Personal residence vs. rental property: analyzing loss carryovers.

A recent surge in ownership of so-called "vacation homes" has led to a renewed interest in tax planning for such ownership. While the basic rules relating to ownership of second homes may be well-known, one aspect that has been overlooked is the interaction of the passive activity rules under Sec. 469 and the income limitation under Sec. 280A. In particular, little attention is paid to loss carryovers and their tax consequences in the year of disposition.

Loss Carryovers

In analyzing the personal residence or rental property classification, several issues must be resolved before making a final determination. Considerations include the size of the interest payments, the amount of rental income received from the property, the availability of other passive activity income and, of course, the taxpayer's adjusted gross income (AGI). Assuming vacation homeowners can control personal use, there is no simple answer. The property's classification as personal or rental can change on an annual basis.

In planning the annual classification, taxpayers often overlook the nature of their loss carryovers. Given the potential for differing classifications for different tax years, a taxpayer may have two different types of loss carryovers relating to the same property. The first is the loss carryover resulting from the passive activity rules of Sec. 469; the second is the loss carryover from the gross income limitation of Sec. 280A. These carryovers are not combined and will retain their character regardless of the classification of the property itself in future years (Sec. 280A(c)(5)). Simply stated, the passive loss carryover can only be used in years in which the unit is a"rental only" property to offset income from passive activities; the Sec. 280A loss carryover can only be used in years in which the unit is a"residence/rental" property to offset its rental income.

Given the time value of the potential tax benefits, a taxpayer would like to use these loss carryovers as quickly as possible. However, the amount and character of the loss carryforwards increase in significance when the taxpayer is planning to dispose of the property. Under ideal planning conditions, the optimal annual classification of property would absorb all loss carryovers prior to the home's disposition. Even if this is not possible, a final planning opportunity exists--arranging the classification of the property in the year of disposition.

Loss Carryover in the Final Year

If a taxpayer has both a passive loss (Sec. 469) and a gross income limitation (Sec 280A) carryover coming into the year of disposition, what is the optimal property classification for this final year of ownership?

If the property is considered "rental only," the passive loss carryover will become available in the year of disposition. Under Sec. 469(g), when a taxpayer disposes of his entire interest in a passive activity in a fully taxable transaction, any passive loss currently generated by that activity or carried forward from earlier years becomes fully deductible without regard to the passive loss limit. Given that these losses could then be used to offset other income (nonpassive as well as passive), while the benefits of the Sec. 280A carryover would be lost forever, it makes sense for the taxpayer to limit his personal use in order to achieve the desired result.

The year of disposition "rental only" classification would prove especially advantageous for high AGI taxpayers. For example, if property is generating a rental loss, a taxpayer with AGI in excess of $150,000 would be better off qualifying the property as a"residence/rental" unit. This classification preserves the taxpayer's itemized deductions, since the rental loss would not be currently deductible. (For "rental only" property, the $25,000 special loss allowance under Sec. 469 is reduced to zero for any taxpayer with AGI in excess of $150,000.) Meanwhile, the expenses disallowed due to the Sec. 280A gross income limitation will continue to carry over in a similar fashion to the passive losses from "rental only" property.

Assuming the losses continue into this final year, there would no longer be any opportunity to use the carryover of previously disallowed "residence/rental" expenses. Consequently, there is no further advantage to be gained from having the unit characterized as a residence. On the other hand, if the taxpayer were to limit his personal use in order to qualify this as"rental only" property during this last year of ownership, the resulting nonpassive rental loss would be available to offset other income. In addition, any previously disallowed passive losses become fully deductible with the"rental only" property's disposition.

Example: T's AGI is $175,000. His rental loss is $25,000. The amount of mortgage interest and taxes allocated to T's personal use of the property is $5,900.

Until T's final year of ownership, it would be more advantageous from a tax perspective to qualify the unit as a residence by personally using it for the greater of 14 days or 10% of the rental days during the year. While the rental loss would not be deductible (due to the Sec. 280A gross income limitation), T would at least get $5,900 in itemized deductions. In contrast, if the unit is characterized as a"rental only" property, not only would the $25,000 rental loss not be deductible (the Sec. 469(i) exemption having been phased out by T's AGI),but the itemized deductions (i.e.,"personal" mortgage interest) of $5,900 would be lost (Sec. 163(h)(5)).

In the year in which T disposes of the property, a "rental only" characterization is preferable. T loses the itemized deduction for qualified residential interest, but gets a $25,000 loss that can be used to offset other income.

Conclusion

Most tax planning decisions are extremely fact sensitive. This is especially true with the ownership of a second or vacation home. Before finalizing any decision on the property's classification, careful consideration must be given to the amount and character of income, expenses, losses and loss carryovers Regardless of the decisions reached during the ongoing ownership of a unit, these factors must be reconsidered carefully for the year in which the property is disposed of; what is best for one year may not be best for another. Vacation homes present a unique planning opportunity; since the personal residence or rental property classification can vary from one year to the next, a golden opportunity exists for planning the most tax advantageous classification prior to and during the year of sale.

From Thomas M. Brinker, Jr., CPA, MS, J.D., Brinker, Simpson, Nicastro & Volk, L.L.P., Drexel Hill, Penn. (Not a DFK Affiliate), and W. Richard Sherman, CPA, J.D., LL.M., Associate Professor of Accountancy, St. Joseph's University, Philadelphia, Penn.