Unfortunately, while a major exclusion for principal residence sales exists, this break does not apply to a vacation home. In addition, a vacation home is considered personal use property and not an “investment” under the tax code, so the IRC Sec 1031 tax-free exchange rules do not apply. More bad news: although your profit from the sale of a vacation home is taxed as a capital gain, a loss is considered personal and therefore not deductible. (See Tax Planning below.)

A vacation home is referred to as a “second residence” under the tax code. It must have sleeping, cooking, and toilet facilities to be eligible for the mortgage interest deduction. Any type of home can be designated a vacation home that contains these amenities – a single-family residence, a condominium, cooperative unit, houseboat, mobile home, or house trailer.

For taxpayers who itemize their deductions, taxes incurred with respect to real estate (including a vacation home) are fully deductible under the regular tax system, but not under the alternative minimum tax (AMT)

There are special rules regarding deducting mortgage interest. The homeowner designates a second residence in addition to their main home. Interest is deductible on the second residence to the same extent as that allowed for the main residence; that is, interest on up to $1 million of indebtedness, in total, to buy, construct or improve a principal or second residence, or both.

In addition, interest incurred on a home equity debt secured by either a principal or second residence, and not exceeding $100,000, is also deductible under the regular tax system, but not under the AMT. If you rent your vacation home for 14 days a year or less, the income received is not taxable. This is good news for those who rent their vacation homes for a short period during major festivals or sporting events.

Note: Evidently Hollywood is abusing this loophole by characterizing prize money as rents and tenant improvements. See the accompanying story. Expect Congress to eliminate the 14-day loophole once it discovers Hollywood's tax-dodging shenanigans.

Renting Out a Vacation Home

Once you rent your vacation home for more than 14 days or 10% of the number of days the property is rented (the 14 day/10% rule), whichever is greater, the rules change.

There are complex regulations covering this subject, but in most cases you do the following: First, you include all rental income, but deductions are limited by a fraction, the numerator of which is the number of days the unit is rented out and the denominator is usually 365. Assume the unit is rented out 100 days, then the fraction for determining your allocable rental expense is 100/365. You then multiply all rental-related expenses, including advertising, commissions, maintenance, depreciation, utilities, taxes and mortgage interest by the fraction to determine the deduction against rental income. The 14 day/10% rule is applied each calendar year.

There are two strategies available to save on taxes when selling your vacation home:

a. Move into the vacation home and convert it into your principal residence. You must live there as your principal residence for at least 24 of the 50-month period prior to sale. By converting your vacation home into a principal residence, single filers may exclude up to $250,000 in gain (married couples filing jointly may exclude up to $500,000).

b. Convert the vacation home into a rental property at the beginning of the year and diligently avoid the 14 day/10% rule. Then use the tax-free exchange provisions to exchange the property for like kind property, which must be used as investment property.

The key decision is whether to rent your vacation home for 2 weeks or less, or limit your personal use to below the 14 day/10% threshold. In any event, unless you convert the vacation home into your principal residence and meet the residency exclusion rules, or convert it to rental property in the year of sale to take advantage of the tax-free exchange rules, be prepared to pay full capital gains taxes on the sale.