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Problems in qualifying a vacation home as rental property.

The most surprising development affecting some vacation home owners would probably be that their ownership and operation of their rental vacation home property may not be a rental activity after all. Some of those taxpayers who had been taking advantage of the $25,000 loss allowance exception for real estate rental activities in which the taxpayer actively participates were really not entitled to do so.

In a typical summer vacation home rental arrangement, a condo is purchased and turned over to a rental agent. The summer rental period runs from 3 p.m. Saturday until noon on the following Saturday; weekend rentals are commonly made during the spring and fall. The typical owner, having been well trained under pre-1986 law, does not use the home for more than 14 days.

The typical owner had been accustomed to deducting his rental losses under prior law and had generally assumed that he would be covered by the $25,000 exception under the Tax Reform Act of 1986, provided he actively (as opposed to materially) participated in the rental activity. (Material participation requires substantially more in the way of day-to-day involvement.)

He had been led to believe that active participation was rather easily achieved by supervision of repairs, approval of lease terms and tenants, and other rather routine chores that he would be inclined to do in any event. He and his tax preparer rather routinely check the box for active participation real estate and go about their business.

Note: If the rental pattern described previously is accurate, our owner may be surprised to learn, first, that he is not engaged in a rental activity; second, that he is not entitled to the $25,000 exception for active participation real estate; and third, that his failure to materially participate means that he has incurred a passive loss.

The taxpayer's problem is that his average period of customer use will be seven days or less - the threshold established by the passive loss regulations for defining a rental activity.

Can the taxpayer still get the benefits of his rental losses? Only if he materially participates. The material participation rules do allow for the possibility of material participation by a taxpayer in this situation, but foresight and knowledge of the rules will be necessary to achieve the desired result.

There are two potential criteria under which the taxpayer may materially participate; only one appears to be a realistic possibility.

First, he can materially participate if his participation constitutes substantially all of the participation of all individuals in the activity for such year. "Substantially all" is not defined for this purpose, but it would be very surprising if it did not mean 90%-95% of the total hours of participation.

The other criterion that could potentially be relied on considers a taxpayer to be a material participant if he participates for more than 100 hours and his participation for the tax year is not less than the participation in the activity of any other individual.

Regulations provide that if an owner of an activity performed the kinds of tasks that an owner would not ordinarily do just for the purpose of meeting the material participation criteria, maybe the hours spent doing that work would not count after all.

What is the solution? It seems clear that a taxpayer who has rental losses from what is not a rental activity, and who would otherwise qualify for part or all of the $25,000 allowance, has three choices.

First, he can attempt to increase his average period of customer use to more than seven days to bring the activity within the definition of a rental activity and qualify himself for the benefits of the $25,000 loss allowance exception.

Second, he can attempt to materially participate under one of the standards for material participation, most likely the "100 hour/more than anybody else" standard.

Third, if the first and second choices are not possible, the taxpayer would be well-advised to use the vacation home more than 14 days to qualify it as a secondary residence; then at least the interest and taxes would be deductible.
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Author:Levinton, Howard
Publication:The Tax Adviser
Date:Feb 1, 1993
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