updated for tax year 2020
Here is a detailed explanation of how to take advantage of these available deductions*:
If you use the property as a second home—rather than renting it out—interest on the mortgage is deductible within the same limits as the interest on the mortgage on
your first home.
You can write off up to $750,000 of debt secured by your first and and second homes for loans originated after December 16, 2017. For loans prior to this date, the limit is $1 million.
You can deduct property taxes on your second home, too. In fact, unlike the mortgage interest rule, you can deduct property taxes paid on any number of homes you own. However, the total of all state and local taxes deducted, including property taxes, is limited to $10,000 per tax return.
IF YOU RENT YOUR PROPERTY
Lots of second-home buyers rent out their property part of the year to get others to help pay the bills. Very different tax rules apply depending on the breakdown
between personal and rental use. If you rent the property out for 14 or fewer days during the year, you can pocket the rental income tax-free. Even if you’re charging $5,000 a week, it is still tax free. The house is considered a personal residence, so you deduct mortgage interest and property taxes under the standard rules for a second home.
LONGER RENTALS MEAN DIFFERENT RULES
Rent for more than 14 days and you must report all rental income. You also get to deduct rental expenses, and that gets complicated because you need to allocate costs between the time the property is used for personal purposes, and the time it is rented.
CONSIDER THIS EXAMPLE
If you and your family use a beach house for 30 days during the year and it’s rented for 120 days, 80 percent (120 divided by 150) of your mortgage interest
and property taxes, insurance premiums, utilities and other costs would be rental expenses. The entire amount you pay a property manager would be deductible,
too. And you could claim depreciation deductions based on 80 percent of the value of the house. If a house is worth $200,000 (not counting the value of the
land) and you’re depreciating 80 percent, a full year’s depreciation deduction would be about $5,800.
You can always deduct expenses up to the level of rental income you report. But what if costs exceed what you take in? Whether a loss can shelter other
income depends on two things: how much you use the property yourself and how high your income is.
YOUR USE CAN BE LIMITED
If you use the place more than 14 days, or more than 10 percent of the number of days it is rented—whichever is more—it is considered a personal residence and
the rental loss can’t be deducted. (But because it is a personal residence, the interest that doesn’t count as a rental expense—20 percent in our example—can
be deducted as a personal expense)
Why maintenance pays
If you limit personal use to 14 days or 10 percent, the vacation home is considered a rental property and up to $25,000 in losses might be deductible each year. That’s why lots of vacation homeowners hold down leisure use and spend lots of time “maintaining” the property.
Fix-up days don’t count as personal use. The tax savings from the loss helps pay for the vacation home. Unfortunately, holding down personal use means you have to forfeit the write-off for the portion of mortgage interest that does not qualify as either a rental or personal-residence expense.
We say such losses might be deductible because real estate losses are considered “passive losses” by the tax law. And passive losses are generally not deductible. But there’s an exception that might protect you.
If your Adjusted Gross Income (AGI) is less than $100,000, up to $25,000 of such losses can be deducted each year to offset income such as your salary. (AGI is basically income before subtracting your exemptions and deductions.) As income rises between $100,000 and $150,000, however, that $25,000 allowance disappears. Passive losses you can’t deduct can be stored up and used to offset taxable profit when you ultimately sell the vacation house.
Tax-free profits – Great Strategy
Although the rule that allows home sellers to take up to $500,000 of profit tax-free (up to $250,000 if you’re unmarried) applies only to a sale of your principal residence, there is a way to extend the break to your second home: make it your principal residence before you sell. That’s not as wacky as it might sound. Some retirees, for example, 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, part of the $500,000 (or $250,000) of profit can be tax-free. 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.
TurboTax Deluxe Edition makes it easy to maximize the tax benefits of mortgage interest, property taxes, owning rental property, tax-free profits and more.
Dreamlifer Case Study
by Clay Adams
To illustrate this last point further, I give you a real world example of one of our Dreamlife clients. We’ll refer to her as JN. JN’s family sold the family farm to a developer, and because there was a rental property on the farm she was able to “exchange” (i.e. sell the farm, and with the proceeds, buy three condos her favorite ocean front building in Myrtle Beach). This was done through a 1031 like kind exchange. If she doesn’t do this she will have to pay many, many thousands of dollars in capital gains tax. So then she puts the three condos on a rental program and rents them out for a few years. When she decides to retire to Myrtle Beach she moves into one of them. She lives in that condo for two years sells that condo tax free based on IRS Section Code 121C and moves into one of the other condos. Then two years later she sells that condo tax free using the same method and moves into the third cono. Then after two years when/if she sells that one, she will be able to sell it tax free. So all the taxes that she was going to have to pay by the sell of the family farm ended up being a non-taxable event.
Now you may not be selling the family farm, but you could sell one of your rental properties tax free by doing the same thing or as mentoned before, buy a beach condo in Myrtle Beach for rental and later move into it when you retire. Live there a couple of years and sell it tax free.
There are all kinds of possibilities. Have fun with it.
*Information provided by Intuit.com. Please see your tax adviser for verification.