Owning a vacation home can bring a new level of fun and luxury to your life. It also brings additional complexities to your tax liability, which can impact you both while you own the house and when you sell it. Depending on how you structure your ownership, you could end up having your vacation house add to your overall tax burden.
The IRS allows you to write off the home mortgage interest that you pay on up to two houses. The rules for your second house are the same as for your first house. For the loan’s interest to be tax deductible, it must be secured by the property. Depending on your state, this means that the loan should have either a mortgage or a trust deed.
The IRS “gotcha” is that it applies the same deduction cap across both of your mortgages. The IRS lets you write off the interest on your first $1 million in home acquisition debt and on your first $100,000 in additional home equity debt. Home acquisition debt isn’t just the money that you borrow to buy the house, but also money that you borrow to improve, repair or remodel the house. Home equity debt is debt that you take out for any and all purposes.
Remember, though, that the cap applies against both properties. If you have an $800,000 mortgage and a $90,000 equity line on your first home and a $400,000 mortgage and a $60,000 equity line on your second home, you’ll only be able to deduct the interest on half of your second home’s mortgage and only on one-sixth of its equity line. This happens because $200,000 and $10,000 is all that is left in the home purchase debt and home equity debt caps after your first home’s two loans.
Property Tax Deduction
The IRS is much kinder to you when it comes to deducting property taxes. Your property tax deductions aren’t capped just because a home is a second — or tenth home, for that matter. You get to write them off along with your personal property taxes or your state income taxes. In this way, second homes have no tax disadvantage when compared to your first home.
Selling Your Vacation House
When you sell your primary house, the IRS lets you exclude the tax liability of $250,000 of the capital gain if you’re single or $500,000 of the gain if you’re married. So, as a married couple, if you buy for $400,000 and sell for $800,000, you pocket the entire $400,000 with no federal tax liability. Unfortunately, to qualify for the tax exclusion, you need to have lived in the home as your primary home for two of the past five years. You can also only claim the deduction once every two years.
If you don’t meet these rules, you’ll have to pay the same kind of capital gains taxes on a profitable sale of your vacation home that you would on a stock or bond sale. This strategy can work particularly well for retired couples.
House or Rental?
When your vacation home is a rental property, even part-time, the rules change completely. The IRS allows you to write off all of the home’s expenses to the extent that it’s used as a rental. If it’s a rental 90 percent of the time, you can write off 90 percent of the maintenance costs, 90 percent of what you pay for utilities, 90 percent of your management and advertising costs. The IRS even lets you claim a portion of its value as depreciation every year, further reducing your tax obligation. While you can also use the home yourself, if you occupy the home for more than 10 percent of the number of days in a year that it’s rented, you won’t be able to write off any losses that you incur from operating it.
If your vacation home is a rental, you could be eligible for a 1031 exchange, allowing you to use the proceeds to buy another investment property and defer your capital gains taxes. However, utilizing a1031 exchange on a property that you use both as a rental property and as a vacation home for personal use can be tricky so it’s best to seek professional help in that situation.
Your vacation home can be a ticket to family fun on the beach, at the lake or on the mountain. Financially savvy homeowners know how to use tax planning to help with the cost of ownership. Tax liability planning ultimately might be as important to a positive vacation home ownership experience as choosing the right property is!