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INVESTING IN A SECOND RESIDENCE
The current slump in the vacation home market has provided an opportunity to acquire one's dream vacation home at a bargain. Investing in a second residence, whether or not it is used as a vacation home, has tax advantages, depending on whether it is treated as personal property, rental property or as a hybrid of both. A second residence may be a house, apartment, condo, stock in a co-op, house trailer, mobile home or even a boat.
If a second residence is rented out for fewer than 15 days during the taxable year, it qualifies as personal property, and the taxpayer or his or her family may use it as often as they wish. Rental income is not reportable for income tax purposes. For taxpayers who itemize deductions, the mortgage interest payments and property taxes are fully deductible, although there is an overall limit on the mortgage interest deduction (discussed later).
In this category, the taxpayer rents the property and personally uses it only occasionally. Personal use is limited to 14 days a year or 10% of the total days it is actually rented out, whichever is greater. The property does not qualify as a residence, but is generally considered investment property, provided there is a profit motive for owning the property. Expenses on this property - utilities, repairs, property taxes, mortgage interest, maintenance, repairs and condominium fees - are allocated between personal and investment use, based on the proportionate number of days of rental use and the total number of days of actual use. For instance, if the property is rented for 90 days out of 100 days of total use, the expenses would be allocated 9/10 to investment and 1/10 to personal.
The portion allocated to investment is deducted on Form 1040, Schedule E, and may produce a taxable loss, which will be subject to the passive activity loss limitations (discussed later). The portion allocated to personal use, except for real estate taxes and casualty losses, is not deductible. NOTE: That portion of mortgage interest allocated to personal use is not deductible since the property fails to meet the second residence definition (discussed later).
This category involves the personal use of a second residence for longer than 14 days per year or longer than 10% of the total days it is rented, whichever is greater. The allocation between investment and personal use is the same as the rental category, except the portion of mortgage interest allocated to personal use is deductible, since the second residence requirements have been met. Investment expenses, however, are deductible only to the extent of income, and any disallowed excess deductions are carried forward to future years.
Deciding on the Proper Category for a Second Residence
A category is determined by the amount of days per year a taxpayer uses the residence or rents it out. This determination can vary annually. Two tax planning variables should be considered in choosing a category: the "passive activity loss" limitations and the "mortgage debt ceiling" limitations.
Availability of Passive Activity Losses
For hybrid property, the amount of deductible losses may not exceed rental income. In contrast, rental property losses may be used to offset other income, subject to the passive activity loss provisions.
In general, passive activity losses cannot be used to offset income or gains from non-passive activities (such as wages, salaries, interest, dividends, and gains from the sale of stocks and bonds). Passive activity losses from the active effort to rent real estate, however, are deductible against non-passive activity income to a maximum of $25,000 per year, provided the taxpayer's adjusted gross income ("AGI") is $100,000 or lower. The $25,000 deduction is phased-out at a ratio of $1 of deduction for every $2 of income for AGIs between $100,000 to $150,000. Therefore, a taxpayer with $140,000 of AGI is entitled to a $5,000 deduction for rental activity losses. Losses that are not currently deductible are carried forward and are generally available to offset any gains when the property is sold (although for taxpayers with multiple real estate activities, the rules are more complex).
Taxpayers with AGIs of more than $150,000 cannot deduct rental losses currently and may want to classify a second residence as either personal or as a hybrid property to fully utilize their mortgage interest deduction. Taxpayers with AGIs of less than $100,000 - who do not plan to use their property for longer than 14 days per year or 10% of the actual days the property is rented - should consider treating the property as a rental to use tax losses from the property against income from other sources. Taxpayers with AGIs between $100,000 and $150,000 must calculate the passive loss deduction available to them before deciding the most advantageous category.
Deduction of Mortgage Interest
For taxpayers itemizing deductions, mortgage interest is deductible on the first $1,000,000 of debt paid or incurred for the acquisition or improvement of a first or second residence, if that debt is secured by either residence. A second residence is a dwelling unit used for personal purposes for longer than 14 days per year or longer than 10% of the total days it is rented, whichever is greater. Generally, taxpayers want to maximize the personal interest deduction on a second residence. If a taxpayer is over the $1,000,000 mortgage interest ceiling, he or she should treat the property as a rental. In general, taxpayers with AGIs greater than $150,000 who are not over the mortgage interest deduction ceiling will gain the best tax results by treating a second residence as a hybrid.
When a taxpayer does not want to rent the second residence, except during an especially lucrative rental period (for instance, renting a vacation home near a ski resort for the week between Christmas and New Year's), the personal use category permits a full deduction for mortgage interest. The income from the rental, provided the second residence is not rented for longer than 14 days total, is not reportable.
Sale or Exchange of Second Residence
Taxpayers considering selling or exchanging a second residence should categorize their property either as rental or as hybrid property (provided it qualifies as investment property) in the year of sale. If the second residence is categorized as personal property, the tax-free exchange provisions will not apply. Gain will be taxable as a capital gain and a loss will be considered a non-deductible personal loss.
If, however, the property is considered investment property, the property will be eligible for tax-free exchange treatment. Gain from the sale of the property will be taxable as a capital gain and a loss will be a capital loss, thereby deductible against capital gains and, to a limited extent, other income. To comply with the tax-free exchange provisions, the property transferred and the property acquired must be held as investment property. In general, property held for profit and categorized as either hybrid (provided personal use does not exceed rental use) or rental should qualify as investment property.