Vacation Homes and Residential Interest Deductions: An Outdated Statute and Conflicting Interpretations Create Confusion (and Planning Opportunities)

Abstract

Tax benefits have been the key in making vacation homes affordable for many taxpayers. In some cases these benefits have been augmented by an inconsistency in allocation methods used to determine allowable expenses for vacation homes under Section 280A. The U.S. Tax Court created this inconsistency years ago with its decision in Bolton, 77 TC 104 (1981), where the Court approved an allocation method that was contrary to IRS guidance. Although most analyses since this decision have focused on how the Bolton decision permits a taxpayer to increase total deductions related to a rental property when the Section 280A limits apply, there is another aspect to the allocation controversy that has not received as much attention. Specifically, the possible loss of the personal deduction for residential interest when the property does not qualify as a second home may create unexpected tax consequences, where the best tax-planning advice may be to encourage the taxpayer to use the vacation home for more personal days. This article provides a brief review of the basic Sec. 280A rules for vacation rental homes and closely examines the tax effects of conflicting statutory, administrative, and judicial guidance on the treatment of interest and taxes related to such a property. As demonstrated by three scenarios, the inconsistent treatments may provide an opportunity for owners of vacation homes to “game” the system for maximum tax benefit near the end of a tax year. As a consequence of Congress's failure to update Sec. 280A following the 1986 changes on interest deductions, such gaming of the system may be accomplished without confronting change of accounting method issues.