Over the past 50 years, the American Dream of home ownership has changed considerably, including the addition of second homes or vacation properties. While their owners are saving up time for the next vacation—and paying the mortgage and property taxes—these lakeside cottages, mountain chalets, and beach huts frequently sit empty for 90% of the year.
Of course, you can rent out your vacation house to others who want to take a break from work instead of letting it sit empty when you can’t be there. Although renting can be profitable, you must think about the tax repercussions.
If you seek to rent out your second home for the remaining period while residing in it for less than two weeks, the IRS will classify it as an investment property.
Only the income from other rentals, a private partnership that you do not manage, or an S-corporation may be used to offset rental losses.
What capital gains taxes you pay depends on how long you’ve held a vacation house.
Start actively managing your second house if you have an AGI under $150,000 and own it with the intention of renting it out.
How to Pay for a Second Home
A significant financial commitment is making the decision to purchase and maintain a second home. A second home has all the expenses of your first home—and frequently more—but none of the simple IRS tax deductions.
One of the initial decisions you must make when thinking about purchasing a second home is whether you will finance it with a mortgage or pay cash. Use a mortgage calculator to compare interest rates offered by lenders in the region where your vacation property is located in order to make a decision. Examine your finances to see whether taking out a mortgage or paying cash makes more sense after gathering estimates of the entire cost of your monthly mortgage payments.
Be aware that the IRS has closed the loophole that allowed you to use a second mortgage to buy a separate investment property while still being able to deduct your payments as personal mortgage interest if you are determined on buying a vacation house but lack the funds for an all-cash purchase. You must take out a new mortgage with tax-deductible interest if you want to borrow money for a second house.
According to the National Association of Home Builders and the Census Bureau, there are 5.6% of all residences in the US that are eligible for the second home mortgage tax deduction.
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Investments in Vacation Homes and the IRS
You are exempt from reporting the revenue if you own a home and rent it out for fewer than 15 days. If you seek to rent out your second house for the remainder of the time after spending less than two weeks there, the IRS will classify it as an investment property. It’s vital to keep in mind that the peak times—when you would likely want to use the property yourself—may be the only times when demand for your cabin in the woods occurs.
The IRS seems to have a problem with second houses. “Passive losses” or “hobby losses” refer to all rental losses. Only revenue from other passive activities, such as other rentals, a private partnership that you do not help run, or an S-corporation, may be used to offset these expenses. Unused passive losses are carried over until the vacation house is sold. You can use the previous losses to offset any gains when you sell the property. After the sale, you can deduct any subsequent passive loss write-offs from your ordinary income.
According to the IRS’s most recent advice for the 2020 tax year, you may be able to deduct up to $25,000 annually if:
- Your gross adjusted income is under $100,000.
- You actively take part in the property’s management.
Despite the fact that most persons who can afford to buy a second house will have an AGI considerably beyond these amounts, this tax advantage ends at $150,000 in adjusted gross income (AGI). Your AGI must fall between the range of $100,000 to $150,000 to qualify for the deduction. The hardest thing is actually participating. If you or your spouse desire to become a licensed real estate professional and actively manage the property while reporting the passive losses, you can claim the annual deduction.
But beware—the IRS is unlikely to think you work a full-time job and manage properties on the side. To support your claim and claim the deduction, you will need a thorough journal detailing why, when, where, and what you are doing as a property manager.
The majority of people who own second homes would be better off having them taxed as mixed-use properties and only using them for the 14 tax-free nights each year.
A Vacation Home for Sale
You might wish to cash out and sell your property at some point because properties in well-liked vacation spots typically tend to appreciate more quickly than normal. Your capital gains tax depends on how long you’ve owned your holiday home. The short-term capital gains rate will apply if you sell before a year has passed. Your federal tax will be assessed at the long-term capital gains rate if you sell after a year.
If you are prepared to entirely relocate, you can however pull off a small dodge. You can use the $250,000 ($500,000 for couples) exemption again if you sell your primary residence while taking advantage of the tax-free deduction of $250,000 per person and relocate into the vacation home, claiming it as your new primary residence for two years.
Unfortunately, this tactic frequently only works for retirees or independent contractors. The capital gains exclusion for second homes that have been turned into principal residences is also subject to additional limitations.
According to the most recent data for 2020, about 54% of Americans have life insurance.
The best course of action may be to become actively involved in managing your own property if you decide that you want to start renting out second homes and your AGI is less than $150,000.
Advice for Second-Time Homeowners
If you have a second house that you intend to rent out and your AGI is less than $150,000, get involved and start managing it. This implies that you won’t be able to find tenants through a leasing agent. Although you will be manually organizing repairs, you will be able to deduct passive losses as a result.
Spend more time at the cabin and convert it into a mixed-use property rather than an investment property if active management doesn’t appeal to you or if your AGI is too high. Because of the change in categorization, the tax consequences have changed, most notably the inability to deduct passive losses. However, you will be able to deduct a portion of your property taxes and mortgage interest from your taxable income.
