by Standard & Poor’s, © 2008

If you have a vacation home, you’re already aware of the enjoyment it provides and the benefits it can offer at tax time. But you may not be aware of how vacation property can be used to generate income in retirement or how it can play into an estate plan. In fact, vacation properties offer retirees a number of different options in managing their finances and estate.

Vacation property may be used to generate income in several different ways. The first, and most obvious, is renting it. The IRS allows you to deduct mortgage interest on your primary residence and one additional property up to a limit of $1 million in combined mortgage debt for mortgages taken out after 1987. Current tax rules also allow you to rent out a second home for up to 14 days per year without having to report the rent as income. If you rent for more than 14 days, the home is considered investment property, and rent must be reported as income. Converting the property to an investment property, however, allows you to deduct rental expenses, such as insurance and utilities, if you have a net profit on the property (deductions are limited if you report a loss). You can still use an income-producing property for personal use while maintaining your tax advantages — but only for the greater of 14 days or 10 percent of the total days it is rented. Maintenance days do not count as personal-use days, but use by in-laws or other part-owners does, even if rent is charged.1

Another way for retirees to generate income from a vacation home is to sell it. By using the federal capital gains exclusion in conjunction with the sale of your primary residence, you can potentially realize tax-free income. Here’s how it works. The basic capital gains exclusion rules state that you must have owned and used the home as your primary residence for at least two years out of the five-year period ending on the date of the sale. If you are married, the full $500,000 exclusion ($250,000 for single homeowners) is available as long as one or both of you satisfies the ownership test (two years) and you both satisfy the use test (primary residence).

Consider the following example: Mr. and Mrs. Smith are married and own two homes. The primary home qualifies for the $500,000 exclusion and could be sold for a $500,000 gain. The Smiths sell the property tax-free and move into their vacation home in Arizona, where they live for two years, sell the property, and once again claim the full $500,000 exclusion. Theoretically, individuals could practice this “use and sell” strategy over and over — using the gain proceeds as income.

Turning Vacation Property into Tax-Free Income

If you have a primary residence and a vacation property that are highly appreciated, you can generate significant tax-free income over time by taking advantage of the IRS capital gains exclusion rules for the sale of a primary residence.1

Year 1

• Sell primary residence for $1 million; realize $500,000 gain from sale.
• Move into vacation property as primary residence.

Year 3

• Sell vacation property at least two years later for $750,000 and claim another $500,000 gain.
• In this example, both gains would qualify for the federal tax exclusion, assuming the owners are married, jointly own both properties, and meet ownership and use tests.*

*This is a hypothetical example and should not be construed as tax advice.

Incorporating Vacation Real Estate into Your Estate Plan

A wide range of estate planning and wealth transfer scenarios can be addressed through the use of trusts. Two types of trusts — qualified personal residence trusts (QPRTs) and charitable remainder trusts (CRTs) — are particularly useful if you have highly appreciated vacation property in your estate.

A QPRT permits you to transfer a residence to your children with its value discounted for gift tax purposes. This discount is based in part on the length of time that the QPRT holds the property between the point you relinquish it and the moment that it is fully conveyed to the beneficiary — the longer the interval, the greater the discount. If the creator of a QPRT does not outlive the term of the trust, however, the property is considered to be part of the taxable estate at its fair market value.

After the QPRT term ends, you would have to rent the property (at its fair market value) from the beneficiaries if you intend to continue to live there or use it. However, such payments create an opportunity for additional transfers of wealth that are not exposed to gift or estate taxes. The beneficiaries might also benefit from the income tax advantages associated with owning rental real estate.

A CRT is an irrevocable, tax-exempt trust in which you place assets to provide income for you during a specific period of time (i.e., your lifetime or a term not to exceed 20 years). At the end of that period, the remaining assets are turned over to the charity of your choice. If you have a highly appreciated vacation property, you will likely pay a great deal in capital gains taxes when you sell it. But if you transfer the property to a charity through a CRT, the trustee can sell it with no gift, estate or capital gains tax consequences. The trustee can then set up an investment that will provide an income stream for you. You’ll also be able to take a charitable income tax deduction based on the present value of the trust’s remainder interest.

However you decide to use your vacation home in retirement, you should speak with a qualified tax professional before choosing a strategy.

1 These are guidelines only; your specific tax obligations should be discussed with a qualified tax advisor.

Points to Remember

1. The IRS allows you to deduct mortgage interest on your primary residence and one additional property to a limit of $1 million in combined mortgage debt.
2. Converting a vacation property to an investment property allows you to deduct rental expenses such as insurance and utilities, but you can use an income-producing property for personal use only for the greater of 14 days or 10 percent of the total days it is rented.
3. If you are married, you may qualify for up to a $500,000 capital gains exclusion ($250,000 for single homeowners) from the sale of your principal residence, as long as you satisfy the ownership and use tests.
4. A qualified personal residence trust permits you to transfer a residence to your children with its value discounted for gift tax purposes.
5. A charitable remainder trust is an irrevocable, tax-exempt trust in which you place assets to provide income for you during a specific period of time (i.e., your lifetime or a term not to exceed 20 years).

This material was prepared by Standard and Poor’s for LPL Financial.

The LPL Financial family of affiliated companies includes LPL Financial, UVEST Financial Services Group, Inc., Mutual Service Corporation, Waterstone Financial Group, Inc., and Associated Securities Corp., each of which is a member of FINRA/SIPC.

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