MAXIMIZE YOUR VACATION- OR SECOND-HOME TAX SAVINGS

Do you own more than one residence that you occupy part of each year? Millions of U.S. residents do, including me. But many of us don't maximize our tax benefits from our two (or more) residences.

Depending on your personal situation, you might be entitled to major tax benefits from both residences during ownership -- and to tax-free sales profits when you're ready to sell.

Always keep careful tax records. Just in case the IRS audits your income tax return, it's simple and easy to keep careful second-home tax records. When should you throw out tax records regarding your personal residences? The correct answer is "never." Sometimes it's necessary to go back many years to establish your cost basis.

If you can document your entitlements, you'll save thousands of tax dollars during ownership and, if your situation is right, when you sell. Save your phone and electricity bills and canceled checks to prove when you were "in residence."

Without good records, especially proving personal occupancy time, you could lose your vacation- or second-home tax breaks. Worse yet, you might even incur a costly IRS negligence penalty.

Is your second home your "main home" part of the year? Depending on how much time you spend in each home, one or both might qualify for the $250,000 home-sale tax exemption (up to $500,000 for a married couple filing jointly) when you sell. To qualify, Internal Revenue Code 121 requires ownership and occupancy of your principal residence an "aggregate" of at least two of the five years before its sale.

For example, suppose you in your Arizona home full time from November to April each year. During May through October, you live full time in your cool Michigan residence. Should you decide to sell either home, the profit up to $250,000 (or $500,000) can be tax-free because you meet the ownership and occupancy tests of IRC 121. However, this tax exemption can only be used once every 24 months, with exceptions for job-location changes and health-related moves.

While not conclusive, evidence of "main home" occupancy includes utility bills, voter and automobile registration, business or retirement income, driver's license, tax return filings, and other indications of the home being a primary residence while you're living there.

Vacation- or second-home tax benefits during ownership. Of course, if you itemize tax deductions, during ownership your mortgage interest and property taxes are fully tax-deductible on both your primary and secondary residences. But there are additional tax benefits for your vacation or second home, depending on how much you personally use it. There are four possible categories:

Fewer than 14 days annual rental time. If you rent your vacation or second home to paying guests fewer than 14 days per year, regardless of the amount of rent received, that rent need not be reported on your income tax returns. However, you can still fully deduct your mortgage interest, property taxes and any uninsured casualty losses (such as rain or snow damage) as itemized deductions on Schedule A of your federal tax returns.

No personal use time. If you didn't occupy your second or vacation home during 2001, except for minimal cleaning and repair time, and it is rented or available for rent the entire year, all the rental income received must be reported on Schedule E of your income tax returns. This is the same place to report applicable expenses such as mortgage interest, property taxes, insurance, utilities, repairs and depreciation. Also, you may be able to deduct reasonable travel expenses to visit your rental property.

If your second or vacation home falls into this category, you will probably have a tax loss. To deduct this tax loss fully against your other ordinary income, such as job salary, you must "materially participate" in managing your property and earn less than $100,000 adjusted gross income in 2001. Then you can deduct up to $25,000 "passive activity" loss from all your rental property against ordinary taxable income.

If your adjusted gross income exceeds $100,000, part of your deductions in this category must be "suspended" for use in future tax years. However, if you are a qualified real estate professional, such as a real estate broker, there is no limit to your deductions in this rental property classification.

Annual personal use exceeds 14 days or 10 percent of the rental days (if rented more than 14 days per year.) When you or your relatives use your vacation or second home heavily in this category, you cannot deduct any loss from the property on your personal income tax returns. Of course, mortgage interest and property taxes are always tax-deductible.

For example, if you rented your lakeside cabin to tenants for three months in 2001, and you personally used it for 30 days, you fall into this category.

The rental income received and applicable deductible rental expenses should be reported on Schedule E. The correct order for deducting expenses is mortgage interest, property taxes, uninsured casualty losses, operating expenses and depreciation. If the mortgage interest, property taxes and uninsured casualty losses exceed the rent received, any excess expenses should be deducted as itemized deductions on Schedule A.

Annual personal use is fewer than 15 days or 10 percent of the rental days that are more than 14 days. In this category, if your personal use is fewer than 15 days annually, or 10 percent of the rental days that exceed 14 days per year, there is no limit to your loss deductions (except for the $25,000 annual passive activity loss limit explained above).

To illustrate, suppose you rented your vacation home to tenants for 120 days last year, and you personally used it just 10 days. Since your personal use was less than 15 days or 10 percent of the rental days, you fall into this category. But the IRS says the profit motive test of Internal Revenue Code 183 applies, requiring a profit at least three out of every five years for your rental activity.

Conclusion. Vacation and second homes are not great tax shelters during ownership. However, they can provide modest tax deductions while, hopefully, the property appreciates in market value.

When selling, if you can meet the "aggregate" principal residence ownership and occupancy tests for two of the last five years, your sale can be tax-free up to $250,000 per qualified home seller. For full details, please consult your tax adviser.

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