Your vacation home may be taxed differently than your primary residence, depending on how you use it. Will you be using it as a second residence, a rental property or an investment property? There are advantages and disadvantages to each with different rules from lenders and the IRS. It’s important to know the rules for vacation homes and taxes before you buy, to see if the costs make sense.
While the IRS draws a firm line between a residence and an investment property, lenders have a looser definition of what “second home” really means. You could have more than one “second” home. Each lender has its own rules about whether it will finance a property used at least partially for rental income. In general, they prefer to lend money for personal residences as opposed to investment properties.
Here’s a guide to making sure you know what kinds of financial issues, including taxes, you may encounter on your second home that might not have appeared with your first.
1. If your vacation house is not rented out but remains a residence for you and your family, taxes are levied like they are for your primary residence.
Mortgage interest may be tax-deductible
As long as you bought your house before 12/15/2017, you can deduct mortgage interest up to $750,000 of mortgage debt. You can do the same for a certain amount of home equity loan interest when you use the money to improve the property.
You can only take the mortgage interest deduction if you’re itemizing. Therefore, if you’re married filing jointly, you’ll need to get over the $24,000 standard deduction hurdle to take it.
Local and state real estate (property) taxes may be tax-deductible
In theory, state and local taxes (SALT) are deductible from your federal return. However, the Tax Cuts and Jobs Act of 2017 limited SALT deductions to $10,000.
If you’ve already reached this limit on your primary home, then you have no more room for deductions on your second home. But if you haven’t, you might get some tax relief from your vacation home.
2. If your vacation house is used for rental property and not entirely personal use, the taxation will likely change.
In the IRS parlance, a “second home” is different from an “investment property” and likewise is taxed differently. If you claim a property as a second home, you must live in it at least some of the time (during the taxable year. An investment property is one you don’t live in.
Second homes qualify for mortgage interest and real estate tax relief, whereas investment properties don’t. On the other hand, maintenance and other expenses can be deducted for investment properties but not for personal residences. That includes the entire property tax bill, not the $10,000 SALT limit on a second home.
3. A second home used for personal and rental use can change characterization according to how many days you use it for each purpose during the calendar year.
If you rent your vacation home for 14 days or fewer during the tax year, you do not owe taxes on the rental income.
Otherwise, the income is characterized as taxable. Expenses related to a rental property, including property management, are deductible against the revenue. You can deduct the expense of utilities and any maintenance that’s performed. You can even deduct the cost of a new roof from your taxes.
You can also take a depreciation deduction, but be aware it may later be recaptured when you sell. The deduction is limited to the percentage of time during the year that you rented the home out.
Although you can’t take a loss on a second home, you can take losses on an investment property to offset income.
Tax considerations of using your vacation home as a residence and a rental
If the home is used both as a personal residence and as a rental property, the costs must be divided between the two. One of two conditions must be met to be considered personal property and qualify for the mortgage interest/property tax deductions. And it has to be the one that would require a greater number of days you lived in the house.
The conditions are either you live in the house for at least 14 days during the year, or you use it at least 10% of the time you rent it out.
For example, suppose you rent your house out for 150 days during the year. If you don’t spend at least 15 days living in it, the house will be considered investment property and taxed accordingly. If you lived there for 14 days, you would meet the first condition, but not the second with its higher residency requirement.
None of these periods have to be consecutive; you could have a two-week stay plus a few three-day weekends here and there in between rentals if you like. The aggregate number of days you live in it during the year is what counts.
While this expense division is technically true for all types of residences, it’s more common with second homes than primary ones.
4. Whether you use the property as a second home or at least partially as an investment property also affects taxes when you sell it.
Depending on when you bought your second home, you may qualify for the residential capital gains exclusion when you sell an appreciated property. There’s no exclusion when it’s used as an investment property, and you might be subject to depreciation recapture as well.
If you bought it before 2008, you’re able to use the capital gains exclusion as long as it’s a second home and not an investment property. You may recall that you’re allowed to exclude a certain amount of the capital gain from your taxes on the sale of your residence. The exclusion is $250,000 when filing singly and $500,000 when you file jointly. In expensive real estate locations like San Diego, the exclusion can save you a lot of money on your taxes if you’re eligible.
But it’s your second home, not your primary. (Or you may have been treating it as an investment property until now.) The way to get around the residency requirement is to move into the home for at least two of the five years preceding the sale. That will allow you to characterize the property as a residence and take the exclusion.
How tax depreciations work on a vacation home
Investment properties are eligible for a tax deduction for depreciation every year to offset rental income. When you sell it, the deductions are subject to recapture. You can avoid it in the year of sale by performing a 1031 exchange with another property, which delays recapture.
Depending on your tax situation, one form of tax relief (taxable interest and SALT deductions, capital gains exclusion) might be more attractive than the other (expense deductions, property taxes). The characterization isn’t set in stone, so you may find that one is more advantageous now and elect to make a different choice later.
If you’d like to talk about how a second home might affect your financial situation, please give us a call at 619.255.9554 or send us an email to set up an appointment.
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