Understanding Tax Deductions for a Second Home

A common dream of most Americans is a 2nd vacation home.  Whether your dream vacation home is a hide away on a ski slope or a bungalow by the beach there are some deductions for taxes that can make owning a vacation home less demanding.  A vacation home is anything that has sleeping space, a toilet, and a kitchen.  This could make the purchase of nonstandard vacation homes a possibility, for example, a boat with those minimum qualifications could qualify as a home as could a mobile home. 

            Probably one of the biggest expenses in a vacation home would be the interest.  Most Americans think of deducting the interest on their primary home but most don’t realize that rule applies to your vacation home as well, with some caveats.  The first is that the loan must be for the acquisition of a home or home equity indebtedness.  An acquisition loan is a loan to purchase a primary home or vacation home.  Home equity indebtedness would be a traditional home equity loan taken out with your primary home securing the loan allowing you to buy a vacation home.  These requirements are pretty broad, but they do rule out a deduction for interest when using products such as signature loans, credit cards and other means of financing.  The second caveat that can catch a few people is the overall limit to the total loan amount.  Generally, the max amount of the combined loans cannot exceed $1 million.  The third is that if you rent out the second home for more than 14 days you must use the second home for 14 days or 10% of the rental days whichever is more.  Finally, this deduction is allowed only for 2 homes.  If you have a 3rd home, you cannot deduct the interest from that home in the same year as the other 2.  However, you are allowed to switch which home is considered as your second home to take advantage of the interest deduction which is more profitable for you on a year by year basis.

            What if you rent the 2nd home out?  About a quarter of vacation homes are rented to other people throughout the year.  For taxes, the IRS has created what is called the 14-day or 10% rule.  The way you divide time between personal use of your vacation home versus the amount of time you rent it is the key to determine your status in the eyes of the IRS.  If you rent your vacation home for less than 14 days a year you can pocket the income without declaring it to the IRS.  If you use the vacation home more than 14 days or more than 10% of the number of days the home is rented out, whichever is longer, it is considered your vacation or personal residence.  If you use it for less than 14 days or less that 10% of the time it is rented to others it is considered a rental property and you are considered a land lord.  These definitions determine the amount of expenses you can deduct and the income you have to declare.  If you are considered a land lord by the IRS by staying in your vacation home less than 14 days or 10% of the rented time you can operate the vacation home as a traditional rental.  Allowing you to take the usual deductions and depreciation of a rental property against the rental income received.   If your personal use exceeds the 14 day or 10% limit you are allowed to deduct up to the amount of the rental income received.  The IRS uses a broad definition of “personal” use.  This definition includes yourself and immediate family, parents, grandparents and grandchildren.  The IRS considers any day you rent the property for less than fair market value as a personal day, trading your vacation home to stay at another, and donating it for charitable use.  If you sell your vacation home, if you didn’t reside in it as your primary residence for 2 of the prior 5 years you will owe taxes on the gain.  If you have owned the property for 18 months or longer you will be eligible for long term capital gains treatment currently at 15%.  As is true with other real estate investments if you took depreciation on the property you will be subject to depreciation recapture currently at 25%. 

            There are two more considerations when owning a vacation home.  The first is that if you operate your property at a loss you can deduct up to $25,000 against your earned income.  Once your AGI exceeds $100,000 you are phased out of the ability to deduct the $25,000 against your earned income ultimately becoming ineligible at an AGI of $150,000.  This loss does not disappear however.  You can carry the loss forward to years where you are eligible to use it and if you sell your vacation property you can ultimately reduce your cost basis in the home by the amount of loss that has not been allowed.  Finally, you must actively manage the property.  The IRS generally considers a broad definition of what is active management.  So generally as long as you are making key decisions on the property such as approving tenants, rental terms, repairs and improvements you would be considered as being active.

            The tax advantages of a second home can make owning a vacation home less financially onerous.  Ultimately, while finances play a role in the decision, the only factor is not financial and is often more of a lifestyle choice.