Updated: Jun 30, 2021
Do you own a second home at the beach, in the mountains, or some other getaway location, or are you thinking about buying one? If so, then you may have thought about the possibility of renting it out. Though many people would never consider inviting renters into their vacation home, preferring to keep it for themselves and their family, 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 homes helps you maximize the financial benefit from your asset and 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 able to be included as an itemized deduction. However, there is a limit on the amount of acquisition debt for a taxpayer’s primary residence and one additional home for which the interest is deductible. For a primary residence and second home acquired before December 16, 2017, that limit is $1,000,000 ($500,000 if filing married separately). After December 15, 2017, the limit is reduced to $750,000 (except the debt incurred before December 16, 2017, still falls under the $1,000,000 limit).
Real property taxes on your primary 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 and file a separate return from your spouse), so the deduction for some of your taxes may be limited.
If You Rent Your Property - The tax ramifications of renting out your designated second home are largely dependent upon the amount of time that it is being rented during the year: (1) fewer than 15 days, (2) 15 days or more, and your personal use is 10% or less and (3) 15 days or more, and your personal use is more than 10%.
Rented Fewer Than 15 Days - When you rent out a dwelling unit that you use as a residence (whether it’s your primary home or a second home) for a period that is fewer than 15 days during the year, you do not report the income and cannot deduct any rental-related expenses. However, you can continue writing off eligible mortgage interest and real property taxes as itemized deductions.
Used Personally But for Less Than the Greater of 15 Days or 10% of the Rental Days – In this scenario, you would allocate the home's use into two separate activities: a rental home and a second home. Let’s say that the home is used 5% for personal use; then 5% of the interest and taxes would be treated as home interest and taxes that can be deducted as an itemized deduction. The other 95% of the interest and taxes would be rental expenses, combined with 95% of the insurance, utilities, 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 adjusted gross incomes (AGI) of $100,000 or less. This loss allowance is phased out when AGI is between $100,000 and $150,000. Thus, if your income exceeds $150,000, the loss cannot be deducted; 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.
Personal Use Exceeds the Greater of 14 Days or 10% of the 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. Suppose there is still a profit after deducting the interest and surcharges. In that case, the direct rental expenses (such as the rental portion of the utilities, insurance, and any other direct rental expenses) are deducted. But not more than will offset the remaining income. If there is still a profit, you can deduce depreciation of the building, furnishings, etc., but it is again limited to the remaining profit. End result: No loss is allowed, but any remaining gain 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. Take note that if the rental income becomes less than the business portion of the interest and taxes, the balance of the interest and taxes is still treated as home mortgage interest and taxes.
If You Sell Your Vacation Home - Even if you use your vacation home to generate rental income, it is still considered property for your personal use. 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, nondeductible use and the business rental portion, which would be deductible.
If You Sell Your Home - When you sell your primary home, you can 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 those two years 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 can take the exclusion. Doing so would allow married homeowners (where both qualify) to exclude from their income up to $500,000 of the home’s gain and single homeowners to exclude home sale gain of up to $250,000, except for depreciation of the home that has previously been deducted.
Other Issues - Certain situations involve designated second homes that are particularly complex, such as homes converted from an investment property to a primary residence or when they were acquired by tax-deferred exchange. In these instances, you must consult with this office to ensure that all appropriate planning is done to provide you with the ability to gain 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, it would be appropriate to contact this office to review the tax impact of all of your real estate transactions.