This time of year, many people’s thoughts turn to second homes and vacation homes. Some return from a winter vacation and think about buying a place in that location to spend a month or more in the winter. Others think about a summer place. Many times, these second homes are intended as an eventual retirement home.
There are many factors to consider before buying a second home, and the income tax treatment is one of the more important. Good tax planning can increase the affordability of a second home.
When you don’t plan to rent the home, the tax treatment is simple. You can deduct mortgage interest and real estate taxes on Schedule A as itemized expenses. The mortgage interest is deductible when the mortgage was taken out to acquire or substantially rehabilitate the home. Also, the balance of the mortgages on your first and second homes can’t exceed $1 million. Interest on mortgage balances above $1 million can’t be deducted. Also, interest on home equity loans up to $100,000 can be deducted.
Often, owners of second homes want to rent the property at least part of the time to generate some income. In that case, the first thing you need to do is determine its tax basis, because that determines depreciation deductions.
When a property is newly purchased for rental, the depreciation basis is the cost. When a property was held for personal use for a while and then converted to a rental property, the depreciation basis is the lower of the current market value or the original cost plus the cost of any improvements. If the property appreciated since you purchased it, the cost is the depreciation basis. If the property declined in value, then current value is the depreciation basis. When the value declines, you need an appraisal to establish the depreciation basis.
In either case, you have to establish separate bases for the building and any land, because land isn’t depreciable.
Let’s look now at the tax rules when the property is rented full time and you make little or no personal use of it.
When you rent a property full time, the deductions for interest and real estate taxes move from Schedule A of your income tax return to Schedule E. On Schedule E you report the rental property as a separate business. You report all the rental income and deduct the expenses of owning and maintaining the property.
Deductible expenses on Schedule E include mortgage interest, property taxes, homeowners’ association fees, insurance, any property management fees, maintenance and repairs. You also can deduct the cost of traveling to the property to look after it when those costs are reasonable in relation to the value of the property and rental income. You can’t deduct capital improvements that increase the value of the property or extend its useful life. These are added to the depreciation basis.
The tax code allows a residential rental building to be depreciated on a straight-line method (equal annual deductions) over 27.5 years. You divide the basis of the property by 27.5 to determine the depreciation, or you can use a table that is in free IRS Publication 946.
When your rental property generates net taxable income, it’s taxed as ordinary income. When there’s a tax loss, you might be able to deduct that loss against other income. Because of the depreciation deductions, a rental property is likely to generate a tax loss.
Rental real estate losses are “passive losses” in the tax code. When your adjusted gross income (AGI) is $100,000 or less (the limit is the same whether you are single or a married couple filing jointly), you can deduct up to $25,000 of rental real estate losses each year against other income. The $25,000 allowance is phased out as AGI rises until it is eliminated at AGIs of $150,000 and higher.
When all or part of a loss isn’t deductible because of the income limit or $25,000 annual limit, the loss is suspended and carried forward to the future. It can be deducted against future passive income you earn or against any income when you dispose of the property. Passive income in this context doesn’t include income from portfolio investments, such as stocks, bonds and mutual funds. Passive activities tend to be businesses and partnerships in real estate, oil and gas, and the like.
The losses aren’t suspended when you qualify as a real estate professional. You can deduct the real estate rental losses against other income in an unlimited amount when you’re a professional. To qualify, you need to spend at least 50% of your work time working in real estate businesses and spend at least 750 hours a year in those businesses. The rules are detailed and complicated and require you to account for your hours. If you want to qualify as a real estate pro, be sure to plan with a good tax advisor.
Now, suppose instead of renting the home full time you use it yourself part of the time and rent it part time. That complicates the tax picture, because you have to pro rate the expenses between the personal use and rental use.
First, if the home isn’t rented for more than 14 days a year, you keep the rental income tax free. You treat the property as though it were only a personal use property. There have been several attempts to change this provision, but for now it still is in the law.
You need to keep a log of the number of days the home was rented or available for rent and the number of personal use days. Personal use days include days you allow friends or relatives to use the home for less than fair market rent. Personal use days don’t include days when you were at the property primarily to maintain or repair it for rental.
Then, you pro rate the expenses between personal use and rental use. The rental use portion of expenses is deducted on Schedule E. For the personal use portion, the mortgage interest and real estate taxes are deducted on Schedule A. The rest of the personal use expenses aren’t deductible.
There’s one more twist. When your personal use is more than the greater of 14 days or 10% of the total days it is rented to others at a fair market rental, then your expenses on Schedule E can’t exceed the rental income for the year. The excess expenses can be carried forward to future years.
Keep in mind that depreciation deductions really are only a loan or deferral of taxes. Depreciation deductions reduce the property’s tax basis. That increases the amount of your gain when the property is sold. Also, depreciation deductions are recaptured as ordinary income when the property is sold. That portion of your gain isn’t taxed as longterm capital gain.
When you have questions about the details of these issues, go first to the free publications on the IRS web site at www. irs.gov. You can find the basics in Publication 17, Your Federal Income Tax. Publication 527 covers Residential Rental Property. Publication 925 details Passive Activity and At-Risk Rules while Publication 946 explains How to Depreciate Property. Also read the instructions for Schedule E and Forms 4562 and 8582.