Should I mortgage my primary residence or my vacation home?

This answer was provided by Mark Misselbeck, CPA, from Levine, Katz, Nannis & Solomon PC in Needham.

Q: My wife and I are thinking about purchasing a vacation home. We have enough cash so that we can either pay off the mortgage on our primary residence and finance the vacation house, or continue our mortgage on the primary house and pay cash for the vacation home. It appears that the interest rate we can get on the vacation home will be about the same as our current mortgage rate. We plan to use the house half of the year, and try to rent the other half. From a tax perspective, which house is the better choice to carry the mortgage? --Kevin, Norfolk

A: The answer most appropriate to your situation depends on more information than has been provided, however, this is the best general answer that can be crafted.

From a personal perspective, you probably should not have your personal residence at risk to carry a vacation property. For that reason, alone, if you can't generate a better rate of return from investing your cash elsewhere, you should pay off your principal residence mortgage, rather than pay cash for the vacation home.

You state that you propose to rent the property for about half the year. You will need to become familiar with the tax rules for vacation rentals. Essentially, you will need to split the expenses between the number of days actually rented and the number of days actually used for personal occupancy (either you, your family or friends). The rental expenses will be deductible for rental income or loss purposese (and will be deductible for MA State income tax purposes, where your principal residence mortgage would not). The rental loss may be limited by tax rules governing Passive Activity Losses.

The allocation of interest and real estate taxes to personal use will be deductible, if you itemize your deductions, since you can select one other residence, in addition to your principal residence for which you may deduct mortgage interest, in full, on your return.