Second-home is a term commonly used when it comes to taxation. There are tax breaks that second-home owners can get while investors cannot. A second home can be defined differently depending on who you ask — if you ask a mortgage lender, real estate agent, and a tax attorney to define it, you will likely get different answers.
Generally, a property is seen as a second home if you visit at least 14 days in a year or use it at least 10% of the days it is rented out. Most homeowners rent out their second homes, but rental and personal use affect taxes differently. For instance, the IRS has set a clear distinction between investment properties and second homes. When paying your taxes, it is vital to know this to avoid any confusion.
Understanding Tax Laws Regarding Second Homes
As mentioned, a second home is simply a personal residence where you stay part of the year. The house remains empty or can be rented for the rest of the time. To enlighten you on how second homes work, here are common characteristics of such properties:
- Purchased after the primary residence is paid off: In most cases, buyers purchase a second home for retirement purposes or enjoy a vacation in a different country. This means the personal residence is usually paid off first before purchasing the property. However, it is not required by law for the private residence to be paid off before buying a second home.
- Far away from the primary residence: Second homes or vacation homes are mostly located in another state or city. In fact, it is a requirement by some mortgage lenders that a second home be at least 50 miles from the first primary residence. If that is not the case, it could be considered an investment property, and you will pay more taxes.
- Has tax benefits for owners: You will enjoy tax benefits when you reserve your second home for family use only rather than renting out to guests. You can pay less of your second home’s property taxes and mortgage interest like your primary residence. This makes it less expensive to own a second home.
Tax Benefits of Second Homes
You will enjoy several tax benefits when you own a second home. However, this will depend on two vital factors: how much money you are taking in rent from tenants and whether you are living in your second home. Here are the specifics you need to understand regarding second home taxation.
Home Equity Interest Deduction
When you stay 14 days in a year, your second home is considered a residence. You might also write off the interest paid on such loans, apart from deducting mortgage interest. You need to meet specific requirements to qualify for mortgage loans. For instance, you must have a mortgage on your second home and use the home equity loan specifically for property modifications and improvements.
Mortgage Interest Deduction
If you rent out your second home for less than 15 days in a year, the second home is considered a personal residence. The property is eligible for itemized deductions like any other homeowner. This means that mortgage interest can be deducted up to $750,000 on the principal for any property you purchase after 2020. Remember that the rental income under the 15-day limit is also exempted. This means you don’t have to report your earnings to the IRS.
Property Tax Deduction
It is possible to deduct property taxes on your second home. However, if you take such tax deductions on your first home, you may not be eligible to claim another tax deduction for your second residence. For every tax return, there is a limit of $10,000. This is equivalent to $5,000 per person if you file and marry separately.
The Difference Between Second Homes and Investment Property
Knowing the difference between a second home and an investment property will help you understand how taxation works. The difference between them is that a second home is a property other than the primary home that you plan to live in for some time. On the other hand, an investment property is one which you will never live in.
While the term second home is widely used to refer to such properties, it is somewhat misleading. This is because you can have more than one home that is considered a second home as long as it meets the definition. With that in mind, the definition of a second home depends on who you ask. Here is how different professionals and organizations define a second home.
Lenders Definition
Lenders have their unique rules on which properties qualify for second home financing. While some lenders let you rent out the property for some time, others will not finance the property if you rent it at all. From a general point of view, it is easier to finance a second home than any other investment property. This is why lenders put in measures to ensure the property is going to remain your second home and not an investment property.
IRS Definition
The IRS has its definition of a second home. This definition is vital, especially for taxation purposes. You can consider a property a second home if it meets either of these two conditions:
- You stay in the house at least 14 days a year
- You use the house at least 10% of the days it is rented out
It is crucial to note that you must satisfy the conditions that result in the required number of days. For instance, if you rent out your second home for 200 days in a year, you need to personally use the property for 20 days for it to be considered a second home. If you use the property for less than the stipulated time, IRS considers it an investment property for tax purposes.
While you must use it for at least 20 days, it doesn’t mean the days have to be consecutive. For example, you can meet the 20-day requirement with two 10-day stays of four five-day stays. Any other combination can also work. Generally, this is how the IRS defines any residence. However, this definition doesn’t apply to primary residences. Instead, a more specific definition is used for taxation purposes.
Second Homes Mortgage Interest Deduction
You must be aware that mortgage interest is deductible on primary residences if the deductions are itemized. However, what you might know is that mortgage interest deduction can also apply to second homes. At the moment, the IRS lets you deduct the interest paid on as high as $750,000 in residence debt. This can apply to a secondary residence or primary residence.
It could also apply to home equity debt if the money you obtained was used to improve or renovate your primary or secondary home. Remember that mortgage deduction is not available for investment property mortgage interest. However, this amount can be deducted as a business expense to lower the rental income. You should also know that the mortgage interest deduction is an itemized tax deduction.
This means that you cannot use it if you claim the standard deduction. In 2019, the standard deduction stood at $12,200 for single taxpayers and $24,400 for married taxpayers. Unless your itemized deductions (including the mortgage interest) are higher than the corresponding standard deduction, you will not benefit from deducting mortgage interest on the secondary home.
Rental Properties Have Depreciation Deduction
Investment properties never qualify for the mortgage interest deduction. However, there is a unique tax benefit known as depreciation that most investment property owners take advantage of. If you are a second homeowner, you can also enjoy this tax benefit.
This benefit works in this way: when a business purchases an asset that has a finite useful life span, the business can deduct the cost of the asset over several years. For example, a $1,000 asset with a useful life of over five years can be deducted at an affordable rate of $200 per year. This is done until the entire amount has been written off.
The same rates apply when businesses buy real estate. The IRS allows investors to depreciate the cost of investment properties over a period of 27.5 years. For commercial properties, the period is 39 years. Therefore, if you purchase an investment property for $200,000, you will get a $7,273 annual depreciation deduction. This is the amount you use to offset the rental income.
Taxes On Rental Income
Whether your home is classified as an investment property or a second home, rental income is taxable. Luckily, there are several expenses you can deduct. Some of these expenses include;
- The interest paid on the mortgage. Remember that this will not apply if used the mortgage interest deduction. The general implies that you cannot take tax deductions for similar expenses. Once you take one, you cannot enjoy the other.
- Property taxes. You can also enjoy deductions in property taxes. The amount you pay for such expenses depends on how IRS defines your property. If it is an investment property, you are likely to pay more in taxes. However, if the IRS defines it as a second home, you could enjoy fewer property taxes.
- Operating expenses such as pest control, property management fees, and landlord-paid utilities. These amounts could be reduced significantly if you apply the depreciation deduction.
- The cost of any repairs you have made on the property over time. This could be the costs incurred in fixing the AC or renovating the premises.
One major difference is that while you deduct operating and maintenance expenses from all rental property income, you cannot deduct losses with a secondary home. Contrary to that, you can deduct rental losses on an investment property.
For example, if you take in $20,000 in rental income and spend $22,000 on maintenance in a year, you can deduct that $2,000 loss against the other income. This is not possible if you own a second home. Instead of deducting losses, you would simply report your taxable rental income as zero.
Conclusion
A second home has various definitions depending on who you ask. But generally, a second home is one which you stay temporarily for a short period. It is vital to know the taxation laws regarding second homes so that you prepare yourself financially. For instance, the IRS defines a second home as one in which you stay at least 14 days in a year. Remember that tax deductions vary from a second home to an investment property. Generally speaking, you will pay less tax for a secondary home than for an investment property.
