Tax treatment of vacation homes depends on how often the property is used for "personal use" and how often it is used as a "rental". There are three possible tax treatments, each with their own rules on tax deductions: "Pure Second Home", "Pure Rental Property", and "Second Home/Hobby Rental".
"Pure Second Home" tax treatment is used if the property is a "rental" for no more than 14 days in a particular tax year. With this tax treatment, mortgage interest and property taxes are generally tax deductible, but other expenses are not. Rent income is entirely tax free.
"Pure Rental Property" tax treatment is used if both of the following two things are true: (i) the property is a "rental" for more than 14 days in a particular tax year," and (ii) the total number of "personal use" days is either no more than 14 or no more than 10% of the total number of "rental" days. (For example, if there were 220 "rental" days, there could be up to 22 "personal use" days; if there were 100 "rental" days, there could be up to 14 "personal use" days.) With "Pure Rental Property" tax treatment, divide the year in two parts, "rental" and "personal use", and allocate each expense proportionally. For the "rental" portion, expenses (including mortgage interest, property tax, insurance, maintenance, repairs, improvements, utilities, management, and even depreciation) are deductible to the extent they exceed rental income, but the deduction cannot be taken against all types of income, and in some cases must be carried forward and deducted in future years. For the "personal use" portion, only property tax is reliably deductible; other expenses, including mortgage interest, generally are not.
"Second Home/Hobby Rental" tax treatment is used when neither of the other categories apply. With this tax treatment, divide the year in two parts, "rental" and "personal use", and allocate each expense proportionally. For the "rental" portion, expenses (again including mortgage interest, property tax, insurance, maintenance, repairs, improvements, utilities, management, and even depreciation) can offset income, but are not otherwise deductible. For the "personal use" portion, mortgage interest and property taxes are generally deductible, but other expenses are not.When determining how often the property is used for "personal use" and how often it is used as a "rental", these rules apply:
- Use by a co-owner, even when the co-owner pays a usage fee, is "personal use".
- Use by a relative of an owner, even if the relative pays full rent, is "personal use".
- Use by a non-owner under a vacation home exchange or swap arrangement is "personal use".
- Days spent primarily repairing or maintaining the vacation home are not "personal use", but need not be counted as "rental" days either.
- A day when the home is available for rent but is not actually rented cannot be counted as a "rental" day.
When vacation property is fractionalized, IRS Regulations seem to contemplate that usage of all the co-owners (and their relatives, non-paying friends, and swappers) should be added together to determine the total number of "personal use" days, and the days when the property was rented to paying tenants who are not owners or relatives (regardless of whether the rent went to an individual owner or was shared by the group) should be added together to determine the total number of "rental" days. The tax treatment should then be determined. If the home qualifies as a Pure Second Home, each owner can then generally deduct all of the mortgage interest and property tax he/she paid. If the home does not qualify as a Pure Second Home, the group will need to determine the collective "rental"/"personal use" expense allocation ratio. Each owner will then need to apply that ratio to the expenses he/she has paid, offset any income he/she received, and apply the appropriate tax deduction rules as outlined above. Nevertheless, at least one article that explores this topic in detail has concluded that this approach may not be either workable or fair in practice, and that it would be reasonable for each owner to determine his/her tax treatment separately based on his/her usage and rental of his/her interval.
This discussion of tax issues is intended as an introduction to the general rules only. Consult a qualified attorney or accountant for complete and personalized tax information.HOW WILL I BE TAXED WHEN THE FRACTIONAL VACATION HOME IS SOLD OR I SELL MY SHARE?
Unless the seller has occupied the property as a primary residence for two of the five years immediately preceding the sale, he/she will not qualify for the $250,000 singele/$500,000 married exclusion from capital gains tax. But the seller is likely to qualify to have any profit taxed at the lower long-term capital gains rates, and may qualify to complete a tax-deferred exchange. In general, the tax treatment of profit or loss on resale will depend upon how the property was used in the 12 months preceding the sale. When contemplating a sale of a vacation property (or just your share of one), it is wise to consult a tax expert at least a year before the planned sale.WHY WOULD AN OWNER OR REALTOR SELLING AN ENTIRE PROPERTY DEVELOP THE FRACTIONAL OWNERSHIP STRUCTURE AND AGREEMENT BEFORE MARKETING? WHY NOT LET THE BUYERS DEVELOP THEIR OWN FRACTIONAL AGREEMENT?
