If you’re thinking of buying a mountain home in Crested Butte or other vacation property, here are twelve tax tips to consider:
The Internal Revenue Service considers a vacation home or a second home one that is permanently in place (even though it could be moved, like an RV) and offers sleeping, cooking and toilet facilities. This would include not only a shore or lake home but a condo, co-op, mobile home, RV, house trailer, yurt or a yacht. It need not be fancy (a bare bones structure works) or located in a vacation area (somebody somewhere has to want a second home in Cleveland, right?). When you’re shopping around, keep in mind that you don’t have to have a Hamptons-style manse to take advantage of available federal tax breaks. It does, however, have to have a structure: bare land doesn’t count.
For tax purposes, you can deduct “qualified residence interest” on a mortgage secured by a second home – that’s in addition to interest that you pay on a mortgage that is your primary residence. It also applies to additional loans on a primary home or second home including a second mortgage, a line of credit, or a home equity loan. If you itemize your deductions on a Schedule A and you have a mortgage on a qualified home in which you have an ownership interest, you can deduct the interest you pay on that mortgage. The total amount of debt that you can use for purposes of calculating the home mortgage interest deduction for your main home and second home cannot be more than $1 million ($500,000 if married filing separately); some exceptions apply for grandfathered debt. You can bump the number up even more if you have qualifying home equity debt.
In addition to mortgage interest, local and state real estate taxes paid on a second or vacation home are also generally deductible.
You can also deduct personal property taxes payable on the value of personal property at your second or vacation home, including those taxes due on your yacht or other boats (that deduction is available if you itemize regardless of your living arrangements). Personal property taxes are imposed by state or local government on certain kinds of property like your cars or boats. In some states, it might also be imposed on recreational vehicles like snowmobiles, ATVs and jet skis; if so, those may be deductible. Note, however, that only personal property taxes are deductible on these items for federal income tax purposes and not your registration fees.
If the property is your own property and you never rent it out, you can claim those breaks (items #2-#4) but not the cost of upkeep of the property. As with your primary residence, home improvements are personal in nature and are rarely deductible (some exceptions apply).
If you rent out your property, you may be able to deduct some home improvement costs. To qualify, you must not personally use the home for at least 14 days or 10% of the number of days you rent it out at a fair rental price (letting your favorite cousin stay there on the cheap doesn’t count). Assuming that you meet the criteria, you don’t take the deduction for home mortgage interest on a Schedule A but rather you claim the expenses related to the property together with rental income received on a Schedule E. Those expenses may include mortgage interest, real estate taxes, casualty losses, maintenance, utilities, insurance, and depreciation – the total of those will reduce the amount of rental income that is taxed.
If your deductible rental expenses are more than your gross rental income, you will report a loss. Your rental losses, however, generally will be limited by the “at-risk” rules and/or the passive activity loss rules. Those rules can be tricky but here’s what you need to know: rental activities are almost always considered passive, even if you materially participate in them, unless you are a real estate professional.
What if you’re somewhere in between hanging at your home for relaxation and renting it occasionally? So long as you rent the property fewer than 15 days during the tax year, you are still allowed to take the deductions for the interest, taxes, and (if applicable) casualty and theft losses.Additionally, you do not have to include the rent you receive in your income, though you may not deduct the corresponding rental expenses.
If you use your vacation home for personal use and you rent it out for more than 15 days, you’ll pro-rate the income and the expenses according to the amount of time you (or your family) are at the property. You’ll report rental income and deduct rental-related expenses on your Schedule E and you’ll deduct the mortgage interest, property taxes, and casualty losses attributable to your personal use on your Schedule A.
What about using your second home as a workspace (and I mean more than checking your smartphone from the comfort of your hammock)? If you rent part of your home to your employer and provide services for your employer in the rented space, you would report the rental income on your Schedule E. You can deduct mortgage interest, qualified mortgage insurance premiums, real estate taxes, and personal casualty losses for the rented part but you cannot deduct any business expenses: that’s because you cannot use your home for profit (rental) and still take a deduction for its business use. If you opt not to collect rent, you may not deduct the related expenses and the “regular” rules for business expenses would apply, including the requirement that your home office be your principal place of business.
When you sell your vacation home, you will likely be subject to capital gains tax. There’s an exception if you convert your vacation home to your primary home: remember, however, that you must have owned and lived in the home as your primary residence for two of the five years prior to sale. The years don’t have to be sequential: you can live in the house in year one and in year five and still qualify. You can only claim the exclusion for one home at a time so if you sell your primary home and move into your vacation house for two years (and otherwise meet the criteria), you can take the exclusion on a subsequent sale. Whether to make that change solely for tax reasons may depend on a number of factors including the amount of the gain or loss (see #11 below).
What if the market turns sour on you? You can never claim a loss for the sale of a personal residence, no matter how much of a bloodbath you take. You may, however, claim a capital loss on investment property (assuming your vacation home as a rental qualifies) depending on the nature of the loss and whether you have offsetting gains.
So there you have it, a quick summary of what you need to know about buying a second home for vacation or for investment this summer… The rules can be tricky so be sure to check with your tax professional before making a move. For now, however, the sun is shining and summer is just heating up… get out there and enjoy it!
