Except as tax shelters, vacation homes stay snug amid reform

With all the huffing and puffing of earlier tax proposals, you were probably bracing for Congress to come along and blow away the benefits of your vacation home. You can relax. It may cost a little more, but the vacation home is still a cherished institution under the Tax Reform Act of 1986. The vacation home concept had been stymied for the past two years by the threat of severe limitations on deductions for mortgage interest and property taxes on second homes, says Jay Lamont, director of Temple University's Real Estate Institute. ``Congress has seen to it that the American Dream, Part 2, a Vacation Home, remains unscathed.''

Just how unscathed depends largely on how long you live there and whether or not you take in renters.

The homeowner who rents for no more than 14 days a year can still deduct interest and taxes, albeit at lower rates. Lower rates mean smaller deductions so the after-tax cost of your second home will go up slightly unless interest rates dip.

Consider, for example, someone in today's top bracket of 50 percent. With interest amounting to $1,000, the deduction is $500. Next year, when the top bracket is 38.5 percent, the deduction drops to $385; in 1988, it bottoms out at $280. Differences in the range of $220 are unlikely to trigger trouble. For the taxpayer who uses the vacation home for pleasure rather than paper losses, not much will change when the new bill is ushered in.

It is when you rent to rack up losses or simply to make ends meet that complications crop up.

The time test the IRS uses to judge the motive behind your rental is the same under reform as it is now. Stay less than 14 days and your second home will be considered rental property; stay longer and the IRS assumes you are trying to cover expenses on a vacation home.

Under reform, the deductions for both groups are smaller.

Owners of rental property will be hit the hardest by reform. The IRS has severely limited the kind of income from which you can offset losses on a rental property. Until the end of the year, you can offset losses with any income including salaries and dividends.

Beginning in 1987, the IRS will label losses on a rental facility ``passive,'' and they can be neutralized only with passive income, like that from limited partnerships or rental facilities. ``The hottest commodity going will be vehicles generating passive income,'' predicts Don Massoglia, a tax partner with Peat, Marwick, Mitchell & Co. in Washington.

Should your expenses exceed your income and you have acquired and settled your property before President Reagan signs the act into law, those additional losses can be phased out against active income using the following schedule: 65 percent in 1987, 40 percent in 1988, 20 percent in 1989, 10 percent in 1990, zero percent in 1991 and thereafter. Whatever losses remain can be carried forward. Property purchased after the bill's enactment will not qualify for any phase-outs, so any excess losses will have to be deferred.

There is a notable exception to the passive loss rules. If you actively manage your house by writing checks, arranging repairs, or even just approving the tenants, then losses exceeding passive income of up to $25,000 can be offset by active income like your salary. This provision is for homeowners with adjusted gross income of $100,000 or less. People earning between $100,000 and $150,000 can deduct a smaller portion. Those earning above $150,000 cannot deduct any passive losses against their active income, unless you acquired the property before the bill's enactment.

Provided you don't bring in an immense amount of passive income or exceed salary limits, this is an exception you should look into. If someone is managing the property for you, try to renegotiate a contract that will give you some authority. Prospective buyers should demand it. ``Be careful whoever is going to operate your property will give you enough authority. Don't sign any more tight binding contracts relinquishing all control,'' says Martin Helpern, a tax partner at Laventhol & Horwath.

The second category of rentals is considered a cross between a vacation home and a rental property. To qualify, you have to take in renters; you also have to personally use your retreat at least 14 days a year. If this describes your setup, the IRS will ask you to apportion expenses between your vacation and that of the renter. Interest and taxes for the time you use will be fully deductible. Expenses allocated to the time used by renters will be subject to the same rules as a rental property.

Financial planners and tax partners encourage homeowners in this category to raise the rent if possible to meet expenses. ``The sooner you raise rents, the better,'' advises Lawrence Krause, president of Lawrence A. Krause & Associates, a San Francisco financial planning firm. ``Of course you have to keep in mind market conditions. You would rather rent than not at all.''

If all this makes you want to sell, think again.

Whether you rent or let your pleasure palace sit idle, you have probably seen it depreciate. Vacation home prices have fallen by as much as 50 percent in resort communities like Miami Beach, and some economists see prices going even lower. It clearly is a buyers' market.

``People worried about the tax implication may bail out,'' says Mr. Massoglia. ``You may pick up a good buy.''

Should you still want to sell under such conditions, now is probably a good time to do so. Taxpayers in the 50 percent bracket are going to see the capital-gains tax climb from 20 percent to 28 percent next year. Say you sell your home for a $100,000 profit. This year you would pay capital gains tax of $20,000. Next year that same tax will collect $28,000. The difference can be even greater in lower brackets.

To qualify for the lower rate, you'll have to sell by the end of the year. You will be fortunate indeed if you can find a buyer with the cash to pay in full. More likely, you'll have to accept installments, and they will be subject to a higher capital-gains tax beginning next year. Vickie King, senior tax manager at Price, Waterhouse & Co. in Los Angeles, has a way around it: Elect to record the entire sale in 1986. Be sure to figure out how much in cash you'll need to pay off what surely will be a sizable tax. You'll probably have to ask for a large down payment.

Beside fire sale prices in many locations, prospective buyers should realize a second benefit to the vacation home in the form of a home equity loan. With the interest on cars and credit cards gradually losing its deductibility, the home equity loan is going to be looking mighty good.

Unless you are one of the few people with a lot of passive income in search of big capital losses, there is no reason to rush into the market, particularly if prices continue to drop. Should you need big capital losses, you can purchase a home before year-end, and you'll qualify for 19-year accelerated depreciation. Write-offs under that schedule come bigger and faster than those under the 27-year straight-line method that will be lost under the new bill.

You should realize from the start that it is very costly to own and maintain a vacation home. Some professionals, including planner Krause, advise their clients against it. ``You get more value for your money if you go out and rent someone else's problem,'' he says.

If you come to the same conclusion, consider time-sharing. When you purchase a time-share unit, you own a week or more each year at a resort accommodation, usually a condominium. Most of the time the contract is forever and can be passed on to your heirs.

To purchase a time-share, you are typically required to plunk down 20 percent of the contract (average price $7,000). You will also have to pay an annual maintenance fee, subject to increase (the average fee is $200). The balance is financed by a note on which you pay interest.

Under current law, that interest is fully deductible. It is unclear yet whether that will be the case under reform. It is also fuzzy whether the interest on fractional estates time-shared for several weeks, or even months, will be deductible.

``We were all waiting to see how it will all come out,'' says Stephany Madsen, executive director of the National Timesharing Council.

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