Second Homes & Tax Implications

Many people dream of owning a mountain cabin or beach house. Wouldn’t it be nice to have a place for family and friends to gather for vacation each year or a second home to spend winters once you retire? Before you make that purchase, you may want to consider the possible tax implications.

Property Tax & Mortgage Interest

Obviously, owning two homes means two property tax bills. But, did you know that deducting state and local taxes paid, which includes property taxes, is limited to $10,000 and is only available for taxpayers who itemize their deductions? Most wealthy taxpayers reach the $10,000 limit based on their state income taxes paid, personal property taxes, and the real estate taxes paid on their primary residence.

The mortgage interest paid on a second residence used personally is deductible as long as the mortgage satisfies the same requirements for deductible interest as on a primary residence. The total amount you can treat as home acquisition debt on your main and second home is limited to $750,000; or $375,000 if married filing separately. Just like property taxes, deducting mortgage interest is available only if you itemize. You should consult your tax advisor prior to purchasing the vacation home to determine if you can deduct the additional property taxes and mortgage interest.

Deductible Income Tax Expenses

If you plan to purchase a second home and use it only for personal use, the tax deductions associated with the property are similar to your primary residence. You may be able to deduct the mortgage interest and property tax if you itemize your deductions on your personal return. However, if you plan to rent the home out, there may be some added tax advantages.

Limiting your personal use days to the greater of 14 days or 10% of the rental days allows you to deduct expenses like mortgage interest, property taxes, utilities, maintenance, and improvement costs to the property, similar to how expenses are deducted on other rental properties. It’s important to note that personal use includes vacation use by your relatives (even if you charge them market-rate rent). If you rent the property out for 14 days or less during a year, then the property isn’t treated as rental property. Rent received on the property isn’t included in income, but your deductions are limited to mortgage interest and property taxes subject to limitations, just like your primary residence.

Capital Gains Tax

A final tax to consider before purchasing a second home is capital gains tax – the tax you pay when you sell the property. If you sell your primary residence, you typically don’t pay any capital gains tax. Single homeowners can exclude gains up to $250,000 on the sale of a home, or $500,000 for those married filing jointly. Because second homes are considered an investment, they are taxed at the current capital gains rate and don’t qualify for the capital gains exclusion applicable to primary residences. Depending on your income, this could mean paying a tax as high as 23.8% on the profit from the sale of your vacation home.

If you own the home for less than a year, then the gain is treated as a short-term capital gain, which is taxed at ordinary income tax rates. When contemplating the sale of a second home, it might be wise to make it your primary residence for a period of time. If you live there for two of the five years prior to the sale, you may avoid paying the capital gains tax.

Record Keeping

You need to keep good records to report your rental income and expenses on your tax return. Keep receipts, canceled checks, or bills, and track any travel expenses you incur for rental property repairs. You may be subject to additional taxes and penalties if you’re audited and can’t provide evidence to support your return.

The purchase of a second home is an exciting experience, but the complexities of these transactions and potential tax implications should involve expert guidance. When making this critical decision, you should always consult with a tax professional and/or financial advisor.

Our team of professionals at Central Trust Company can assist with tax planning, investments, retirement planning, estate planning, and more. We have several CPAs, attorneys, and Certified Financial Planners^TM on staff to assist with all your financial needs.