Tax Implications of a Vacation Home or Rental

Having a second home can be a delight for you and your family. If you live in the city but have a favorite place where you like to spend time—such as the beach, a lake, or a mountain you love to ski—buying a vacation home there can provide a much-needed respite. Or if your main home is in the country, perhaps you want an urban pied-a-terre for when you need to stay in the city for work.

Fortunately, there can be significant tax benefits when you have a second home—the definition of which may include some boats and recreational vehicles, as well.

The tax implications of a second home depends primarily on how you use it: as a personal residence, a rental property, or a mix of both.

Almost by definition, you're not using a second home all the time. Maybe it's your primary home for part of the year and you live elsewhere in the summer. Or perhaps you, and your family and friends, use it as a vacation spot for part of the year. So long as you don't rent it, the property will be treated as a residence and the tax reporting can be fairly straightforward.

There are two main deductions available to you, but to get these deductions you must itemize on your tax return (as opposed to taking the standard deduction):

• Mortgage interest: As a homeowner, you can deduct interest paid on up to $750,000—$375,000 for married filing separately—in mortgage debt. (The limit for debt taken out before December 15, 2017, is $1 million.) That limit applies to your mortgage debt from your primary and secondary residences combined.

  Unfortunately, if your two mortgages exceed the deductible debt limit you don't get to choose to apply the deduction to the loan with the higher interest rate. Your interest deduction will basically be prorated over the two properties.

• Property taxes: You may also be able to deduct up to $10,000 for state and local taxes, including taxes on income and real estate taxes. As with the mortgage deduction, the limit applies to the property taxes you pay on your primary residence and second home combined.

If you rent out the second home, tax filing can start to get a bit more complicated. The IRS has certain use guidelines that can help determine which tax reporting rules apply to a property that has been rented. Ask yourself:

How often did I use the rental? Did you, or your friends and family, use the property for more than 14 days or a number of days equal to 10% or more of the time the property was rented during the year? Whichever total amount of days is greater will count.

• If no, then the second home will likely be considered a rental and not a residence. That means all income and deductions (aka. expenses) for the rental will be reported in a Schedule E on your tax return.
• If yes, then the second home may be considered both a rental and a residence at the same time. In this case you may have to split your deductions between Schedule A and Schedule E. All rental income is reported on Schedule E.

If your second home meets the requirement of a rental, the income will be reported on Schedule E. Fortunately, you can deduct numerous expenses to help lower, or even wipe out, the tax bill from the rental income. Here are some of the most common expenses you may be able to deduct on your Schedule E:

• Mortgage interest and property taxes: Unlike itemized deductions, there is generally no limit on the mortgage interest and property-tax deduction for a rental property. 
• Operating and rental expenses: Rentals generate many expenses that can generally be deducted such as: advertising, cleaning costs, property management fees, maintenance, utilities, and insurance.
• Depreciation: The IRS allows a deduction for the wear and tear on rental properties, called depreciation expense. This deduction is taken over the property's useful life and is based on the purchase price and the cost of any improvements. But be aware, if you sell your rental, you may have to "recapture" that depreciation and pay up to a 25% tax rate on it.

If you do use your second home as a residence and rent it out for 15 total days or more, what you can or can't deduct gets a little complicated. In general, expenses such as utilities, insurance, and maintenance will be limited according to the percentage of time the home was used for personal versus rental use. The mortgage interest and property tax deduction will also be split this way, with some available as an itemized deduction on Schedule A and some counted as an expense against the rental income.

Often rental properties end up creating a net loss. In some cases, those losses many be able to offset some of your other income; however, be aware that there are numerous limits on the deductibility of rental losses. See IRS Publication 527 to learn more about your potential deductions and the limits that may apply to your rental property.

A second home can be a lovely retreat from daily life and a great place to gather family, but it can potentially create tax liabilities if you end up renting it. That's why we recommend working with a tax professional to help ensure you're making the right moves to take advantage of available real estate tax breaks.

Reach out to your financial or wealth consultant to see how buying a second home or investment property fits in your overall financial plan.