Vacation homes can be a source of great pleasure during their ownership; the reality of how they are treated for tax purposes happens once you decide to sell the property. You may have determined that the cottage at the beach or condo slope side at the mountain is your “investment” property, however, the truth is, not for tax purposes!
In order for vacation property to qualify as “investment” property, personal use is limited. The guidance provides that personal use cannot exceed the greater of fourteen calendar days or 10% of the days actually rented to others. It can also be used during periods of repair of maintenance without limitation as long as you maintain good records. If you rent to family members it will count against your personal use days if they have a direct lineal relationship (mother, father siblings, and grandparents). This can be avoided by renting to your in-law and not your brother or sister but the rent must be deemed to be market rent.
If this sounds like too much record keeping to avoid falling astray of the regulations, then consider a period of compliance before sale. For instance, you have owned and freely used your vacation property for the past five years but now want to spend time in another locale. The way to accomplish having your personal use property deemed to be investment property is to suspend your free access to no more than the limitations outlined above. In plain terms, stop using it for at least two years. Offer the property for rent by using a management company. This will help in clarifying your rental intent and the record keeping becomes someone else’s problem. Don’t forget to inform your tax preparer to report the property on your Schedule E and review IRS Publication 527 for additional details.
Now you are free to go ahead and sell the vacation property and acquire new vacation/rental property in another location. Since your property has been converted to “investment” property by virtue of your abandonment of personal use, upon sale, the property will qualify for a Section 1031 Exchange. Once you exchange, the new property must be rented to others for the next two years. You can make limited use as previously described and then convert it back to personal use after the lock out period.
While all of this sounds tedious, it can bring significant tax savings, thereby allowing you to use all of your proceeds for the next purchase, not 20-40% less. If you consider that some family properties are now in the third and further generation of ownership, the tax basis is generally so low that the tax impact is monumental. A planning strategy is key to your success and future enjoyment!