Tax Benefits & Second Homes
As you embark on buying your second home, the financial advice you receive can make your decision sane, secure and profitable. Your accountant or tax advisor should be a key part of your decision making once you have found the location you want. Here are some tips to discuss with your professionals:
To Rent or Not to Rent
Generally speaking, if you rent out your second home for less than 14 days a year, you do not have to report any rental income, and you can still deduct your mortgage interest and real estate taxes
(see below). If you rent it out for more than 14 days, you will need to report the income, and deduct expenses associated with renting on Schedule E, Supplemental Income and Loss. The Schedule E categories for deductions include advertising, cleaning, maintenance, insurance, management fees, repairs, mortgage interest, taxes, utilities, and depreciation. In general, if you use your second home for both rental and personal use, you prorate the expenses accordingly. You will want to keep very accurate records for your property, and always work with your accountant. Also, check out the IRS Publication 527, Residential Rental Property.
Personal Use Deductions
Personal use of your second home is when you use it as your home more than either 14 days or 10% of the total days it is rented to others at a fair rental price. If you only use your property for personal purposes and do not rent it out, you can take allowable expenses as itemized deductions on Schedule A. These expenses include the full amount of mortgage interest (for your first and second homes only), real estate taxes, and casualty and theft losses. For more information, talk to your accountant, and check out IRS Publications 936, Home Mortgage Interest Deduction.
Limits on Deductions
Generally, the amount of rental expenses deductible is limited to the amount of rental income. If, for example, the mortgage interest, real estate taxes, casualty and theft losses, and rental activity expenses (such as rental agency fees, advertising, etc.) create a rental loss, then other expenses such as depreciation, operating expenses (i.e., repairs, utilities, pest control) would no longer be deductible. If, on the other hand, you used an equity loan on your main personal residence to pay off the second home, this loan interest would be deductible on Schedule A and more of the rental expenses would be deductible on Schedule E. There are pros and cons to an equity loan, so be sure to discuss this option with your accountant.
Selling your second home
If you sell your second home, you will ultimately report capital gain or loss on Schedule D, Capital Gains and Losses. The basis of the property is reduced by the amount of depreciation you claimed previously. The rates on capital gains have been changing since 1997, so consult your tax advisor. One thing to check into is that if you sell your primary residence, and take your $250,000 (or up to $500,000) capital gains exclusion, and then move into your vacation home (and live there for 2 out of the past 5 years), you may be able to sell that home and take another $250,000 to $500,000 in capital gains tax free. For more information, check out IRS Publication 523, Selling your home.
*Tax regulations and laws change on a regular basis. Before buying or selling real property, be sure to obtain advice from your own tax or legal advisors for the most current laws and regulations.