If you own a second home or are planning to buy one, you should know how owning more than one home will affect your taxes. The IRS has specific rules relating to owning a second home, including rules about tax credits and deductions and how and when to report the rental income. The rules vary depending on if the property qualifies as a rental property or is considered a personal residence.
At CMP, we work with homeowners every day to ensure they understand their tax obligations as they relate to owning property. Continuing reading to learn what you need to know about owning or buying a second home.
What is Considered a Second Home for Tax Purposes?
The Internal Revenue Service allows for any home that is not your private residence to be considered a second home. The rules vary slightly depending on how you use your second home. For example, the second home mortgage interest deduction rules are different if you rent the property out for most of the year than they are if you don't rent it out at all.
Mortgage interest for a second home is deductible provided that it meets IRS requirements, which are the same as for your primary residence, and you use it for 14 days or 10% of the total time you rent it out, whichever is greater.
The amount of the deductible mortgage interest depends upon when you bought your second home. If you bought it before December 15, 2017, you can deduct interest up to a mortgage value of $1 million or $500,000 if married and filing separately. For homes purchased after December 15, 2017, the limit is $750,000 or $375,000 if married and filing separately.
If you rent out your second home for most of the year, you are required to report rental income on your tax return. You may also, in some circumstances, be required to pay the self-employed income tax if you provide extensive services to the people who rent from you. We go into detail about that requirement in a later section.
Tax Deductions on a Second Home
One of the most common questions we get at CMP is about tax deductions. When you file your tax return, you are entitled to certain tax deductions on your second home. The deductions you take depends upon how you use the home and whether you rent it for all or part of the year.
Mortgage Interest Deduction
The first tax deduction you may take for your second home is the mortgage interest deduction. As stated above, you qualify for the mortgage deduction if your second home meets the requirements and you live in it for the greater of:
- 14 days; or
- 10% of the time you rent it out at the fair market value
In other words, if you rent your second home out for 200 days a year, you would need to stay there for a minimum of 20 days to qualify for the deduction. If you don't rent it out at all, the requirement would be to stay there for a minimum of 14 days during the year.
As previously stated, the maximum mortgage amount to qualify for a deduction is $1,000,000 for married couples whose homes were purchased before December 15, 2017. The amount drops to $500,000 for married couples filing separately.
If you bought your home after December 15, 2017, then the maximum mortgage amount to qualify is $750,000 if married filing jointly and $375,000 if married and filing separately.
Real Estate Taxes
Homeowners have long been able to deduct property taxes on their federal tax returns. However, the rules changed with the Tax Cuts and Jobs Act of 2017 and the amount that is eligible for a deduction has been reduced.
The TCJA cuts off the deduction for property taxes at $10,000 per return -- $5,000 per return if married and filing separately. Many people who own two homes will max out the property tax deduction from their first home. That means that the property taxes for your second home will not be deductible.
It is important to note that some property taxes are not eligible for the deduction:
- Taxes are charged for local benefits and improvements that increase the value of the real property (examples include assessments for parking lots, sewer mains, water mains, and sidewalks.)
- Itemized charges for service, even if they are paid to the taxing authority. Examples include water fees or residential services such as trash and recycling.
Working with an experienced real estate tax accountant can help you determine which property taxes are deductible.
If you paid points to reduce your mortgage interest rate on your first home, you may be wondering if you can do the same for your second. The short answer is yes, but some rules dictate how the points may be deducted.
With a first home, the points can be deducted in the year you buy the home. If you paid $3,000 for points, you could deduct the entire amount in the tax year you bought the home.
For a second home, the points payment may still be deducted, but IRS rules state that the deduction must be spread out over the life of the loan. That means if you paid $3,000 and took out a 30-year mortgage, you could deduct only $100 per year. If you took out a 20-year mortgage, the annual deduction would increase to $150 per year.
If you rent out your property for part of the year, you may be able to deduct expenses related to the rental. The general rule is that if you rent out the home for fewer than 14 days per year, you are not required to report rental income, but you also may not deduct expenses related to the rental.
