The month of April has arrived and tax season is in full swing. If you are waiting on a big refund, congratulations! If, on the other hand, you ended up owing the IRS a few bucks this year, we feel for you.
And if you haven’t even started thinking about your tax return yet, don’t worry, because you are definitely not alone!
One of the most often overlooked areas of income tax returns involves the tax treatment of second or vacation homes. Even the simplest differences in how you define these properties can make a huge impact on your personal return each year, so let’s dive in and take a look at some of the things that you should definitely be aware of. (Keep in mind: We are not your attorneys or tax advisors, and this is not legal or tax advice. Talk to the advisors of your choice to find out what is right for you.)
Renting the Home
The biggest decision, by far, with any second home or vacation home is whether or not to rent out the home while you are not using it.
Sites like HomeAway and AirBnB have made it incredibly easy to earn some extra income from your properties, but you want to make sure you also understand the tax implications.
As a general rule, 14 days is the amount of time that the IRS cares about. If you rent the home for 14 days or less during the year, they really don’t want to know about it.
But when you cross that 14 day barrier, the IRS considers the home a rental, meaning you are required to report any income received and you can start writing off expenses.
If the second house is not going to be used as a rental, then you can deduct mortgage interest from your taxes. Of course, like any good tax break, there is a cap involved: you can only deduct the interest paid on mortgage balances up to $1.1 million in total for both your primary residence and the second home.
On the other hand, if you choose to rent the property while you are not using it, you can prorate the mortgage interest proportionally to the amount of time the property is rented and deduct that as a rental expense.
Property taxes are another area where you can find a tax break pretty much no matter what you choose to do with the property.
If you use it primarily for personal use, you can deduct the property taxes on your personal taxes. If you use the property primarily as a rental, you can deduct the property taxes as a rental expense.
Improvements & Maintenance
One of the most popular reasons for positioning a second home as a rental is that it gives you the ability to write off any money spent on improvements and maintenance against the rental income.
This is something you just can’t do with a personal residence, but there are also limits to the amount of expenses you can have relative to the amount of income you receive from renting the property.
Profit on Selling the Home
Another thing that you definitely want to consider is how you will be affected if the second home appreciates in value and you choose to sell it for a profit.
Whether it is primarily a rental property or a vacation home, you will have to pay capital gains taxes on your profits.
However, if the home becomes your primary residence for a period of two years before selling you can avoid having to pay those capital gains taxes.
Ownership of the Home
It’s also important to consider how adding another home to your net worth could impact your estate planning. It is possible that an additional asset like a vacation home could place you into a higher tax bracket that could really take a significant chunk out of the inheritance you plan to pass on to your heirs.
While there are plenty of pros and cons to either renting out your second home or keeping it strictly as a personal vacation home, the best way to get a full understanding of what will be the best fit for your situation is to talk with your accountant, lawyer, and estate planner to discuss all of the possible ramifications before you commit to anything.