Have a second home? Is the rental expense deductible?

If a second home is going to be used purely as a vacation property for you, your family and other guests, it is considered your second home. You can claim your mortgage interest and property taxes as deductions if you itemize, and add the cost of improvements to your basis. But you are not entitled to the $500,000 ($250,000 for single taxpayers) capital gains exclusion, which is limited to your personal residence, or main home. Only if you occupy a place full-time for two of the previous five years can you claim that exclusion.

It also is worth noting that you can claim only one vacation home. If you own more than one, you can deduct property taxes only on the second and subsequent vacation properties. So, if besides a place, say, in Arizona, you own a ski chalet in Aspen and a hunting cabin in the Texas woods, you can claim your full vacation home deductions on just one. Which one is your choice. But for the other two, only the property taxes are deductible.

If you plan to rent your vacation property, the tax rules governing rental real estate apply. However, if you plan to use the place yourself and also rent it to others, the rules are somewhat more complicated. First, if the place is a pure rental, you are required to count as income all rents. A security deposit is not considered income if you plan to return it when the lease expires. But if you keep all or part of the deposit because the tenant leaves early or there is damage to your place, the amount withheld must be reported as income in that year.

However, if you collect the first and the last month's rent as well as a security deposit, the extra month's rent is considered advance rent and must be reported as income in the year it was received as opposed to the year it is due. As a homeowner, you can add the cost of improvements to the cost basis of your principal residence but not the cost of repairs. As an owner of rental property, though, just the opposite is true. Landlords recover the cost of improvements by taking depreciation and by deducting repair costs from ordinary income. As the IRS views it, improvements add to the value of your property, prolong its useful life or adapt it to new uses.

Repairs, on the other hand, is work done to your property to keep it in good operating condition that does not materially add to its value. Other expenses that are deductible from rental income include advertising, cleaning, utilities, insurance, commissions, tax-return preparation fees, travel expenses and local transportation expenses. However, the expenses incurred to obtain financing -- commissions paid to the mortgage brokers, for example, or recording fees -- must be amortized over the life of the loan.

If yours is a condominium or cooperative, special rules apply. Moreover, each form of ownership is treated differently. With condos, you can deduct depreciation, repairs, upkeep, dues, interest and taxes -- as well as assessments for the care of the common areas owned jointly by you and the other owners. But you cannot claim special assessments paid to a management company for improvements. Your share of the cost of improvements is recoverable by taking depreciation. With a co-op, you usually can deduct all the maintenance fees paid to the cooperative housing corporation. But you cannot claim a payment earmarked for a capital asset or improvement such as a parking lot or new roof. Those payments must be added to the cost basis of your stock in the corporation.

It also is worth noting that if you don't earn a profit from your rental, you can claim your expenses only up to the amount of your rental income. Moreover, you cannot carry forward to the next year the rental expenses that exceeded your income in the previous year. So if you occupy your home for part of the year and rent it to others for all or even a portion of the rest of the year, you must divide your expenses between personal and rental use based on the number of days used for each purpose. A day of personal use is considered any day the property is occupied by you, another person who has an interest in the property, a member of your family or anyone with whom you have an arrangement that permits you to use another dwelling. Any day the property is used for personal purposes and rented -- in other words, the day you leave and your tenant arrives, or vice versa -- counts as a rental day. But days in which the property is available for rent but not actually rented do not count as days of rental use.

If you use the property and rent it for less than 15 days during the year, you are not required to report your rental income. In other words, your rental income is tax free. But you can't claim any rental expenses, either. If you use the house more than 14 days or more than 10 percent of the days it is rented, your place is considered as "a vacation home used as a residence." In this case, if you have a net loss -- your expenses exceed your income -- you cannot use the excess expense to offset income from other sources. Instead, you must carry forward your loss to the next year to be treated as rental expenses for the same property. Realize, though, that unless you turn a profit in subsequent years, you may never get to claim the excess expense.

If you use your home for less than 15 days or no more than 10 percent of the number of days it is rented, the property is considered a "vacation home used as a rental property." Here, too, you must report and pay taxes on the income less your rental expenses. But if you have a loss, more complicated passive and hobby loss rules apply and you should seek professional counsel.

By the way, newcomers to the rental business are allowed to write-off their start-up expenses. Among other things, these include the cost to investigate potential real estate markets, fees paid for various professional services (other than those paid to actually purchase a property) and even attending classes or real estate seminars. These would be normal operating costs for an ongoing business, but they are considered start-up expenses when they are incurred before the business begins. But you can deduct no more than $5,000 in your first year of business. Anything over that amount must be claimed in equal amounts over the next 15 years.

You also are allowed to deduct legitimate expenses -- travel, entertainment and other "fun" expenses don't count -- as start-up expenses up to the day you put the place in service; that is, the day you offer it for rent as opposed to the first day on which it is actually rented. If you already own rental property, these are considered as costs incurred to expand your business and must be claimed as business operating expenses, not start-up expenses. And if you should change your mind and decide not to rent your new vacation-home digs, all bets are off. These costs become personal costs and are not deductible.

Disclosure

This information considers the impact of second homes, rental homes and government taxes. The information below is intended solely as general guidelines and should not be construed as legal advice. Be sure to consult professional tax counsel ( your tax attorney, tax preparer or IRS as an example) for confirmation and advice before taking action.