We've already mentioned the requirements, but if you rent out your property and live in it less than 14 days or 10% of the days you rented it, whichever is higher, you may deduct qualifying expenses on your income tax return. Qualifying expenses include the following:
- Mortgage interest (provided you meet the requirements listed above)
- Property taxes
- Insurance premiums
- Property management fees
- Depreciation of the property
Keep in mind that you may deduct expenses only for the time when the property was rented. If you rented it for 200 days and lived in it for 20 days, you must apportion the qualifying expenses you deduct between the rental time and your personal use of the property. Keeping meticulous records will minimize the risk of you making a mistake when you file your taxes.
Tax Rules When Renting Out Your Second Home
Owning a second home and renting it out to vacationers is a good source of passive income and offset some of the expenses of homeownership. However, you should know that with the addition of rental income, there is increased complexity when you file your taxes. Here are the rules you should know.
- You are not required to report rental income if you rent your second home for 14 days or fewer in a calendar year. This option is in place so that if you want to rent your home during an annual event, you don't need to worry about paying taxes on that income.
- If you rent your home for more than 14 days, you must report your rental income either as a landlord or as a self-employed person. The latter applies only if you provide what the IRS deems to be "significant services" to your tenants, including transportation, concierge service, cleaning, meals, entertainment, or tours.
- If your second home operates primarily as a source of rental income, you may deduct qualified expenses as listed above, including property taxes, insurance premiums, and property management fees.
It is important to note that if you spend time on your property making improvements, that time does not count as personal use of the property. That means if you plan to rent your second home for most of the year, you can stay there to make repairs and improvements without dipping into your personal use limit for rental deductions.
If you plan to use your second home as a source of income, we strongly recommend using an experienced tax accountant to ensure you take advantage of all tax breaks that are available to you.
Selling Your Second Home
Another common question we get from our clients at CMP has to do with selling a second home. People understandably have concerns about things like capital gains tax, which can significantly decrease your net profit from selling a home. Let's talk about what you need to know.
The rules about selling a home differ depending on whether the home is considered a personal residence, a vacation home, or a rental property. If you plan to sell your second home because the real estate market is good or you have made significant improvements, you should know how the sale will impact your taxes.
Under normal circumstances, selling a vacation home would require you to pay a capital gains tax on 100% of your profits. There are no tax breaks available for selling a vacation home or a rental property that generates income.
The alternative would be to use the vacation home as your primary residence before the sale. That would mean you would need to live there for two of the five years before the sale. If you do so, you will be eligible to deduct up to $250,000 in capital gains from your income. The number goes up to $500,000 if you are married and filing a joint tax return.
Another rule: if you plan to sell your second home- You cannot have sold another home for which you took the capital gains tax exclusion in the two years immediately preceding the sale of the property in question. In other words, if you owned more than two homes and had already used the capital gains tax exclusion on one home, you would need to wait at least two years before selling another home and taking the capital gains tax exclusion.
The other potential way to minimize or eliminate the capital gains tax you pay is simple. It is known as the 1031 exclusion. If you take the money you earned from the sale of your vacation home and use it to buy a similar property, you are not required to pay capital gains tax. You must identify the replacement property within 45 days and buy it within 180 days.
There are some conditions that you must meet to qualify for a 1031 exchange:
- You must have owned the property you are selling for at least two years.
- In each of the two, 12-month periods preceding the sale, you must have rented the property for at least 14 days.
- Your personal use of the property may not have exceeded 14 days per year or 10% of the days the home was rented at fair market value, whichever is higher.
- The replacement property must meet the same conditions as the property you sold, meaning that you must hold it for at least two years after the 1031 exchange, rent it for at least 14 days per year, and not use it for more than 14 days per year or 10% of the days the house was rented at fair market value.
As you can see, the rules are complicated and can sometimes be confusing. If not paying personal gains tax is a priority for you -- and it should be -- then you need to be mindful of how and when you use and sell the home to minimize your tax burden.
Maximize Your Tax Deductions with the Help from a Trusted Tax Pro
When you own a second home, filing your taxes can be complex and confusing. To ensure that you maximize your tax deductions, the safest bet is to get help from a trusted tax pro who has the knowledge and experience to assist you. Contact us today to learn how CMP can help!