Do you own a second home at the beach, in the mountains or another getaway location? Or are you thinking about buying one? If so, then you may have thought about the possibility of renting it out. Doing so can offset some of the expenses related to the property, and you may even reap a tax benefit at the same time. Whichever route you choose to go, knowing the applicable tax rules regarding designated second home can help you get the maximum financial benefit out of your asset and keep you from making tax filing errors.
If You Don’t Rent Your Property
Depending upon your individual tax situation, a designated second home’s acquisition mortgage interest may be eligible as an itemized deduction. However, there is a limit on the amount of acquisition debt for a taxpayer’s main residence and one additional home for which the interest is deductible. For a primary residence and second home acquired on or before December 15, 2017, that limit is $1,000,000 ($500,000 if married filing separately). After December 15, 2017, the limit is reduced to $750,000 (except that debt incurred prior to that date still falls under the $1,000,000 limit).
Real property taxes on your main and any number of additional homes are also deductible if you itemize deductions when figuring your regular tax, but not for the alternative minimum tax (AMT). However, even though itemized taxes include property tax, state income tax and certain other taxes, the total amount allowed per year is limited to $10,000 ($5,000 if you are married filing separately), so the deduction for some of your taxes may be limited.
If You Rent Your Property
The tax implications of renting out your designated second home are largely dependent upon the amount of time that it is rented out during the year. Your home will fall into one of these three categories:
- Rented 14 days or fewer: When you rent out a dwelling unit that you use as a residence–whether it’s your main home or a second home–for a period that is 14 days or fewer during the year, you do not report the income and cannot deduct any rental-related expenses. However, you are still able to continue writing off eligible mortgage interest and real property taxes as itemized deductions.
- Rented 15 days or more, and personal use does not exceed 14 days or more than 10% of rental days: In this scenario, the home’s use would be allocated into two separate activities: a second home and a rental home. For example, if the home is used 5% for personal use, then 5% of the total interest and taxes would be treated as home interest and taxes that can be taken as an itemized deduction. The other 95% of the interest and taxes would be rental expenses, combined with 95% of the insurance, utilities and allowable depreciation, and 100% of the direct rental expenses. The result can be a deductible tax loss, which would be combined with all other rental activities and limited to a $25,000 loss per year for taxpayers with modified adjusted gross incomes (MAGI) of $100,000 or less. This loss allowance is ratably phased out when MAGI is between $100,000 and $150,000. Therefore, if your income exceeds $150,000, the loss cannot be deducted. Instead, it is carried forward until the home is sold or there are gains from other passive activities that can be used to offset the loss.
- Rented 15 days or more, and personal use exceeds 14 days or more than 10% of rental days: For those whose personal use of the home is more than 10% of the amount of time that it is rented (or more than 14 days, whichever is greater), no rental tax loss is allowed. Let’s assume that the personal use of the home is 20%. As for the remaining 80%, it is used as a rental. The rental income is first reduced by 80% of the taxes and interest. If after deducting the interest and taxes, there is still a profit, the direct rental expenses (such as the rental portion of the utilities, insurance and any other direct rental expenses) are deducted, but no more than will offset the remaining income. If there is still a profit, you can take a deduction for depreciation of the building, furnishings, etc., but it is again limited to the remaining profit. End result: No loss is allowed, but any remaining profit is taxable. The personal 20% of the interest and taxes is deducted as an itemized deduction, subject to the interest, taxes and AMT limitations discussed earlier.
If You Sell Your Vacation Home
Even if you use your vacation home to generate rental income, it is still considered to be a property for your personal use, and that means that once you sell it, you are subject to taxation on any gains you realize. By contrast, if the sale results in a loss, you are not permitted to deduct any losses–at least not in the examples we’ve provided above. In some cases, a loss on a property can be broken down between the personal use (nondeductible) and the business rental portion (deductible).
If You Sell Your Home
When you sell your primary home, you are able to take advantage of what is known as the home gain exclusion, but this is not true of designated second homes. The gain from the sale of a second home is taxable, but eligible for favorable capital gains tax rates in most cases. The only exception to this rule is when the taxpayer has occupied the second home as their primary residence for at least two of the five years immediately before the sale takes place. At no time during that two-year period can the home have been rented. When this is the case, and the taxpayer hasn’t applied the home gain exclusion on the sale of another property in the previous two years, the taxpayer is able to take the exclusion. Doing so would allow married homeowners to exclude up to $500,000 of the home’s gain from their income, and single homeowners to exclude up to $250,000, except for depreciation of the home that has previously been deducted.
There are certain situations involving designated second homes that are particularly complex, such as homes that are converted from an investment property to a primary residence, or those acquired by tax-deferred exchange. In these instances, it is essential that you consult with your tax advisor in order to ensure that all appropriate planning is done to provide you with the most benefit.
If you rent out your property and provide additional services such as maid service, or rent it out for short-term stays, the IRS may view that activity as a business operation rather than a rental. When this is the case, the tax ramifications are entirely different. Because of this and many other complicating factors and exceptions, we encourage you to contact our office to review the tax impact of your real estate transactions.