Tax Planning for Owning a Second Home

Are you in the market to buy a second home? Mortgate interest, property taxes, rental income, and expenses will affect your tax return. Here's how:

Mortgage Interest

If you will be using the second home and will not be renting it out, interest on the mortgage is deductible in the same way you would deduct interest for your primary home. You are able to write off 100% of the interest you pay, up to $1.1 million of debt combined for primary and secondary homes.

Property Taxes

If you will be using the second home as a rental property, which a lot of second-home buyers do, very different tax rules may apply depending on the rental use. You do not need to report the rental income if you rent the property out for 14 or less days during the year. The amount of income you receive does not matter just the amount of days rented. However, if you rent the home for more than 14 days during the year, all income must be reported because the home is now being viewed as a business. You can deduct rental expenses factoring in the amount of time the property is used for personal use versus rental use.

Unlimited Use Versus Limited Use

If you use the second home more than 14 days, or more than 10% of the days it is rented then it is considered a personal residence and you are not able to deduct your rental loss. However, because you are not able to count the interest as a rental expense, you will be able to deduct it as a personal expense.

If you limit your personal use of the home to 14 days or 10%, the home will be considered a business and up to $25,000 in losses might be deductible each year. This is why most vacation homeowners, second-home owners, spend lot's of time "maintaining" the property. Days spent fixing up the home do not count as personal use, so you can spend more than 14 days at the property as long as it is for maintenance purposes. Unfortunately, holding down personal use means forfeiting the write-off for the portion of mortgage interest that fails to qualify as either a rental or personal expense. 

It is said that such losses might be deductible because real estate losses are considered "passive losses" by the tax law. Passive losses are generally not deductible, but there is an exception that might protect you, if your adjusted gross income is less than $100,000, up to $25,000 of losses can be deducted each year to offset income such as your salary. As your income increases between $100,000 and $150,000, the $25,000 allowance disappears. However, passive losses you aren't able to deduct can be stored up and used to offset taxable profit when you decide to sell your second home.

Tax-Free Profit

Tax laws allow you to take up to $500,000 profit ($250,000 if you are unmarried) tax free on the sale of your primary residence. This primary-home sale exclusion does not apply if you sell your second home: If you sell a house that is not your primary residence, you may have to pay the usual capital gains tax. However, if you make the second home your primary residence for at least two years before you sell it, you may be able to reap some tax benefits. This actually isn't as far-fetced as you may think, however, it is not as lucrative as it used to be either. Some retirees, are selling the big family home and moving full time into what had been their vacation home.

Once you live in that home for two years, up to $500,000 of profit could be tax free, including appreciation in value during the years it was your second home. Any profit attributable to depreciation while you rented the place, though, would be taxable. Depreciation reduces your tax basis in the property and, therefore, increases profit dollar for dollar. Congress recently cracked down on this break, though, stating if you use the property after 2008 for purposes other than your principal residence, part of the eventual gain on the sale won't be eligible for the $500,000/$250,000 exclusion. Regardless of whether the seller meets the two-year ownership and use tests. The portion of the profit that is subject to tax is based on the ratio of time after 2008 when the house was a second home or a rental unit to the total time you owned it.

Posted on April 9, 2015 at 9:07 pm
Tina Chapman | Category: Tina's Blog

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