications as well as the emotional toll of purchasing vacation homes can be complicated. But understanding these rules and your clients' expectations will open the door to some great discussions with your clients as well as other advisors they may have.