Summer is here again and vacation is on everyone’s mind. While planning your holiday, you might begin thinking that perhaps you should just buy a second home rather than spend the money renting a beach house or staying in hotels. In the right situations, a vacation home can be a great thing; however, there are significant tax implications to consider. Below are a number of issues to be aware of when making your decision.
First, what qualifies as a vacation or second home? The answer might surprise you. The Internal Revenue Service considers any dwelling that has all three features of cooking, sleeping, and toilet facilities to qualify. This means a condominium, mobile home, or even a boat can count.
Generally, owning a second or vacation home allows you to deduct mortgage interest and real estate taxes. If you rent the property, you also may be able to deduct certain costs related to the care and maintenance of the home.
Tax breaks become tricky when you rent out a vacation home. There are basically three different tiers to consider. First, if you use the vacation home 100 percent for personal use, then you actually need never stay there to deduct the real estate taxes and mortgage interest. Second, if you use the home yourself and rent it out to others for 14 days or less during the year, then you do not need to include the rental income you receive on your taxes, but you can’t deduct rental-related expenses. You are still allowed to deduct the interest and real estate taxes, though. The third situation is where it gets more complicated.
If you rent out your vacation home regularly but do not personally use it for at least 14 days or 10 percent of the number of days you rent it out, then you are not allowed to take the deduction for all of the mortgage interest and real estate taxes on Schedule A. Instead, you report your rental income and claim a share of these expenses on Schedule E and the rest on Schedule A.
Another thing to consider with a vacation home is what happens when you sell it. In most situations, due to a combination of appreciation and basis reduction through depreciation, your property sale will most likely be subject to capital gains tax. Is there any way around this? The answer – as with most tax questions – is maybe.
Currently, homeowners are allowed to exclude up to $250,000 for a single filer or $500,000 for joint filers of gain on their primary residence. You can use this rule to avoid paying taxes on some of the gain of your vacation home if you can make it your primary residence before you sell.
On a former vacation home, a portion of the gain is ineligible for the home-sale exclusion, even if you meet the two-year residency test. The portion of the profit subject to tax is based on the ratio of the time after 2008 that the house was a second home or a rental unit to the total time you owned it. The mechanics of this are beyond the scope of this article, so you should consult your tax advisor before executing a specific strategy.