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 on sites like airbnb. Though many people would never consider inviting renters into their vacation home, preferring to keep it for themselves and their family, doing so can defer some of your expenses and may even reap a tax benefit at the same time.
Whichever route you choose to go, knowing all of the applicable tax rules regarding designated second homes helps you get the maximum financial benefit out of your asset, and keeps you from making tax filing errors. Keep reading for some great tips about renting your vacation home and taxes!
If You Never Rent Your Property to Anybody
Depending upon your individual tax situation, a designated second home’s mortgage interest may be able to be listed on your itemized deductions. The big questions regarding eligibility to do this are what the combined acquisition debt is between your first and second homes, as well as what your equity debt is.
Taxpayers are permitted to deduct the interest on up to $1,000,000 of acquisition debt on their primary residence and one designated second home. As long as they are not subject to the Alternative Minimum Tax (AMT), they can also deduct the interest on up to $100,000 of equity debt real property taxes on your main and second homes are also deductible if you itemize deductions when figuring your regular tax, but not for the AMT.
If You Rent Your Property Out
The tax ramifications of renting out your designated second home are largely dependent upon the amount of time that it is rented: (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 the property for a period that is fewer than 15 days, you are able to continue writing off your interest and taxes as if you never rented it out at all, and simply keep the cash on a tax-free basis. Keep in mind that even if you have incurred rental-related expenses such as post-rental cleaning, any fee charged by a rental agent, the cost of utilities or any other cost, they cannot be deducted because the income is being excluded. Being able to generate this kind of tax-free money can be extremely attractive, especially if your second home is in demand as a setting for gatherings or even for short-term television or film productions. The same rule applies to your primary residence as well.
- Personal Use Is Less Than the Greater of 15 Days or 10% of the Rental Days– In this scenario, the home’s use would be allocated into two separate activities: a rental home and a second home. Let’s say that the home is used 5% for personal use; 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 between $100,000 and $150,000 of AGI. 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. If, after deducting the interest and taxes, there is still a profit, 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 take depreciation, but it is again limited to the remaining profit. End result: No loss is allowed, but any remaining profit is taxable. The other personal 20% of the interest and taxes is deducted as an itemized deduction, subject to the interest 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 deductible 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 to be a property for your personal use, and 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.
When you sell your primary home, you are able to take advantage of what is known as the home gain exclusion, but this is not true of designated second homes. The gain that is earned on 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 that two-year period 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 is able to 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.
There are certain situations involving designated second homes that are particularly complex, such as homes that are converted from an investment property to a primary residence, or when they were acquired by tax-deferred exchange. In these instances, it is essential that you consult with an experienced tax professional in order to ensure that all appropriate planning is done to provide you with the ability to gain the most benefit.
One Other Thing
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 is a good idea to review the tax impact of all of your real estate transactions with a TaxBuzz professional. We are here to provide you with the information you need to address your specific situation.
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