Although it is theoretically possible to gather an entire buyer group, have them prepare a single offer as a group, then allow them the time and flexibility to create their own structure and agreement prior to close (while the property is held off the market), this approach fails much more often than it succeeds and consumes a huge amount of effort and time even when successful. Most sellers and Realtors find it much easier and more productive to accept individual offers from prospective buyers of each fractional share even when they intend to simultaneously close the sales to all the buyers at once. (Note that closing the sales one at a time is also possible.) Accepting individual offers on the fractional shares is virtually impossible without having a structure and documentation in place. The structure created by the agreement is necessary to avoid the uncertainty and risk that would otherwise be associated with a series of purchase contracts for percentages of the property.WHAT TYPE OF SHARED OWNERSHIP AGREEMENT OR FRACTIONAL GOVERNING DOCUMENT IS NEEDED FOR A FRACTIONAL OWNERSHIP ARRANGEMENT?
Every fractional ownership group needs a document or group of documents detailing their rights (especially usage/rental, alteration, financing and resale) and obligations (especially cost allocation, dues structure, repair/replacement, and rules). The document or documents must be prepared in view of the fact that it/they will only be used if the owners disagree, and will only be useful if it can resolve the disagreement (more on this later).
Where the fractional owners will hold title to the property (a "direct ownership" arrangement), governing documents fall into two general categories: (i) those that are recorded in the chain of title and thereby become binding on each fractional interest owner without that owner's signature, and (ii) those that are unrecorded and bind only those fractional owners that sign them. The principle advantages of recorded documents, often called "Declarations" or "CC&Rs" (which stands for "Covenants, Conditions and Restrictions"), are that they reduce the risks of shared ownership (particularly the risk that there will be a co-owner that is not bound by the documents because he/she has not signed them), and facilitate collection in the event of non-payment of co-owner obligations. The principle disadvantages of recorded documents are that they may violate a local or private regulation, are more difficult to modify, and are generally not compatible with group financing. A common misconception is that co-owners obtain "separate deeds" only if there are recorded fractional ownership documents. In fact, all fractional ownership arrangements involving direct ownership can have separate deeds, regardless of the type of documents used and whether the documents are recorded or unrecorded.
Most vacation fractional arrangements involve a combination of recorded and unrecorded documents, and it is difficult to make generalizations about what the documents are typically called or say what documents (as opposed to what content items) are needed. Some common names (aside from "Declaration" and "CC&Rs" mentioned above) are "User Agreement", "Bylaws", Shared Ownership Agreement", "Co-Ownership Agreement", "Owner Agreement", "Management Agreement", and "Usage Rules", but there is no pattern as to what is in a document with a particular name, or how the various necessary provisions are distributed among the documents when a project has multiple documents. The key is to make sure all the important content items are present, and to assess the extent to which a particular content item will be enforceable against current and future owners.
Some fractional ownership arrangements involve the creation of a legal entity such as a corporation, and the entity may be for-profit or nonprofit. Sometimes the entity actually owns the property and the co-owners own the entity (discussed more fully below), but in most cases the entity is formed just to manage and operate the property. When an entity is formed, a formation document, often called the "Articles" or the "Certificate", will exist, and annual filing and tax reporting requirements may exist. The benefits of forming an entity for the management and operation of vacation fractional property is debatable, and the decision is often driven by group size.DO VACATION FRACTIONAL OWNERS WHO ARE CLOSE FRIENDS OR FAMILY REALLY NEED FORMAL DOCUMENTS?
People and circumstances change in unforeseeable ways, and new people can come into a co-ownership group at any time as a result of death or other unexpected events. When these changes occur, even the best of friends, the closest of families, and the most agreeable and easygoing people in the world, can disagree. The purpose of an agreement is to help resolve these conflicts quickly, inexpensively, and without ruining the personal relationships of the group members.SHOULD VACATION FRACTIONAL OWNERSHIP AGREEMENTS BE KEPT SHORT AND SIMPLE?
No one reads co-ownership documents for pleasure. The only time one is likely to read the documents is if there is a conflict that can't be resolved informally. In that situation, one wants the shared ownership agreement to provide a specific and clear resolution. The shorter a fractional ownership agreement is, the less likely it is to address the specific problem that caused one to look at the agreement. The advantage of length is that it allows the co-ownership agreement to cover more issues, and makes it more likely to be helpful. There is no disadvantage to length, as long as the document has a complete table of contents. Simplicity is desirable, as long as it doesn't come at the expense of breadth.